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Sonos Inc

2019-11-26

2019-09-28

Item 7. Management’s discussion and analysis of financial condition and results of operations You should read the following discussion of our financial condition and results of operations in conjunction with the financial statements and the notes thereto included elsewhere in this Annual Report on Form 10-K. The following discussion contains forward-looking statements that reflect our plans, estimates and beliefs. Our actual results could differ materially from those discussed in the forward-looking statements. Factors that could cause or contribute to these differences include those discussed below and elsewhere in this Annual Report on Form 10-K, particularly in the section titled "Risk Factors." We operate on a 52- or 53-week fiscal year ending on the Saturday nearest September 30 each year. Our fiscal year is divided into four quarters, each beginning on a Sunday and containing two 4-week periods followed by a 5-week period.References to fiscal 2019 are to our 52-week fiscal year ended September 28, 2019, references to fiscal 2018 are to our 52-week fiscal year ended September 29, 2018 and references to fiscal 2017 are to our 52-week fiscal year ended September 30, 2017. Overview Sonos is one of the world's leading sound experience brands. As the inventor of multi-room wireless home audio, Sonos' innovation helps the world listen better by giving people access to the content they love and allowing them to control it however they choose. Known for delivering unparalleled sound experience, thoughtful design aesthetic, simplicity of use and an open platform, Sonos makes the breadth of audio content available to anyone. Our sound system provides an immersive listening experience created by our thoughtfully designed speakers and components, our proprietary software platform and the ability to wirelessly stream the content our customers love from the services they prefer. We manage the complexity of delivering a seamless customer experience in a multi-user and open-platform environment. The Sonos sound system is easy to set up, use and expand to bring audio to any room in the home. Through our software platform, we frequently enhance features and services on our products, improving functionality and customer experience. Our innovative products, seamless customer experience and expanding global footprint have driven 14 consecutive years of sustained revenue growth since our first product launch. We generate revenue from the sale of our wireless speakers, home theater speakers and component products, as new customers buy our products and existing customers continue to add products to their Sonos sound systems. We have developed a robust product and software roadmap that we believe will help us capture the expanding addressable market for our products. We believe executing on our roadmap will position us to acquire new customers, offer a continuously improving experience to our existing customers and grow follow-on purchases. Our most recent steps in this direction occurred in October 2017, with the introduction of our first voice-enabled wireless speaker, Sonos One, in July 2018, with the introduction of our first voice-enabled home theater speaker, Sonos Beam. In fiscal 2019, we accelerated new product introductions including the introduction of Sonos Amp, Sonos Move, our first battery-powered, Bluetooth-enabled speaker for use both indoors and outdoors, Sonos One SL, and Sonos Port. Key metrics In addition to the measures presented in our consolidated financial statements, we use the following additional key metrics to evaluate our business, measure our performance, identify trends affecting our business and assist us in making strategic decisions. Our key metrics are revenue, products sold, adjusted EBITDA and adjusted EBITDA margin. The most directly comparable financial measure calculated under U.S. GAAP for adjusted EBITDA is net income (loss). In the fiscal years ended September 28, 2019, September 29, 2018 and September 30, 2017, we had a net loss of $4.8 million, $15.6 million and $14.2 million, respectively. Revenue We generate substantially all of our revenue from the sale of wireless speakers, home theater speakers and components. We also generate revenue from other sources, such as module revenue, the sale of Sonos and third-party accessories like speaker stands and wall mounts, as well as licensing revenue. Module revenue is comprised of sales of hardware and embedded software that is integrated into final products that are manufactured and sold by our partners. For a description of our revenue recognition policies, see the section titled "-Critical accounting policies and estimates." Products sold Products sold represents the number of products that are sold during a period, net of returns. Products sold includes the sale of wireless speakers, home theater speakers, components and module units. Products sold excludes the sale of Sonos and third-party accessories. Historically, the sale of other items has not materially contributed to our revenue. Growth rates between products sold and revenue are not perfectly correlated because our revenue is affected by other variables, such as the mix of products sold during the period, promotional discount activity and the introduction of new products that may have higher or lower than average selling prices. Adjusted EBITDA and adjusted EBITDA margin We define adjusted EBITDA as net loss adjusted to exclude the impact of stock-based compensation expense, depreciation, interest income, interest expense, other income (expense), income taxes and items considered to be non-recurring. We define adjusted EBITDA margin as adjusted EBITDA divided by revenue. See the section titled "Selected Consolidated Financial and Other Data-Non-GAAP Financial Measures" for information regarding our use of adjusted EBITDA and adjusted EBITDA margin, and a reconciliation of net loss to adjusted EBITDA. Factors affecting our performance New product introductions. Since 2005, we have released a number of products in multiple home audio categories. We intend to introduce new products that appeal to a broad set of consumers, as well as bring our differentiated listening platform and experience to all the places and spaces where our customers listen to the breadth of audio content available on demand today, including outside of the home. Accordingly, our future financial performance may be affected by our ability to drive cost of revenue savings as we scale production over time. Seasonality. Historically, we have experienced the highest levels of revenue in the first fiscal quarter of the year, coinciding with the holiday shopping season. For example, revenue in the first quarter of fiscal 2019 accounted for 39.4% of our revenue for fiscal 2019. Our promotional discounting activity is higher in the first fiscal quarter as well, which negatively impacts gross margin during this period. For example, gross margin in the first quarter of fiscal 2019 was 39.3%, compared to gross margin of 41.8% for all of fiscal 2019. However, our higher sales volume in the holiday shopping season has historically resulted in a higher operating margin in the first fiscal quarter due to positive operating leverage. Ability to sell additional products to existing customers. As our customers add Sonos to their homes and listen to more audio content, they typically increase the number of our products in their homes. In fiscal 2019, follow-on purchases represented approximately 37% of new product registrations. As we execute on our product roadmap to address evolving consumer preferences, we believe we can expand the number of products in our customers’ homes. Our ability to sell additional products to existing customers is a key part of our business model, as follow-on purchases indicate high customer engagement and satisfaction, decrease the likelihood of competitive substitution and result in higher customer lifetime value. We will continue to innovate and invest in product development in order to enhance customer experience and drive sales of additional products to existing customers. Expansion of partner ecosystem. Expanding and maintaining strong relationships with our partners will remain important to our success. We believe our partner ecosystem improves our customer experience, attracting more customers to Sonos, which in turn attracts more partners to the platform further enhancing our customer experience. We believe partners choose to be part of the Sonos platform because it provides access to a large, engaged customer base on a global scale. We look to partner with a wide variety of streaming music services, voice assistants, connected home integrators, content creators and podcast providers. To date, our agreements with these partners have all been on a royalty-free basis. As competition increases, we believe our ability to give users the freedom to choose across the broadest set of streaming services and voice control partners will be a key differentiating factor. Our product roadmap is largely focused on delivering products with voice control. Our ability to develop, manufacture and sell voice-enabled speakers that deliver differentiated consumer experiences will be a critical driver of our future performance, particularly as we compete in a larger market with an expanding number of competitors. We currently compete with, and will continue to compete with, companies that have greater resources than we do, many of which have already brought voice-enabled speakers to market. We are also partnering with certain of these companies in the development of our own voice-enabled products. Our competitiveness in the voice-enabled speaker market will depend on successful investment in research and development, market acceptance of our products and our ability to maintain and benefit from these technology partnerships. Channel strategy. We are focused on reaching and converting prospective customers through third-party retail stores, e-commerce retailers, custom installers of home audio systems and our website sonos.com. We are investing in our e-commerce capabilities and in-app experience to drive direct sales. Sales through sonos.com represented 12.2% of our revenue in fiscal 2019 and 11.5% of our revenue in fiscal 2018 and we believe the growth of our own e-commerce channel will be important to supporting our overall growth and profitability as consumers continue the shift from physical to online sales channels. Our physical retail distribution relies on third-party retailers, as our company-owned stores do not materially contribute to our revenue. While we seek to increase sales through our direct-to-consumer sales channel, we expect that our future sales will continue to be substantially dependent on our third-party retailers. We will continue to seek retail partners that can deliver differentiated in-store experiences to support customer demand for product demonstrations. International expansion. Our products are sold in over 50 countries and in fiscal 2019, 50.0% of our revenue was generated outside the United States. Our international growth will depend on our ability to generate sales from the global population of consumers, develop international distribution channels and diversify our partner ecosystem to appeal to a more global audience. We are committed to strengthening our brand in global markets and our future success will depend in part on our growth in international markets. Investing in product and software development. Our investments in product and software development consist primarily of expenses in personnel who support our research and development efforts and capital expenditures for new tooling and production line equipment to manufacture and test our products. We believe that our financial performance will significantly depend on the effectiveness of our investments to design and introduce innovative new products and services and enhance existing products and software. If we fail to innovate and expand our product and software offerings or fail to maintain high standards of quality in our products, our brand, market position and revenue will be adversely affected. Further, if our development efforts are not successful, we will not recover the investments made. Investing in sales and marketing. We intend to invest resources in our marketing and brand development efforts. Our marketing investments are focused on increasing brand awareness through advertising, public relations and brand promotion activities. While we maintain a base level of investment throughout the year, significant increases in spending are highly correlated with the holiday shopping season, new product launches and software introductions. We also invest in capital expenditures on product displays to support our retail channel partners. Sales and marketing investments are typically incurred in advance of any revenue benefits from these activities. Components of results of operations Revenue We generate substantially all of our revenue from the sale of wireless speakers, home theater speakers and components. We also generate revenue from other sources, such as module revenue, the sale of Sonos and third-party accessories like speaker stands and wall mounts, as well as licensing revenue. Module revenue is comprised of sales of hardware and embedded software that is integrated into final products that are manufactured and sold by our partners. Our revenue is recognized net of allowances for returns, discounts, sales incentives and any taxes collected from customers. We also defer a portion of our revenue that is allocated to unspecified software upgrades and cloud-based services. Our revenue is subject to fluctuation based on the foreign currency in which our products are sold, principally for sales denominated in the euro and the British pound. For a description of our revenue recognition policies, see the section titled "-Critical accounting policies and estimates." Cost of revenue Cost of revenue consists of product costs, including costs of our contract manufacturers for production, component costs, shipping and handling costs, tariffs, duty costs, warranty replacement costs, packaging, fulfillment costs, manufacturing and tooling equipment depreciation, warehousing costs, hosting costs and excess and obsolete inventory write-downs. In addition, we allocate certain costs related to management and facilities, personnel-related expenses and other expenses associated with supply chain logistics. Personnel-related expenses primarily consist of salaries, bonuses, benefits and stock-based compensation expense. Gross profit and gross margin Our gross margin may in the future fluctuate from period to period based on a number of factors, including the mix of products we sell, the channel through which we sell our products, the foreign currency in which our products are sold and tariffs and duty costs implemented by governmental authorities. We have historically seen that the gross margin for our newly released products are lowest at launch and have tended to increase over time as we realize cost efficiencies. In addition, our ability to reduce the cost of our products is critical to increasing our gross margin over the long term. Operating expenses Operating expenses consist of research and development, sales and marketing and general and administrative expenses. Research and development. Research and development expenses consist primarily of personnel-related expenses, consulting and contractor expenses, tooling, test equipment and prototype materials and overhead costs. To date, software development costs have been expensed as incurred, because the period between achieving technological feasibility and the release of the software has been short and development costs qualifying for capitalization have been insignificant. We expect our research and development expenses to increase in absolute dollars as we continue to make significant investments in developing new products and enhancing existing products. Sales and marketing. Sales and marketing expenses consist primarily of advertising and marketing promotions of our products and personnel-related expenses, as well as trade show and event costs, sponsorship costs, consulting and contractor expenses, travel, product display expenses and related depreciation, customer care costs and overhead costs. General and administrative. General and administrative expenses consist of personnel-related expenses for our finance, legal, human resources and administrative personnel, as well as the costs of professional services, any overhead, information technology, litigation expenses, patent costs and other administrative expenses. We expect our general and administrative expenses to increase in absolute dollars due to the growth of our business and related infrastructure as well as legal, accounting, insurance, investor relations and other costs associated with operating as a public company. Other income (expense), net Interest income. Interest income consists primarily of interest income earned on our cash and cash equivalents balances. Interest expense. Interest expense consists primarily of interest expense associated with our debt financing arrangements and amortization of debt issuance costs. Other expense, net. Other expense, net consists primarily of our foreign currency exchange gains and losses relating to transactions and remeasurement of asset and liability balances denominated in currencies other than the U.S. dollar. We expect our foreign currency gains and losses to continue to fluctuate in the future due to changes in foreign currency exchange rates. Provision for income taxes We are subject to income taxes in the United States and foreign jurisdictions in which we operate. Our provision for income taxes includes income tax in our foreign operations. Foreign jurisdictions have statutory tax rates different from those in the United States. Accordingly, our effective tax rates will vary depending on the relative proportion of foreign to U.S. income, the utilization of foreign tax credits and changes in tax laws. Deferred income taxes reflect the net tax effects of temporary differences between the carrying amounts of assets and liabilities for financial reporting purposes and the amounts used for income tax purposes. A valuation allowance is provided when it is more likely than not that the deferred tax assets will not be realized. We have established a full valuation allowance to offset our U.S. and certain foreign net deferred tax assets due to the uncertainty of realizing future tax benefits from our net operating loss carryforwards and other deferred tax assets. It is possible that within the next 12 months there may be sufficient positive evidence to release a significant portion of the valuation allowance. Release of the U.S. valuation allowance would result in the establishment of certain deferred tax assets and a benefit to income tax expense for the period the release is recorded, which could have a material impact on net earnings. The exact timing and amount of the valuation allowance release are subject to change based on the level of profitability achieved. Results of operations The following table sets forth our consolidated results of operations and data as a percentage of revenue for the periods indicated (percentages in the table may not foot due to rounding). The period-to-period comparison of financial results is not necessarily indicative of financial results to be achieved in future periods. (1) Amounts include stock-based compensation expense as follows: Comparison of fiscal years 2019 and 2018 Revenue Revenue increased by $123.8 million, or 10.9%, from $1,137.0 million for fiscal 2018 to $1,260.8 million for fiscal 2019, primarily due to the continued success of Sonos Beam and launches of Sonos Amp and our IKEA partnership. Products sold increased by 1.1 million, or 20.8%, from 5.1 million for fiscal 2018 to 6.1 million for fiscal 2019. The volume growth was primarily driven by sales of our newest home theater speaker product, Sonos Beam, which launched in July 2018, as well as by sales of our newest component product, Sonos Amp, which launched in November 2018. Wireless speakers continue to be the largest category and revenue in the category declined largely due to a volume shift from Play:1 to Sonos One speakers and the discontinuation of Play:3. Revenue growth from the sale of our home theater speakers was primarily driven by continued success of our Sonos Beam. Volume growth from the sale of our components was driven by sales of our new Sonos Amp, which was partially offset by a decrease in sales of our Connect:Amp, which was discontinued in fiscal 2019. Revenue from the Americas increased $74.8 million, or 12.4%, from $603.5 million for fiscal 2018 to $678.2 million for fiscal 2019. The increase in the Americas revenue was driven primarily by growth in sales of home theater speakers and components and partially offset by a decline in wireless speaker sales. Revenue from EMEA increased $6.3 million, or 1.3%, from $478.5 million for fiscal 2018 to $484.8 million for fiscal 2019. EMEA revenue increased due to growth in sales of home theater speakers and components and offset by a decline in wireless speaker sales. Revenue from APAC increased $42.8 million, or 77.7%, from $55.0 million for fiscal 2018 to $97.8 million for fiscal 2019. APAC growth was driven primarily by module sales associated with the launch of the IKEA relationship. In constant U.S. dollars, total revenue increased by 13.4% for fiscal 2019 compared to fiscal 2018, which excludes the impact of foreign currency fluctuations against the U.S. dollar. We calculate constant currency growth percentages by translating our prior-period financial results using the current period average currency exchange rates and comparing these amounts to our current period reported results. Cost of revenue and gross profit Cost of revenue increased $85.8 million, or 13.2%, from $647.7 million for fiscal 2018 to $733.5 million for fiscal 2019. The increase was primarily due to the increase in revenue, which increased 10.9%. Gross margin decreased to 41.8% for fiscal 2019 from 43.0% for fiscal 2018. The decrease was primarily due to product mix, unfavorable foreign currency impact and the launching of a new distribution channel, partially offset by product and material cost reductions. Research and development Research and development expenses increased $29.1 million, or 20.5%, from $142.1 million for fiscal 2018 to $171.2 million for fiscal 2019. The increase was primarily due to higher personnel-related expenses of $22.7 million as our headcount, particularly in software personnel, increased during the period as we focused on increasing the pace of new product introductions. Sales and marketing Sales and marketing expenses decreased by $23.3 million, or 8.6%, from $270.9 million for fiscal 2018 to $247.6 million in fiscal 2019 as we demonstrated improved operating leverage. The decrease was primarily due to decreases in personnel-related costs of $17.9 million driven by a decrease in headcount, and decreases in marketing and advertising costs of $7.7 million as we transitioned away from traditional paid media and we adopted more efficient direct-to-consumer and digital marketing tools. These decreases were partially offset by an increase in professional services fees associated with production costs of $4.1 million related to a new product launch campaign. General and administrative General and administrative expenses increased $17.7 million, or 20.7% from $85.2 million for fiscal 2018 to $102.9 million for fiscal 2019. The increase was primarily due to increases in personnel-related costs of $10.6 million, and professional fees of $4.8 million, as we continue to invest in personnel and programs to create the infrastructure necessary to support our operations as a public company. Other income (expense), net * not meaningful Interest income increased by $3.6 million, from $0.7 million for fiscal 2018 to $4.3 million for fiscal 2019, primarily related to interest income generated from both higher balances and increased investment yields. Interest expense decreased by $2.7 million, from $5.2 million in fiscal 2018 to $2.5 million in fiscal 2019, primarily due to the effect of reduced effective interest rate as a result of refinancing our J.P. Morgan Chase Bank, N.A. Secured Term Loan (the “Term Loan"). Other expense, net increased $7.5 million, from $1.2 million in in fiscal 2018 to $8.6 million in in fiscal 2019, due to foreign currency exchange losses. Provision for income taxes Provision for income taxes increased $2.6 million, from a $1.1 million provision for fiscal 2018 to a provision of $3.7 million for fiscal 2019. For the year ended September 28, 2019, we recorded a provision for income taxes of $1.2 million for certain profitable foreign entities and $2.5 million for U.S. federal and state income tax for a total provision of $3.7 million. We recorded a provision for income taxes of $1.1 million for certain profitable foreign entities for the year ended September 29, 2018. Comparison of fiscal years 2018 and 2017 For the comparison of fiscal years 2018 and 2017, refer to Part II, Item 7 "Management's discussion and analysis of financial condition and results of operations" on Form 10-K for our fiscal year ended September 29, 2018, filed with the SEC on November 28, 2018 under the subheading "Comparison of fiscal years 2018, 2017 and 2016." Liquidity and capital resources Our operations are financed primarily through cash flow from operating activities, net proceeds from the sale of our equity securities, including net proceeds of $90.6 million from the closing of our IPO on August 6, 2018, borrowings under our Secured Credit Facility with J.P. Morgan Chase Bank, N.A. (the “Credit Facility”) and the Term Loan. As of September 28, 2019, our principal sources of liquidity consisted of cash flow from operating activities, cash and cash equivalents of $338.6 million, including $26.5 million held by our foreign subsidiaries, and borrowing capacity under our credit facility. In accordance with our policy, the undistributed earnings of our non-U.S. subsidiaries remain indefinitely reinvested outside of the United States as of September 28, 2019, as they are required to fund needs outside the United States. In the event funds from foreign operations are needed to fund operations in the United States and if U.S. tax has not already been previously provided, we may be required to accrue and pay additional U.S. taxes in order to repatriate these funds. We believe our existing cash and cash equivalent balances, cash flow from operations and committed credit lines will be sufficient to meet our working capital and capital expenditure needs for at least the next 12 months. Our future capital requirements may vary materially from those currently planned and will depend on many factors, including our rate of revenue growth, the timing and extent of spending on research and development efforts and other business initiatives, the expansion of sales and marketing activities, the timing of new product introductions, market acceptance of our products and overall economic conditions. To the extent that current and anticipated future sources of liquidity are insufficient to fund our future business activities and requirements, we may be required to seek additional equity or debt financing. The sale of additional equity would result in additional dilution to our stockholders. The incurrence of debt financing would result in debt service obligations and the instruments governing such debt could provide for operating and financing covenants that would restrict our operations. Debt obligations Our debt obligations consist of the Credit Facility and the Term Loan. Our short- and long-term debt obligations are as follows: (1) Bears interest at a variable rate equal to an adjusted LIBOR plus 2.25% and is payable quarterly. Due in October 2021, with quarterly principal payments beginning in July 2019. (2) Debt issuance costs are recorded as a debt discount and charged to interest expense over the term of the agreement. The Credit Facility allows us to borrow up to $80.0 million restricted to the value of the borrowing base which is based on the value of our inventory and accounts receivable and is subject to quarterly redetermination. The Credit Facility matures in October 2021 and may be drawn as Commercial Bank Floating Rate Loans (at the higher of the prime rate or adjusted LIBOR plus 2.50%) or Eurocurrency Loans (at LIBOR plus an applicable margin). As of September 28, 2019 and September 29, 2018, we did not have any outstanding borrowings and $4.5 million and $4.5 million, respectively, in undrawn letters of credit that reduce the availability under the Credit Facility. Debt obligations under the Credit Facility and the Term Loan require that we maintain a consolidated fixed charge ratio of at least 1.0, restrict distribution of dividends unless certain conditions are met, such as having a fixed charge ratio of at least 1.15, and require financial statement reporting and delivery of borrowing base certificates. As of September 28, 2019 and September 29, 2018, we were in compliance with all financial covenants. The Credit Facility and the Term Loan are collateralized by our eligible inventory and accounts receivable as well as our intellectual property including patents and trademarks. Cash flows Fiscal 2019 changes in cash flows The following table summarizes our cash flows for the periods indicated: Cash flows from operating activities Net cash provided by operating activities of $120.6 million for fiscal 2019 was primarily due to non-cash adjustments of $89.5 million, and by a net increase in net operating assets and liabilities of $35.9 million, slightly offset by a net loss of $4.8 million. Non-cash adjustments primarily consisted of stock-based compensation expense of $46.6 million and depreciation of $36.4 million. The net increase in net operating assets and liabilities was primarily due to an $85.9 million increase in accounts payable and accrued expenses, primarily related to inventory purchases, an $8.2 million increase in accrued compensation primarily due to an increase in bonuses, a $7.1 million increase in other liabilities, and a $6.2 million increase in deferred revenue. The increase in net operating assets and liabilities was offset by a $32.1 million increase in accounts receivable primarily related to timing of receipts, as well as due to new customers, a $31.8 million increase in inventory related to our new products such as Sonos Move and Sonos One SL, and $7.6 million increase in other assets primarily related to an increase in prepaid expenses. Cash flows from investing activities Cash used in investing activities for fiscal 2019 of $23.2 million was due to payments for property and equipment, which primarily comprised of manufacturing-related tooling and test equipment to support the launch of new products, leasehold improvements and marketing-related product displays. Cash flows from financing activities Cash provided by financing activities for fiscal 2019 of $21.9 million primarily consisted of $31.6 million in proceeds from the exercise of stock options. This increase was partially offset by payment of outstanding borrowings under the Term Loan of $6.7 million, $2.4 million to repurchase treasury stock related to our election to withhold shares to cover taxes in conjunction with restricted stock vesting beginning in our second quarter of fiscal 2019, and $0.6 million in payments for offering costs. Fiscal 2018 changes in cash flows For the comparison of fiscal 2018 to fiscal 2017, refer to Part II, Item 7 "Management's discussion and analysis of financial condition and results of operations" of our Form 10-K for our fiscal year ended September 29, 2018, filed with the SEC on November 28, 2018 under the subheading "Liquidity and capital resources." Commitments and contingencies The following table summarizes our contractual commitments as of September 28, 2019: (1) Interest payments were calculated using the applicable interest rate as of September 28, 2019. (2) Operating lease amounts in the table above represent fixed rental payments and fixed maintenance costs. We lease our facilities under long-term operating leases, which expire at various dates through 2027. The lease agreements frequently include provisions that require us to pay taxes, insurance or maintenance costs. (3) We enter into various inventory-related purchase agreements with suppliers. Under these agreements, 100% of orders are cancelable by giving sufficient notice prior to the expected shipment date. Off-balance sheet arrangements We have not entered into any off-balance sheet arrangements and do not have any holdings in variable interest entities. Critical accounting policies and estimates Our financial statements are prepared in accordance with U.S. GAAP. The preparation of these financial statements requires us to make estimates and assumptions that affect the reported amounts of assets, liabilities, revenue, expenses and related disclosures. We evaluate our estimates and assumptions on an ongoing basis. Our estimates are based on historical experience and various other assumptions that we believe to be reasonable under the circumstances. Actual results could differ materially from those estimates. Our critical accounting policies requiring estimates, assumptions and judgments that we believe have the most significant impact on our consolidated financial statements are described below. Revenue recognition Revenue is recognized upon transfer of control of promised products or services to customers in an amount that reflects the consideration we expect to receive in exchange for those products or services. We generally enter into contracts that include a combination of products and services. Revenue is allocated to distinct performance obligations and is recognized net of allowances for returns, discounts, sales incentives and any taxes collected from customers, which are subsequently remitted to governmental authorities. Shipping and handling costs associated with outbound freight after control over a product has transferred to a customer are accounted for as a fulfillment cost and are included in cost of revenue. We do not have material assets related to incremental costs to obtain or fulfill customer contracts. Nature of products and services Our product revenue includes sales of wireless speakers, home theater speakers and components, which include software that enables our products to operate over a customer’s wireless network, as well as connect to various third-party services, including music and voice. We also generate a small portion of revenue from other revenue sources such as sales of module units and Sonos and third-party accessories, which include speaker stands and wall mounts. Module revenue is comprised of hardware and embedded software that is integrated into final products that are manufactured and sold by our partners. Our software primarily consists of firmware embedded in the products and the Sonos app, which is software that can be downloaded to consumer devices at no charge, with or without the purchase of one of our products. Products and related software are accounted for as a single performance obligation and all intended functionality is available to the customer upon purchase. The revenue allocated to the products and related software is the substantial portion of the total sale price. Revenue is recognized at the point in time when control is transferred, which is either upon shipment or upon delivery to the customer, depending on delivery terms. Our service revenue includes revenue allocated to (i) unspecified software upgrades and (ii) cloud services that enable products to access third-party music and voice assistant platforms, which are each distinct performance obligations and are provided to customers at no additional charge. Unspecified software upgrades are provided on a when-and-if-available basis and have historically included updates and enhancements such as bug fixes, feature enhancements and updates to the ability to connect to third-party music or voice assistant platforms. Service revenue is recognized ratably over the estimated service period. Significant judgments Our contracts with customers generally contain promises to transfer products and services as described above. Determining whether products and services are considered distinct performance obligations that should be accounted for separately may require significant judgment. Judgment is required to determine the standalone selling price ("SSP") for each distinct performance obligation. We estimate SSP for items that are not sold separately, which include the products and related software, unspecified software upgrades and cloud services, using information that may include competitive pricing information, where available, as well as analyses of the cost of providing the products or services plus a reasonable margin. In developing SSP estimates, we also consider the nature of the products and services and the expected level of future services. Determining the revenue recognition period for unspecified software upgrades and cloud services also requires judgment. We recognize revenue attributable to these performance obligations ratably over the best estimate of the period that the customer is expected to receive the services. In developing the estimated period of providing future services, we consider our past history, our plans to continue to provide services, including plans to continue to support updates and enhancements to prior versions of our products, expected technological developments, obsolescence, competition and other factors. The estimated service period may change in the future in response to competition, technology developments and our business strategy. We offer sales incentives through various programs, consisting primarily of discounts, cooperative advertising and market development fund programs. We record cooperative advertising and market development fund programs with customers as a reduction to revenue unless it receives a distinct benefit in exchange for credits claimed by the customer and can reasonably estimate the fair value of the benefit received, in which case we record it as an expense. We recognize a liability, or a reduction to accounts receivable, and reduce revenue for sales incentives based on the estimated amount of sales incentives that will be claimed by customers. Estimates for sales incentives are developed using the most likely amount and are included in the transaction price to the extent that a significant reversal of revenue would not result once the uncertainty is resolved. In developing its estimate, we also consider the susceptibility of the incentive to outside influences, the length of time until the uncertainty is resolved, our experience with similar contracts and the range of possible outcomes. Reductions in revenue related to discounts are allocated to products and services on a relative basis based on their respective SSP. Judgment is required to determine the timing and amount of recognition of marketing funds, which we estimate based on past practice of providing similar funds. We accept returns from direct customers and from certain resellers. To establish an estimate for returns, we use the expected value method by considering a portfolio of contracts with similar characteristics to calculate the historical returns rate. When determining the expected value of returns, we consider future business initiatives and relevant anticipated future events. Inventories Inventories consist of finished goods and component parts, which are purchased from contract manufacturers and component suppliers. Inventories are stated at the lower of cost or market and net realizable value on a first-in, first-out basis. We assess the valuation of inventory balances including an assessment to determine potential excess and/or obsolete inventory. We may be required to write down the value of inventory if estimates of future demand and market conditions indicate estimated excess and/or obsolete inventory. Product warranties Our products are covered by warranty to be free from defects in material and workmanship for a period of one year, except for products sold in the EU and select other countries where we provide a two-year warranty. At the time of sale, an estimate of future warranty costs is recorded as a component of the cost of revenue. Our estimate of costs to fulfill our warranty obligations is based on historical experience and expectations of future costs to repair or replace. Income taxes Our income tax expense, deferred tax assets and liabilities and liabilities for unrecognized tax benefits reflect our best estimate of current and future taxes to be paid. Significant judgments and estimates are required in the determination of the consolidated income tax expense. We prepare and file income tax returns based on our interpretation of each jurisdiction’s tax laws and regulations. In preparing our consolidated financial statements, we estimate our income tax liability in each of the jurisdictions in which we operate by estimating our actual current tax expense together with assessing temporary differences resulting from differing treatment of items for tax and financial reporting purposes. These differences result in deferred tax assets and liabilities, which are included in our consolidated balance sheets. Significant management judgment is required in assessing the realizability of our deferred tax assets. In performing this assessment, we consider whether it is more likely than not that some portion or all the deferred tax assets will not be realized. The ultimate realization of deferred tax assets is dependent upon the generation of future taxable income during the periods in which those temporary differences become deductible. In making this determination, we consider the scheduled reversal of deferred tax liabilities, projected future taxable income and the effects of tax planning strategies. We recorded a valuation allowance against all our U.S. deferred tax assets and certain of our foreign deferred tax assets as of September 28, 2019. We intend to continue maintaining a full valuation allowance on our U.S. and certain foreign deferred tax assets until there is sufficient evidence to support the reversal of all or some portion of these allowances. We account for uncertain tax positions using a "more-likely-than-not" threshold for recognizing and resolving uncertain tax positions. We evaluate uncertain tax positions on a quarterly basis and consider various factors, that include, but are not limited to, changes in tax law, the measurement of tax positions taken or expected to be taken in tax returns, the effective settlement of matters subject to audit, information obtained during in process audit activities and changes in facts or circumstances related to a tax position. We accrue for potential interest and penalties related to unrecognized tax benefits in income tax expense. Our policy with respect to the undistributed earnings of our non-U.S. subsidiaries is to maintain an indefinite reinvestment assertion as they are required to fund needs outside of the United States and cannot be repatriated in a manner that is substantially tax-free. This assertion is made on a jurisdiction by jurisdiction basis and takes into account the liquidity requirements in both the United States and of our foreign subsidiaries. Stock-based compensation We measure stock-based compensation cost at fair value on the date of grant. Compensation cost for share-based awards is recognized, on a straight-line basis, as expense over the period of vesting as the employee performs the related services, net of estimated forfeitures, over the remaining requisite service period. The fair value of restricted stock units ("RSUs") is based on the Company's closing stock price on the trading day immediately preceding the date of grant. We estimate the fair value of stock option awards using the Black-Scholes option-pricing model to determine the fair value of stock options. Determining the fair value of stock-based awards at the grant date requires judgment. Our use of the Black-Scholes model requires the input of assumptions regarding a number of variables. The assumptions used in calculating the fair value of stock-based awards represent our best estimates, but these estimates involve inherent uncertainties and the application of judgment. As a result, if factors change or we use different assumptions, stock-based compensation expense could be materially different in the future. In addition, we estimate at the time of grant the expected forfeiture rate and only recognize expense for those stock-based awards expected to vest. We estimate the forfeiture rate of our stock-based awards based on an analysis of our actual and historical forfeitures and other factors such as employee turnover. The impact from a forfeiture rate adjustment would be recognized in the period in which the forfeiture rate changes and, if the actual number of future forfeitures differs from our prior estimates, we may be required to record adjustments to stock-based compensation.

<s>[INST] Overview Sonos is one of the world's leading sound experience brands. As the inventor of multiroom wireless home audio, Sonos' innovation helps the world listen better by giving people access to the content they love and allowing them to control it however they choose. Known for delivering unparalleled sound experience, thoughtful design aesthetic, simplicity of use and an open platform, Sonos makes the breadth of audio content available to anyone. Our sound system provides an immersive listening experience created by our thoughtfully designed speakers and components, our proprietary software platform and the ability to wirelessly stream the content our customers love from the services they prefer. We manage the complexity of delivering a seamless customer experience in a multiuser and openplatform environment. The Sonos sound system is easy to set up, use and expand to bring audio to any room in the home. Through our software platform, we frequently enhance features and services on our products, improving functionality and customer experience. Our innovative products, seamless customer experience and expanding global footprint have driven 14 consecutive years of sustained revenue growth since our first product launch. We generate revenue from the sale of our wireless speakers, home theater speakers and component products, as new customers buy our products and existing customers continue to add products to their Sonos sound systems. We have developed a robust product and software roadmap that we believe will help us capture the expanding addressable market for our products. We believe executing on our roadmap will position us to acquire new customers, offer a continuously improving experience to our existing customers and grow followon purchases. Our most recent steps in this direction occurred in October 2017, with the introduction of our first voiceenabled wireless speaker, Sonos One, in July 2018, with the introduction of our first voiceenabled home theater speaker, Sonos Beam. In fiscal 2019, we accelerated new product introductions including the introduction of Sonos Amp, Sonos Move, our first batterypowered, Bluetoothenabled speaker for use both indoors and outdoors, Sonos One SL, and Sonos Port. Key metrics In addition to the measures presented in our consolidated financial statements, we use the following additional key metrics to evaluate our business, measure our performance, identify trends affecting our business and assist us in making strategic decisions. Our key metrics are revenue, products sold, adjusted EBITDA and adjusted EBITDA margin. The most directly comparable financial measure calculated under U.S. GAAP for adjusted EBITDA is net income (loss). In the fiscal years ended September 28, 2019, September 29, 2018 and September 30, 2017, we had a net loss of $4.8 million, $15.6 million and $14.2 million, respectively. Revenue We generate substantially all of our revenue from the sale of wireless speakers, home theater speakers and components. We also generate revenue from other sources, such as module revenue, the sale of Sonos and thirdparty accessories like speaker stands and wall mounts, as well as licensing revenue. Module revenue is comprised of sales of hardware and embedded software that is integrated into final products that are manufactured and sold by our partners. For a description of our revenue recognition policies, see the section titled "Critical accounting policies and estimates." Products sold Products sold represents the number of products that are sold during a period, net of returns. Products sold includes the sale of wireless speakers, home theater speakers, components and module units. Products sold excludes the sale of Sonos and thirdparty accessories. Historically, the sale of other items has not materially contributed to our revenue. Growth rates between products sold and revenue are not perfectly correlated because our revenue is affected by other variables, such as the mix of products sold during the period, promotional discount activity and the introduction of new products that may have higher or lower than average selling prices. Adjusted EBITDA and adjusted EBITDA margin We define adjusted EBITDA as net loss adjusted to exclude the impact of stockbased compensation expense, depreciation, interest income, interest expense, other income (expense), income taxes and items considered to be nonrecurring. We define adjusted EBITDA margin as adjusted EBITDA divided by revenue. See the section titled "Selected Consolidated Financial [/INST] Negative. </s>

Cigna Corp

2019-02-28

2018-12-31

ITEM 7. Management's Discussion and Analysis of Financial Condition and Results of Operations ITEM 7. Management's Discussion and Analysis of Financial Condition and Results of Operations Page Executive Overview Liquidity and Capital Resources Critical Accounting Estimates Segment Reporting Integrated Medical Health Services International Markets Group Disability and Other Corporate Investment Assets Management's Discussion and Analysis of Financial Condition and Results of Operations ("MD&A") is intended to provide information to assist you in better understanding and evaluating our financial condition and results of operations. We encourage you to read this MD&A in conjunction with our Consolidated Financial Statements included in Part II, Item 8 of this Annual Report on Form 10-K ("Form 10-K") and the "Risk Factors" contained in Part I, Item 1A of this Form 10-K. Unless otherwise indicated, financial information in the MD&A is presented in accordance with accounting principles generally accepted in the United States of America ("GAAP"). See Note 2 to our Consolidated Financial Statements for additional information regarding the Company's significant accounting policies. In some of our financial tables in this MD&A, we present either percentage changes or "N/M" when those changes are so large as to become not meaningful. Changes in percentages are expressed in basis points ("bps"). In this MD&A, our consolidated measures "adjusted income from operations," earnings per share on that same basis, and "adjusted revenues" are not determined in accordance with GAAP and should not be viewed as substitutes for the most directly comparable GAAP measures "shareholders' net income," "earnings per share" and "total revenues." As discussed in Note 21, we also use pre-tax adjusted income from operations and adjusted revenues to measure the results of our segments. We use adjusted income from operations as our principal financial measure of operating performance because management believes it best reflects the underlying results of our business operations and permits analysis of trends in underlying revenue, expenses and profitability. We define adjusted income from operations as shareholders' net income (or income before taxes for the segment metric) excluding realized investment gains and losses, amortization of acquired intangible assets, results of Anthem, Inc. and Coventry Health Care Inc. ("Coventry") (collectively, the "transitioning clients") (see the "Key Transactions and Developments" section of the MD&A for further discussion of transitioning clients) and special items. Beginning in 2018, Cigna's share of certain realized investment results of its joint ventures reported using the equity method of accounting are also excluded. Income or expense amounts excluded from adjusted income from operations because they are not indicative of underlying performance or the responsibility of operating segment management include: •Realized investment gains (losses), including changes in market values of certain financial instruments between balance sheet dates, as well as gains and losses associated with invested asset sales. •Amortization of acquired intangible assets, because these relate to costs incurred for acquisitions. •Results of transitioning clients, because those results are not indicative of ongoing results. •Special items, if any, that management believes are not representative of the underlying results of operations due to the nature or size of these matters. See Note 21 to the Consolidated Financial Statements for descriptions of special items. Adjusted revenues is defined as total revenues excluding the following adjustments: revenue contributions from transitioning clients, special items and, beginning in 2018, Cigna's share of certain realized investment results of its joint ventures reported using the equity method of accounting. Executive Overview Cigna Corporation, together with its subsidiaries (either individually or collectively referred to as "Cigna," the "Company," "we," "our" or "us") is a global health service organization dedicated to a mission of helping those we serve improve their health, well-being and peace of mind. Our evolved strategy in support of our mission is Go Deeper, Go Local, Go Beyond using a differentiated set of medical, pharmacy, dental, disability, life and accident insurance and related products and services offered by our subsidiaries. For further information on our business and strategy, see Item 1, "Business" in this Form 10-K. As described more fully in Note 3 to our Consolidated Financial Statements, on March 8, 2018, we entered into a merger agreement with Express Scripts Holding Company ("Express Scripts"). Following entry into the merger agreement and throughout the pendency of the transaction, Cigna and Express Scripts designed integration plans to implement a new management and business reporting structure for the combined company upon closing. On December 20, 2018, we completed the acquisition of Express Scripts and, our segments have changed effective in the fourth quarter of 2018. See Note 1 to our Consolidated Financial Statements for a description of our segments. Prior year financial information has been restated to reflect this new segment presentation. Additionally, as described further in Note 2 to the 42 CIGNA CORPORATION - 2018 Form 10-K PART II ITEM 7. Management's Discussion and Analysis of Financial Condition and Results of Operations Consolidated Financial Statements, we adopted Article 5 of Regulation S-X issued by the Securities and Exchange Commission effective December 31, 2018. Results of 2018 include 11 days of Express Scripts activity beginning December 21. Financial Summary Summarized below are certain key measures of our performance for the years ended December 31: (1) For additional information related to net investment income included in transaction-related costs, please refer to Note 3 to the Consolidated Financial Statements in this Form 10-K. CIGNA CORPORATION - 2018 Form 10-K 43 PART II ITEM 7. Management's Discussion and Analysis of Financial Condition and Results of Operations Consolidated Results of Operations (GAAP Basis) Financial Summary Reconciliation of Shareholders' Net Income (GAAP) to Adjusted Income from Operations (non-GAAP): 44 CIGNA CORPORATION - 2018 Form 10-K PART II ITEM 7. Management's Discussion and Analysis of Financial Condition and Results of Operations Earnings and Revenue Commentary Shareholders' net income increased in 2018 compared with 2017, primarily driven by a lower effective tax rate. Income before income taxes was essentially flat, reflecting higher adjusted income from operations, largely offset by reduced realized investment results and higher special item charges due to transaction costs associated with the Express Scripts acquisition. In 2017, the increase in shareholders' net income as compared to 2016 was due to higher adjusted income from operations, with special item charges for debt extinguishment costs and charges resulting from U.S. Tax reform partially offsetting the increase. Adjusted income from operations increased in 2018 compared with 2017, primarily due to earnings growth across all of our segments, including contributions from the acquired Express Scripts business and the lower effective tax rate in 2018. In 2017, the increase in adjusted income from operations compared with 2016 was due to earnings growth across all of our segments. Medical customers increased in both 2018 and 2017, compared with each prior year primarily resulting from growth in the Commercial and Government segments. See the Integrated Medical segment section for additional discussion. Revenues increased in both 2018 and 2017, primarily due to business growth in the Integrated Medical and International Markets segments. In 2018, revenues from the acquired Express Scripts business of $2.6 billion also contributed to the increase. Detailed revenue items are discussed further below. •Premiums increased in 2018 compared with 2017, primarily reflecting customer growth in Integrated Medical including contributions from specialty products as well as growth in International Markets. Also contributing to the increase were higher premium rates in our Integrated Medical segment driven by: 1) underlying medical trend; 2) suspension of the government's cost share reduction subsidies; and 3) resumption of the health insurance industry tax. The increase in 2017 compared with 2016 primarily resulted from customer growth in the Commercial segment and in International Markets, partially offset by decreases in Government segment premiums due to Medicare disenrollment. •Pharmacy revenues increased in 2018 compared with 2017 primarily resulting from contributions from the acquired Express Scripts business. See the Health Services section of this MD&A for further discussion of pharmacy revenues and costs. •Fees and other revenues. The increases in both 2018 and 2017 compared with each prior year were primarily attributable to growth in our specialty businesses and an increased customer base for our administrative services only ("ASO") business. In 2018, contributions from the acquired Express Scripts business also contributed to the increase. •Net investment income was higher in 2018 compared with 2017, reflecting growth in average assets and higher yields, largely driven by increased partnership income. Net investment income in 2018 also included $123 million earned from proceeds on the debt issued in September 2018 that is reported as a special item. Those debt proceeds were used to finance the Express Scripts acquisition on December 20, 2018. In 2017, net investment income increased compared with 2016, driven by growth in average invested assets, partially offset by lower yields. Commentary on Other Components of Consolidated Results of Operations •Medical costs and other benefit expenses increased in both 2018 and 2017, compared with the prior year, reflecting customer growth in Integrated Medical and International Markets, as well as medical cost inflation in Integrated Medical. •Selling, general and administrative expenses increased in 2018 compared with 2017, driven by higher transaction-related costs associated with the acquisition of Express Scripts, resumption of the health insurance industry tax and volume-based expenses reflecting business growth. In 2017, the increase in selling, general and administrative expenses compared with 2016 reflected a long-term care guaranty fund assessment and higher volume-based expenses reflecting business growth. These increases were offset by suspension of the health insurance industry tax in 2017 and a reduction in costs related to our Center for Medicare and Medicaid Services ("CMS") audit response. •Amortization of acquired intangible assets increased in 2018 compared with 2017, primarily reflecting the impact of the acquired Express Scripts business. The decrease in 2017 compared with 2016 was driven by the expected continuing decline in amortization from our 2012 acquisition of HealthSpring, Inc. •Interest expense and other increased significantly in 2018 compared with 2017, primarily due to $227 million of interest incurred on debt issued in the third quarter of 2018 prior to the acquisition of Express Scripts. This amount is included in the overall special item for transaction-related costs, net of $123 million of investment income earned on the debt proceeds through the closing date of the transaction. • Realized investment results declined significantly in 2018 compared with 2017, resulting from lower gains on sales of alternative, partnership and fixed maturity investments as well as mark-to-market losses on equity securities reported in net income as required by Accounting Standards Update 2016-01, Recognition and Measurement of Financial Assets and Liabilities, beginning in 2018 (see Note 2 to our Consolidated Financial Statements). In 2017, realized investment results increased compared with 2016, primarily due to higher gains on sales of alternative and real estate investments, as well as lower impairment losses. • The consolidated effective tax rate decreased in 2018 compared with 2017, primarily due to a lower U.S. tax rate in 2018, partially offset by resumption of the non-deductible health insurance industry tax and the absence of the incremental tax benefit recognized in the second quarter of 2017 for certain transaction costs associated with the terminated merger with Anthem. In 2017, the effective tax rate was flat compared with 2016. The unfavorable impact of additional tax expense associated with the U.S. tax reform legislation enacted in 2017 was offset by favorable effects of a suspension of the health insurance industry tax in 2017 and an incremental tax benefit from previously non-deductible transaction-related costs. See Note 18 to our Consolidated Financial Statements for additional information. CIGNA CORPORATION - 2018 Form 10-K 45 PART II ITEM 7. Management's Discussion and Analysis of Financial Condition and Results of Operations Key Transactions and Developments Acquisition of Express Scripts As discussed in more detail in Note 3 to the Consolidated Financial Statements, Cigna acquired Express Scripts on December 20, 2018 in a cash and stock transaction valued at $52.8 billion. See the "Liquidity" section of this MD&A for further discussion of the financing of this transaction. We incurred a significant amount of costs related to this acquisition, both before and after closing. These costs are being reported in "transaction-related costs" as a special item and excluded from adjusted income from operations. The results of Express Scripts are included in Cigna's consolidated financial information from the date of the acquisition. On January 30, 2019, Anthem exercised its early termination right and terminated the pharmacy benefit management services agreement with us, effective March 1, 2019. There is a twelve-month transition period ending March 1, 2020. It is expected that the transition of Anthem's customers will occur at various dates, as informed by Anthem's technology platform migration schedule. Over the next twelve months, we will focus on an effective transition of this relationship and related services over Anthem's accelerated timeline. We exclude the results of Express Scripts' contract with Anthem (and also Coventry) from our non-GAAP reporting metric "adjusted income from operations." We refer to this adjustment as "transitioning clients." U.S. Tax Reform Legislation Major U.S. tax reform legislation was signed into law on December 22, 2017. The legislation reduced the corporate income tax rate from 35% to 21% effective January 1, 2018, among other things. See Note 18 to our Consolidated Financial Statements for further discussion of the impacts of this legislation on our results of operations. 46 CIGNA CORPORATION - 2018 Form 10-K PART II ITEM 7. Management's Discussion and Analysis of Financial Condition and Results of Operations Health Care Industry Developments and Other Matters Affecting Our Integrated Medical and Health Services Segments The "Regulation" section of this Form 10-K provides a detailed description of The Patient Protection and Affordable Care Act provisions and other legislative initiatives that impact our health care business, including regulations issued by CMS and the Departments of the Treasury and Health and Human Services ("HHS"). The table presented below provides an update of the impact of these items and other matters affecting our Integrated Medical and Health Services segments as of December 31, 2018. CIGNA CORPORATION - 2018 Form 10-K 47 PART II ITEM 7. Management's Discussion and Analysis of Financial Condition and Results of Operations Risk Mitigation Programs In 2016, we recorded an allowance for the balance of our risk corridor receivable based on court decisions and the large program deficit. During 2018, the U.S. Federal Circuit court ruled that health insurers are not entitled to receive amounts due under the risk corridor program that have been withheld by Congress. The plaintiffs have petitioned the U.S. Supreme Court to review this unfavorable decision. As of December 31, 2018, we continue to carry this allowance of $109 million based on the current status of court decisions. Risk adjustment balances are subject to audit and adjustment by CMS following each program year. In February 2018, a federal judge issued a decision invalidating the use of statewide average premium for risk adjustment purposes. In response, in July 2018, CMS issued a final rule clarifying the 2017 program methodology and addressing issues raised in the ruling by the federal judge. This rule clears the way for CMS to resume risk adjustment collections and payments for the 2017 program year. Despite this final rule, resolution of the legal matter remains uncertain. As of December 31, 2018, our financial statements reflect the risk adjustment balances for the 2018 and 2017 plan years under the rules currently in effect for the program. The following table presents our balances associated with the risk adjustment program as of December 31, 2018 and 2017. (1) Receivables, net of allowances, are reported in accounts receivable in the Consolidated Balance Sheets. (2) Payables are reported in accrued expenses and other liabilities (current) in the Consolidated Balance Sheets. After-tax charges for the risk adjustment program were $116 million in 2018 and $105 million in 2017, compared with after-tax benefits of $25 million in 2016. Liquidity And Capital Resources Liquidity We maintain liquidity at two levels: the subsidiary level and the parent company level. Liquidity requirements at the subsidiary level generally consist of: • medical costs, pharmacy and other benefit payments; • expense requirements, primarily for employee compensation and benefits, information technology and facilities costs; and • income taxes. Our subsidiaries normally meet their operating requirements by: • maintaining appropriate levels of cash, cash equivalents and short-term investments; • using cash flows from operating activities; • matching investment durations to those estimated for the related insurance and contractholder liabilities; • selling investments; and • borrowing from affiliates, subject to applicable regulatory limits. Liquidity requirements at the parent company level generally consist of: • debt service and dividend payments to shareholders; • lending to subsidiaries as needed; and • pension plan funding. The parent company normally meets its liquidity requirements by: • maintaining appropriate levels of cash and various types of marketable investments; • collecting dividends from its subsidiaries; • using proceeds from issuance of debt and common stock; and • borrowing from its subsidiaries, subject to applicable regulatory limits. Dividends from our insurance, Health Maintenance Organization ("HMO") and foreign subsidiaries are subject to regulatory restrictions. See Note 17 to the Consolidated Financial Statements for additional discussion of these restrictions. Because most of Express Scripts' subsidiaries are not subject to regulatory restrictions on paying dividends, acquiring Express Scripts provides significantly increased financial flexibility to Cigna. 48 CIGNA CORPORATION - 2018 Form 10-K PART II ITEM 7. Management's Discussion and Analysis of Financial Condition and Results of Operations Cash flows for the years ended December 31, were as follows: Operating activities Cash flows from operating activities consist principally of cash receipts and disbursements for premiums, fees, pharmacy revenues and costs, investment income, taxes, benefit costs and other expenses. Cash flows from operating activities decreased in 2018 compared with 2017 primarily driven by the timing of settlement of pharmacy payables, partially offset by higher net income. Cash flows from operating activities increased slightly in 2017 compared with 2016 primarily driven by higher net income, partially offset by lower receipts from Medicare Part D and Medicare Advantage programs and a voluntary pension contribution of $150 million in 2017. Investing and Financing activities Our most significant investing and financing activities of 2018 related to acquiring Express Scripts. See Note 3 to the Consolidated Financial Statements for additional information on the acquisition. Cigna financed a portion of the acquisition in cash, primarily with debt financing as shown above and described more fully in Note 5 to the Consolidated Financial Statements, with the remaining required cash coming from cash on hand. In 2018, Cigna also acquired OnePath Life for approximately $480 million, largely with cash held in our foreign operations. Net investment purchases increased in 2018 compared with 2017, largely due to reinvesting our cash flows into fixed income investments. The decrease in net investment purchases in 2017 compared with 2016 primarily reflects higher cash used for share repurchases in 2017. Stock repurchases declined in 2018 compared with 2017 as Cigna suspended stock repurchase activity to provide liquidity for the Express Scripts acquisition. Stock repurchase activity was significantly higher in 2017 than 2016, as stock repurchase activity was suspended for much of 2016 during the pendency of the Anthem transaction. We maintain a share repurchase program authorized by our Board of Directors. Under this program, we may repurchase shares from time to time, depending on market conditions and alternate uses of capital. The timing and actual number of shares repurchased will depend on a variety of factors, including price, general business and market conditions and alternate uses of capital. The share repurchase program may be effected through open market purchases or privately negotiated transactions in compliance with Rule 10b-18 under the Securities Exchange Act of 1934, as amended, including through Rule 10b5-1 trading plans. The program may be suspended or discontinued at any time. In 2018, we repurchased 1.6 million shares for approximately $330 million. From January 1, 2019 through February 27, 2019 we repurchased 1.9 million shares for approximately $356 million. The remaining share repurchase authority as of February 27, 2019 was $590 million. We repurchased 15.7 million shares for $2.8 billion in 2017 and 0.8 million shares for $110 million in 2016. Capital Resources Our capital resources (primarily cash flows from operating activities and proceeds from the issuance of debt and equity securities) provide protection for policyholders, furnish the financial strength to underwrite insurance risks and facilitate continued business growth. Our acquisition of Express Scripts increased our debt and shareholders' equity in 2018 as follows: • Stock. Express Scripts shareholders received 0.2434 of a share of common stock of Cigna for every one share of Express Scripts. Cigna issued 137.6 million additional shares to Express Scripts shareholders. • Debt. See Note 5 to the Consolidated Financial Statements for further description of the debt issued to finance the acquisition. • Assumption of Express Scripts Senior Notes. See Note 5 to the Consolidated Financial Statements for further description of the notes assumed in the acquisition of Express Scripts. At December 31, 2018, our debt-to-capitalization ratio was 50.9%. We expect to deleverage to the upper 30s within 18 to 24 months by using cash flows from operating activities. CIGNA CORPORATION - 2018 Form 10-K 49 PART II ITEM 7. Management's Discussion and Analysis of Financial Condition and Results of Operations Cigna entered into a new Revolving Credit Agreement and Term Loan Credit Agreement in financing the Express Scripts acquisition. A select number of subsidiaries guarantee Cigna obligations under the Revolving Credit Agreement and the Term Loan Credit Agreement. See Note 5 to the Consolidated Financial Statements for further information on these guarantees, as well as information on our Revolving Credit Agreement and the Term Loan Credit Agreement. Cigna had $22 million of letters of credit outstanding as of December 31, 2018. Management, guided by regulatory requirements and rating agency capital guidelines, determines the amount of capital resources that we maintain. Management allocates resources to new long-term business commitments when returns, considering the risks, look promising and when the resources available to support existing business are adequate. We prioritize our use of capital resources to: • provide the capital necessary to support growth and maintain or improve the financial strength ratings of subsidiaries and to fund pension obligations; • consider acquisitions that are strategically and economically advantageous; and • return capital to investors primarily through share repurchases. We continue to maintain a capital management strategy to retain overseas a significant portion of the earnings from our foreign operations. These undistributed earnings are deployed outside of the United States predominantly in support of the liquidity and regulatory capital requirements of our foreign operations as well as to support growth initiatives overseas. This strategy does not materially limit our ability to meet our liquidity and capital needs in the United States. Liquidity and Capital Resources Outlook At December 31, 2018, there was approximately $4.2 billion in cash and short-term investments, $1.2 billion of which was held by the parent or subsidiaries with no regulatory or other restrictions on transferring cash to the parent via dividend or loan. In 2019, we expect to generate an additional $6.2 billion of capital available for deployment, including $2.1 billion of dividends that our regulated insurance companies may pay without prior regulatory approval. The parent company's cash obligations in 2019 are expected to approximate $3.2 billion primarily for repayment of debt, interest and anticipated dividends. We expect to re-issue the $1.5 billion commercial paper borrowing upon its maturity. We expect to have sufficient liquidity to meet the obligations discussed above, based on the cash currently available to the parent and current projections for subsidiary dividends and cash flows from the newly acquired Express Scripts operations. In addition, we actively monitor our debt obligations and engage in issuance or redemption activities as needed in accordance with our capital management strategy. Our cash projections may not be realized and the demand for funds could exceed available cash if our ongoing businesses experience unexpected shortfalls in earnings, or we experience material adverse effects from one or more risks or uncertainties described more fully in the Risk Factors section of this Form 10-K. In those cases, we expect to have the flexibility to satisfy liquidity needs through a variety of measures, including intercompany borrowings. The parent company can borrow an additional $650 million from its insurance subsidiaries without additional state approval. We have additional liquidity available through short-term commercial paper borrowing capacity and the $3.25 billion revolving credit agreement discussed in Note 5 to the Consolidated Financial Statements. As of December 31, 2018, our unfunded pension liability was $590 million, reflecting a decrease of $98 million from December 31, 2017, primarily attributable to an increase in discount rates of approximately 75 basis points. Contributions required in 2019 under the Pension Protection Act of 2006 are immaterial. See Note 13 to our Consolidated Financial Statements for additional information regarding our pension plans. Though we believe we have adequate sources of liquidity, significant disruption or volatility in the capital and credit markets could affect our ability to access those markets for additional borrowings or increase costs associated with borrowing funds. Guarantees and Contractual Obligations We are contingently liable for various contractual obligations entered into in the ordinary course of business. See the "Liquidity and Capital Resources" section of this MD&A beginning on page 48 for additional background on how we manage our liquidity requirements related to these obligations. The maturities of our primary contractual cash obligations as of December 31, 2018 are estimated to be as follows: 50 CIGNA CORPORATION - 2018 Form 10-K PART II ITEM 7. Management's Discussion and Analysis of Financial Condition and Results of Operations On balance sheet: • Insurance liabilities. Excluded from the table above are $4 billion of insurance liabilities ($3 billion in contractholder deposit funds; $1 billion in future policy benefits) associated with the sold retirement benefits and individual life insurance and annuity businesses, as well as the reinsured workers' compensation, personal accident and supplemental benefits businesses as their related net cash flows are not expected to impact our cash flows. Excluding these amounts, the sum of the obligations presented above exceeds the corresponding insurance and contractholder liabilities of $22 billion recorded on the balance sheet because some of the recorded insurance liabilities reflect discounting for interest and the recorded contractholder liabilities exclude future interest crediting, charges and fees. The timing and amount of actual future cash flows may differ from those presented above. •Contractholder deposit funds: see Note 7 to our Consolidated Financial Statements for our accounting policy for this liability. Expected future cash flows presented above also include estimated future interest crediting on current fund balances based on current investment yields less the estimated cost of insurance charges and mortality and administrative fees for universal life policies. •Future policy benefits and unpaid claims and claim expenses: see Note 7 to our Consolidated Financial Statements for our accounting policies for these liabilities. Expected future cash flows for these liabilities presented in the table above are undiscounted. The expected future cash flows for guaranteed minimum death benefit ("GMDB," reported in future policy benefits) do not consider any of the related reinsurance arrangements. •Long-term debt includes scheduled interest payments. Capital leases are included in long-term debt and primarily represent obligations for information technology network storage, servers and equipment. •Other non-current liabilities include estimated payments for guaranteed minimum income benefit ("GMIB") contracts (without considering any related reinsurance arrangements), pension and other postretirement and postemployment benefit obligations, supplemental and deferred compensation plans, interest rate and foreign currency swap contracts, and reinsurance liabilities. Estimated payments of $78 million for deferred compensation, non-qualified and international pension plans and other postretirement and postemployment benefit plans are expected to be paid in less than one year and are included in the table above. We expect to make immaterial contributions to the qualified domestic pension plans during 2019 and they are reflected in the above table. We expect to make payments subsequent to 2019 for these obligations; however, subsequent payments have been excluded from the table as their timing is based on plan assumptions that may materially differ from actual activities. See Note 13 to our Consolidated Financial Statements for further information on pension and other postretirement benefit obligations. The liability for uncertain tax positions that could result in future payments was $928 million as of December 31, 2018. This amount has been excluded from the table above because we are not able to provide a reasonably reliable estimate of the timing of such future tax payments. See Note 18 for additional information on uncertain tax positions. Off-Balance Sheet: •Purchase obligations. As of December 31, 2018, purchase obligations consisted of estimated payments required under contractual arrangements for future services and investment commitments as follows: See Note 9 to our Consolidated Financial Statements for additional information. Our estimated future service commitments primarily represent contracts for certain outsourced business processes and information technology maintenance and support. We generally have the ability to terminate these agreements, but do not anticipate doing so at this time. Purchase obligations exclude contracts that are cancelable without penalty and those that do not contractually require minimum levels of goods or services to be purchased. •Operating leases. For additional information, see Note 16 to our Consolidated Financial Statements. Guarantees We are contingently liable for various financial and other guarantees provided in the ordinary course of business. See Note 19 to our Consolidated Financial Statements for additional information on guarantees. CIGNA CORPORATION - 2018 Form 10-K 51 PART II ITEM 7. Management's Discussion and Analysis of Financial Condition and Results of Operations Critical Accounting Estimates The preparation of Consolidated Financial Statements in accordance with GAAP requires management to make estimates and assumptions that affect reported amounts and related disclosures in the Consolidated Financial Statements. Management considers an accounting estimate to be critical if: • it requires assumptions to be made that were uncertain at the time the estimate was made; and • changes in the estimate or different estimates that could have been selected could have a material effect on our consolidated results of operations or financial condition. Management has discussed how critical accounting estimates are developed and selected with the Audit Committee of our Board of Directors and the Audit Committee has reviewed the disclosures presented below. In addition to the estimates presented in the following table, there are other accounting estimates used in preparing our Consolidated Financial Statements, including estimates of liabilities for future policy benefits, as well as estimates with respect to postemployment and postretirement benefits other than pensions, certain compensation accruals, and income taxes. Management believes the current assumptions used to estimate amounts reflected in our Consolidated Financial Statements are appropriate. However, if actual experience differs from the assumptions used in estimating amounts reflected in our Consolidated Financial Statements, the resulting changes could have a material adverse effect on our consolidated results of operations and, in certain situations, could have a material adverse effect on our liquidity and financial condition. The table below presents the adverse impacts of certain possible changes in assumptions. The effect of assumption changes in the opposite direction would be a positive impact to our consolidated results of operations, liquidity or financial condition, except for assessing impairment of goodwill and fixed maturities carried at a fair value below cost. The tax rate used to calculate the after-tax impact of assumption changes is based on the new corporate income tax rate discussed in the "Key Developments" section of this MD&A. 52 CIGNA CORPORATION - 2018 Form 10-K PART II ITEM 7. Management's Discussion and Analysis of Financial Condition and Results of Operations See Note 2 to our Consolidated Financial Statements for further information on significant accounting policies. Balance Sheet Caption / Nature of Critical Accounting Estimate Effect if Different Assumptions Used Goodwill and other intangible assets Goodwill represents the excess of the cost of businesses acquired over the fair value of their net assets at the acquisition date. Intangible assets primarily reflect the value of customer relationships and other intangibles acquired in business combinations. Fair values of reporting units are estimated using models and assumptions that we believe a hypothetical market participant would use to determine a current transaction price. The significant assumptions and estimates used in determining fair value include the discount rate and future cash flows. A discount rate is used, corresponding with each reporting unit's weighted average cost of capital, consistent with that used for investment decisions considering the specific and detailed operating plans and strategies within each reporting unit. Projections of future cash flows are consistent with our annual planning process for revenues, claims, operating expenses, taxes, capital levels and long-term growth rates. In addition to these assumptions, we consider market data to evaluate the fair value of each reporting unit. The fair value of intangibles and the amortization method were determined using an income approach that relies on projected future cash flows including key assumptions for the customer attrition and discount rates. Management revises amortization periods if it believes there has been a change in the length of time that an intangible asset will continue to have value. We completed our normal annual evaluations for impairment of goodwill and intangible assets during the third quarter of 2018. The evaluations indicated that the fair value estimates of our reporting units exceed their carrying values by adequate margins and no impairment was required. As a result of the changes in our reportable segments, we reallocated existing goodwill to reporting units based on their relative fair values and updated our evaluations for impairment of goodwill. These evaluations indicated that the fair value estimates of our reporting units continue to exceed their carrying values by adequate margins and no impairments were required. During the fourth quarter of 2018, goodwill and intangible assets increased by $38.4 billion as a result of the acquiring Express Scripts and OnePath Life. If we do not achieve our earnings objectives or our cost of capital rises significantly, the assumptions and estimates underlying these impairment evaluations could be adversely affected and result in future impairment charges that would negatively impact our operating results. Except for the recent acquisitions of Express Scripts and OnePath Life, where fair value equals carrying value, based on our most recent evaluations, the fair value estimates of our reporting units exceed their carrying values by adequate margins. Future changes in the funding for our Medicare programs by the federal government could materially reduce revenues and profitability in our Government reporting unit and have a significant impact on its fair value. Our Government operating segment contracts with CMS and various state governmental agencies to provide managed health care services, including Medicare Advantage plans and Medicare-approved prescription drug plans. Estimated future cash flows for this reporting unit's business incorporate the potential effects of Medicare Advantage reimbursement rates for 2019 and beyond as discussed in the "Executive Overview" section of this MD&A. Revenues from the Medicare programs are dependent, in whole or in part, upon annual funding from the federal government through CMS. Funding for these programs is dependent on many factors including general economic conditions, continuing government efforts to contain health care costs and budgetary constraints at the federal level and general political issues and priorities. Goodwill and other intangibles as of December 31 were as follows (in millions): • 2018 - Goodwill $44,505; Other intangible assets $39,003 • 2017 - Goodwill $6,164; Other intangible assets $345 See Note 15 to our Consolidated Financial Statements for additional discussion of our goodwill and other intangible assets. Balance Sheet Caption / Nature of Critical Accounting Estimate Effect if Different Assumptions Used Income taxes - uncertain tax positions We evaluate tax positions to determine whether their benefits are more likely than not to be sustained on audit based on their technical merits. If not, we establish a liability for unrecognized tax benefits. These amounts have increased significantly in 2018 as a result of acquiring Express Scripts. The acquired amounts primarily relate to federal and state uncertain positions of the value and timing of deductions and uncertain positions of attributing taxable income to states. Balances that are included in other non-current liabilities on the Consolidated Balance Sheets are as follows: The factors that could impact our estimates of uncertain tax positions include the likelihood of being sustained upon audit based on the technical merits of the tax position and related assumed interest and penalties. If our positions are upheld upon audit, our net income would increase. • 2018 - $928 million • 2017 - $35 million See Note 18 to our Consolidated Financial Statements for additional discussion around uncertain tax positions. CIGNA CORPORATION - 2018 Form 10-K 53 PART II ITEM 7. Management's Discussion and Analysis of Financial Condition and Results of Operations Balance Sheet Caption / Nature of Critical Accounting Estimate Effect if Different Assumptions Used Pharmaceutical Manufacturer Receivables We bill pharmaceutical manufacturers based on management's interpretation of the contractual terms and estimate contractual allowances at the time a claim is processed for uncertainty in the amount we are entitled to collect. We determine these contractual allowances by reviewing each manufacturer's payment experience and specific known items that potentially could be adjusted under contract terms. We may also record allowances for doubtful accounts based on a variety of factors including the length of time the receivables are past due, the financial health of the manufacturer and our past experience. Actual contractual allowances could differ from our estimates due to disputes regarding contractual terms, changes in the business environment as well as factors and risks associated with specific customers. Our estimates of the allowance for doubtful accounts could be impacted by changes in economic and market conditions as well as changes to our customers' financial condition. In determining the fair value of Express Scripts' accounts receivable at the acquisition date, the historical allowances were eliminated. Prospectively, we expect these allowances to become significant to the consolidated financial statements. See Note 2 to our Consolidated Financial Statements for assumptions and methods used to estimate receivables and the related allowances. Balance Sheet Caption / Nature of Critical Accounting Estimate Effect if Different Assumptions Used Unpaid claims and claim expenses - Integrated Medical Unpaid claims and claim expenses include both reported claims and estimates for losses incurred but not yet reported. Unpaid claims and claim expenses in Integrated Medical are primarily impacted by assumptions related to completion factors and medical cost trend. Changes in either assumption from actual results could impact the unpaid claims balance as noted below. A large number of factors may cause the medical cost trend to vary from the Company's estimates, including: changes in medical management practices, changes in the level and mix of benefits offered and services utilized, and changes in medical practices. Completion factors may be affected if actual claims submission rates from providers differ from estimates (that can be influenced by a number of factors, including provider mix, and electronic versus manual submissions), or if changes to the Company's internal claims processing patterns occur. Based on studies of our claim experience, it is reasonably possible that a 100 basis point change in the medical cost trend and a 50 basis point change in completion factors could occur in the near term. A 100 basis point increase in the medical cost trend rate would increase this liability by approximately $35 million, resulting in a decrease in net income of approximately $30 million after-tax, and a 50 basis point decrease in completion factors would increase this liability by approximately $80 million, resulting in a decrease in net income of approximately $65 million after-tax. Unpaid claims and claim expenses for the Integrated Medical segment as of December 31 were as follows (in millions): • 2018 - gross $2,697; net $2,433 • 2017 - gross $2,420; net $2,158 These liabilities are presented above both gross and net of reinsurance and other recoverables. See Note 7 to our Consolidated Financial Statements for additional information regarding assumptions and methods used to estimate this liability. 54 CIGNA CORPORATION - 2018 Form 10-K PART II ITEM 7. Management's Discussion and Analysis of Financial Condition and Results of Operations Balance Sheet Caption / Nature of Critical Accounting Estimate Effect if Different Assumptions Used Unpaid claims and claim expenses - long-term disability reserves The liability for long-term disability reserves is the present value of estimated future benefits payments over the expected disability period and includes estimates for both reported claims and for claims incurred but not yet reported. Key assumptions in the calculation of long-term disability reserves include the discount rate and claim resolution rates, both of which are reviewed annually and updated when experience or future expectations would indicate a necessary change. The discount rate is the interest rate used to discount the projected future benefit payments to their present value. The discount rate assumption is based on the projected investment yield of the assets supporting the reserves. Claim resolution rate assumptions involve many factors including claimant demographics, the type of contractual benefit provided and the time since initially becoming disabled. The Company uses its own historical experience to develop its claim resolution rates. Based on recent and historical resolution rate patterns and changes in investment portfolio yields, it is reasonably possible that a five percent change in claim resolution rates and a 25 basis point change in the discount rate could occur. A five percent decrease in the claim resolution rate would increase long-term disability reserves by approximately $90 million and decrease net income by approximately $70 million after-tax. A 25 basis point decrease in the discount rate would increase long-term disability reserves by approximately $45 million and decrease net income by approximately $35 million after-tax. Long-term disability reserves as of December 31 were as follows (in millions): • 2018 - gross $4,069; net $3,975 • 2017 - gross $3,884; net $3,790 These liabilities are presented above both gross and net of reinsurance recoverables. See Note 7C. to our Consolidated Financial Statements for additional information regarding assumptions and methods used to estimate this liability. Balance Sheet Caption / Nature of Critical Accounting Estimate Effect if Different Assumptions Used Valuation of fixed maturity investments Most fixed maturities are classified as available for sale and are carried at fair value with changes in fair value recorded in accumulated other comprehensive income (loss) within shareholders' equity. Fair value is defined as the price at which an asset could be exchanged in an orderly transaction between market participants at the balance sheet date. If the interest rates used to calculate fair value increased by 100 basis points, the fair value of the total fixed maturity portfolio of $23 billion would decrease by approximately $1.5 billion, resulting in an after-tax decrease to shareholders' equity of approximately $0.9 billion. Determining fair value for a financial instrument requires management judgment. The degree of judgment involved generally correlates to the level of pricing readily observable in the markets. Financial instruments with quoted prices in active markets or with market observable inputs to determine fair value, such as public securities, generally require less judgment. Conversely, private placements including more complex securities that are traded infrequently are typically measured using pricing models that require more judgment as to the inputs and assumptions used to estimate fair value. There may be a number of alternative inputs to select based on an understanding of the issuer, the structure of the security and overall market conditions. In addition, these factors are inherently variable in nature as they change frequently in response to market conditions. Approximately two-thirds of our fixed maturities are public securities, and one-third are private placement securities. Typically, the most significant input in the measurement of fair value is the market interest rate used to discount the estimated future cash flows of the instrument. Such market rates are derived by calculating the appropriate spreads over comparable U.S. Treasury securities, based on the credit quality, industry and structure of the asset. See Notes 9A. and 10 to our Consolidated Financial Statements for a discussion of our fair value measurements, the procedures performed by management to determine that the amounts represent appropriate estimates and our accounting policy regarding unrealized appreciation on fixed maturities. CIGNA CORPORATION - 2018 Form 10-K 55 PART II ITEM 7. Management's Discussion and Analysis of Financial Condition and Results of Operations Balance Sheet Caption / Nature of Critical Accounting Estimate Effect if Different Assumptions Used Assessment of "other-than-temporary" impairments on fixed maturities Certain fixed maturities with a fair value below amortized cost are carried at fair value with changes in fair value recorded in accumulated other comprehensive income. For these investments, we have determined that the decline in fair value below its amortized cost is temporary. To make this determination, we evaluated the expected recovery in value and our intent to sell or the likelihood of a required sale of the fixed maturity prior to an expected recovery. In making this evaluation, we considered a number of general and specific factors including the regulatory, economic and market environments, length of time and severity of the decline, and the financial health and specific near term prospects of the issuer. If we subsequently determine that the excess of amortized cost over fair value is other-than-temporary for any or all of these fixed maturities, the amount recorded in accumulated other comprehensive income would be reclassified to shareholders' net income as an impairment loss. The after-tax amounts as of December 31 in accumulated other comprehensive income for fixed maturities in an unrealized loss position were as follows (in millions): • 2018 - ($370) • 2017 - ($80) See Note 9 to our Consolidated Financial Statements for additional discussion of our review of declines in fair value, including information regarding our accounting policies for fixed maturities. Segment Reporting The following section of this MD&A discusses the results of each of our segments. As a result of the Express Scripts acquisition, during the fourth quarter of 2018, we changed our segment reporting to reflect the new management and business reporting structure of the combined company. Prior year financial information has been restated to conform to the new segment presentation. See Note 1 to our Consolidated Financial Statements for a description of our segments. In segment discussions, we present adjusted revenues and "pre-tax adjusted income from operations," defined as income before taxes excluding realized investment gains (losses), amortization of acquired intangible assets, results of transitioning clients and special items. Ratios presented in this segment discussion exclude the same items as adjusted income from operations. See Note 21 to our Consolidated Financial Statements for additional discussion of these metrics and a reconciliation of income before income taxes to pre-tax adjusted income from operations. In these segment discussions, we also present "pre-tax adjusted margin," defined as adjusted income from operations before taxes divided by adjusted revenues. See the MD&A Executive Overview beginning on page 42 for summarized financial results of each of our reporting segments. Integrated Medical Segment The Integrated Medical segment includes the businesses previously reported in "Global Health Care" except as follows: 1) international health care products are now reported in the International Markets segment; 2) mail order pharmacy business is now reported in the Health Services segment; and 3) Medicare supplement business previously reported in "Global Supplemental Benefits" is now reported in Integrated Medical. The business section of this Form 10-K (see the "Integrated Medical" section beginning on page 3) describes the various products and funding solutions offered by this segment, including the various revenue sources. As described in the introduction to Segment Reporting above, performance of the Integrated Medical segment is measured using pre-tax adjusted income from operations. Key factors affecting profitability for this segment include: • customer growth; • revenues from integrated specialty products, including pharmacy services, sold to clients and customers across all funding solutions; • percentage of Medicare Advantage customers in plans eligible for quality bonus payments; • benefit expenses as a percentage of premiums (medical care ratio or "MCR") for our insured commercial and government businesses; and • selling, general and administrative expense as a percentage of adjusted revenues (expense ratio). We adopted new accounting guidance for revenue recognition effective January 1, 2018. Prior year revenues along with adjusted margin and both the medical care and expense ratios for the Integrated Medical segment have been retrospectively adjusted to conform to this new basis of accounting. See Note 2 to the Consolidated Financial Statements for additional information. 56 CIGNA CORPORATION - 2018 Form 10-K PART II ITEM 7. Management's Discussion and Analysis of Financial Condition and Results of Operations Results of Operations Financial Summary 2018 versus 2017 Adjusted revenues increased, primarily due to customer growth in our Commercial and Government segments including contributions from specialty products. Also contributing to the increase were higher premium rates across our businesses reflecting: 1) underlying medical cost trend; 2) the government's suspension of cost share reduction subsidies; and 3) resumption of the health insurance industry tax. Pre-tax adjusted income from operations increased, reflecting improved margins in our Individual business and strong ongoing performance in our Commercial business, including increased contributions from specialty products. Medical care ratio. The medical care ratio decreased, reflecting the pricing impact of resumption of the health insurance industry tax and improvement from our Individual business. Expense ratio. The expense ratio increased, reflecting resumption of the health insurance industry tax and ongoing investments in growth and innovation, partially offset by higher revenues. 2017 versus 2016 Adjusted revenues increased, primarily due to customer growth in our Commercial risk and Individual businesses, partially offset by lower customer enrollment in our Medicare Advantage business. Pre-tax adjusted income from operations increased, reflecting higher earnings in both our Commercial and Government operating segments. The increase in the Commercial segment reflects customer growth including increased contributions from our specialty products. The Government segment's earnings growth reflects lower operating expenses related to the moratorium of the health insurance industry tax in 2017 and our 2016 CMS audit response as well as favorable claims experience in our Individual business, partially offset by lower customer enrollment in our Medicare Advantage business. Pre-tax adjusted income from operations included favorable prior year reserve development of $148 million for 2017; prior year reserve development in 2016 was not material. Medical care ratio. The medical care ratio remained fairly consistent, reflecting the 2017 moratorium on the health insurance industry tax offset by improved performance in our Government segment businesses and favorable prior year reserve development. Expense ratio. The expense ratio decreased, reflecting suspension of the health insurance industry tax in 2017 and lower costs related to our 2016 CMS audit response. Other Items Affecting Integrated Medical Results Unpaid Claims and Claim Expenses Unpaid claims and claim expenses were higher as of December 31, 2018 compared with 2017 and were higher as of December 31, 2017 compared with 2016, primarily due to customer growth and medical cost trend. See Note 7 to our Consolidated Financial Statements for additional information. CIGNA CORPORATION - 2018 Form 10-K 57 PART II ITEM 7. Management's Discussion and Analysis of Financial Condition and Results of Operations Medical Customers A medical customer is defined as a person meeting any one of the following criteria: • is covered under a medical insurance policy, managed care arrangement or service agreement issued by us; • has access to our provider network for covered services under their medical plan; or • has medical claims that are administered by us. Medical customers now include the Medicare Supplement business. For the Integrated Medical segment, medical customers excludes international health care customers. Our medical customer base was higher at December 31, 2018 compared to December 31, 2017, primarily reflecting growth across our targeted Commercial markets as well as our Government segment businesses. Our medical customer base increased as of December 31, 2017 compared with 2016, reflecting growth across our Commercial and Government segments. The Government segment growth was primarily driven by our Medicare Supplement and Individual businesses, partially offset by declines in our Medicare Advantage business. Health Services Segment We established the Health Services segment to include the pharmacy benefit management ("PBM") and health services operations of Express Scripts effective with the acquisition, as well as Cigna's legacy mail order pharmacy business. As described in the introduction to Segment Reporting on page 56, performance of the Health Services Segment is measured using pre-tax adjusted income from operations. The key factors that impact Health Services revenues and costs of revenues are volume, mix and price. These key factors are discussed further below. See Note 2 for additional information on revenue and cost recognition policies for this segment. • As our clients' claim volumes increase or decrease, our resulting revenues and cost of revenues correspondingly increase or decrease. Our gross profit could also increase or decrease as a result of changes in purchasing discounts. • The mix of claims generally considers the type of drug and distribution method used for dispensing and fulfilling. As our mix of drugs changes, our resulting pharmacy revenues and cost of revenues correspondingly may increase or decrease. The primary driver of fluctuations within our mix of claims is the generic fill rate. Generally, higher generic fill rates reduce revenues, as generic drugs are typically priced lower than the branded drugs they replace. However, as ingredient cost paid to pharmacies on generic drugs is incrementally lower than the price charged to our clients, higher generic fill rates generally have a favorable impact on our gross profit. The home delivery generic fill rate is currently lower than the network generic fill rate as fewer generic substitutions are available among maintenance medications (such as therapies for chronic conditions) commonly dispensed from home delivery pharmacies as compared to acute medications that are primarily dispensed by pharmacies in our retail networks. • Our contract pricing is impacted by our ability to negotiate contracts for pharmacy network, pharmaceutical and wholesaler purchasing, and manufacturer rebates. We are able to reduce the rate of drug price increases and, in some cases, lower our clients' prescription drug spend through our integrated set of solutions, including sharing of significant amounts of pharmaceutical manufacturer rebates with our clients. We refer to this as "management of the supply chain." Inflation also impacts our pricing because most of our contracts provide that we bill clients and pay pharmacies based on a generally recognized price index for pharmaceuticals. Therefore, the rate of inflation for prescription drugs and our efforts to manage this inflation for our clients can affect our revenues and cost of revenues. In this MD&A, we present revenues, gross profit and pre-tax adjusted income from operations "excluding transitioning clients" in addition to those metrics including transitioning clients. See the "Key Transactions and Developments" section on page 46 of this MD&A for further discussion of transitioning clients and why we present this information. Results of Operations Financial Summary 58 CIGNA CORPORATION - 2018 Form 10-K PART II ITEM 7. Management's Discussion and Analysis of Financial Condition and Results of Operations 2018 versus 2017 Adjusted revenues increased, primarily due to the acquisition of Express Scripts. Excluding the acquired business, revenues increased slightly, reflecting increased utilization of specialty medications and higher prices. Pre-tax adjusted income from operations before taxes increased, due to the acquisition of Express Scripts. Excluding the acquired business, adjusted income from operations increased, reflecting volume growth due to increased specialty utilization and net savings related to management of supply chain. 2017 versus 2016 Adjusted revenues increased, reflecting increased Commercial customers, specialty medication prices and utilization (e.g., certain injectables), offset by lower oral medication volumes and Medicare customers. Pre-tax adjusted income from operations before taxes increased, due to Commercial customer growth including increased margin contributions from specialty medications. International Markets Segment As described in the business section of this Form 10-K, the International Markets segment includes supplemental health, life and accident business previously reported in the "Global Supplemental Benefits" segment, except for Medicare Supplement business that is now reported in the Integrated Medical segment and certain international businesses in run-off that are now reported in Group Disability and Other. International health care products previously reported in the "Global Health Care" segment are now reported in International Markets. As described in the introduction to Segment Reporting on page 56, performance of the International Markets segment is measured using pre-tax adjusted income from operations. Key factors affecting pre-tax adjusted income from operations for this segment are: • premium growth, including new business and customer retention; • benefit expenses as a percentage of premiums (loss ratio); • selling, general and administrative expense and acquisition expense as a percentage of revenues (expense ratio and acquisition cost ratio); and • the impact of foreign currency movements. Results of Operations Financial Summary 2018 versus 2017 Adjusted revenues increased primarily due to business growth mainly in South Korea, Middle East, Hong Kong and Europe. Pre-tax adjusted income from operations increased primarily due to business growth, largely in South Korea, and a lower expense ratio, partially offset by a less favorable acquisition cost ratio. The segment's loss ratio decreased slightly, reflecting favorable claims experience in South Korea and Europe, largely offset by unfavorable claims experience in North America and other Asian markets. The acquisition cost ratio increased due to higher amortization primarily in Korea and Taiwan. The decrease in the expense ratio (excluding acquisition costs) was primarily driven by lower value added tax and disciplined expense management. CIGNA CORPORATION - 2018 Form 10-K 59 PART II ITEM 7. Management's Discussion and Analysis of Financial Condition and Results of Operations 2017 versus 2016 Adjusted revenues were higher primarily due to business growth mainly in South Korea and the Middle East. Pre-tax adjusted income from operations increased primarily due to business growth, largely in South Korea, and lower loss ratios, partially offset by higher expense ratios. The segment's loss ratio decreased, reflecting favorable claims in South Korea and Europe. The acquisition cost ratio decreased slightly due to lower spending in certain markets. The increase in the expense ratio (excluding acquisition costs) was primarily driven by strategic investment in the Middle East and higher value added tax, partially offset by strong expense management. Other Items Affecting International Markets Results South Korea is the single largest geographic market for our International Markets segment. South Korea generated 40% of the segment's revenues and 68% of the segment's pre-tax adjusted income from operations in 2018. In 2018, our International Markets segment operations in South Korea represented 5% of our consolidated revenues and 11% of consolidated pre-tax adjusted income from operations. Group Disability and Other Group Disability and Other includes the results of the business previously reported in the "Group Disability and Life" segment and "Other Operations" comprising the corporate-owned life insurance ("COLI") business along with run-off of the following businesses: 1) reinsurance; 2) settlement annuity; and 3) the sold individual life insurance and annuity and retirement benefits businesses. In addition, certain international run-off business previously reported in the "Global Supplemental Benefits" segment is now reported in Group Disability and Other. As described in the introduction of Segment Reporting on page 56, performance of Group Disability and Other is measured using pre-tax adjusted income from operations. Key factors affecting pre-tax adjusted income from operations are: • premium growth, including new business and customer retention; • net investment income; • benefit expenses as a percentage of premiums (loss ratio); and • selling, general and administrative expense as a percentage of revenues excluding net investment income (expense ratio). Results of Operations Financial Summary 2018 versus 2017 Adjusted revenues decreased slightly, due to the continued run-off of international business and lower life premiums, mostly offset by moderate growth in the group disability business and higher investment income. Pre-tax adjusted income from operations increased, reflecting improved results in the life business and run-off operations, partially offset by unfavorable disability claims experience. 2017 versus 2016 Adjusted revenues were relatively flat, with higher investment income driven by higher asset levels offset by cancelations in non-core specialty and association products. Pre-tax adjusted income from operations increased, reflecting significantly improved claim experience in the group disability and life segment. 60 CIGNA CORPORATION - 2018 Form 10-K PART II ITEM 7. Management's Discussion and Analysis of Financial Condition and Results of Operations Corporate Corporate reflects amounts not allocated to operating segments, including net interest expense (defined as interest on corporate debt less net investment income on investments not supporting segment and other operations), certain litigation matters, compensation cost for stock options, expense associated with our frozen pension plans, charitable contributions, severance, certain overhead and project costs and intersegment eliminations for products and services sold between segments. Financial Summary 2018 versus 2017 Pre-tax adjusted loss from operations was higher, primarily due to higher interest expense. 2017 versus 2016 Pre-tax adjusted loss from operations was higher, primarily due to higher charitable contributions and operating expenses, partially offset by higher net investment income. Investment Assets The following table presents our invested asset portfolio, excluding separate account assets, as of December 31, 2018 and 2017. Additional information regarding our investment assets and related accounting policies is included in Notes 2, 9, 10, 11, and 12 to our Consolidated Financial Statements. Fixed Maturities Investments in fixed maturities include publicly traded and privately placed debt securities, mortgage and other asset-backed securities and preferred stocks redeemable by the investor. These investments are classified as available for sale and are carried at fair value on our balance sheet. Additional information regarding valuation methodologies, key inputs and controls is included in Note 10 to our Consolidated Financial Statements. More detailed information about fixed maturities by type of issuer and maturity dates is included in Note 9 to our Consolidated Financial Statements. The following table reflects our fixed maturity portfolio by type of issuer as of December 31, 2018 and 2017. The fixed maturity portfolio decreased during 2018, reflecting decreased valuations due to increases in market yields and weakening foreign currencies, partially offset by increased investment in fixed maturities. As of December 31, 2018, $20.6 billion, or 90% of the fixed maturities in our investment portfolio were investment grade (Baa and above, or equivalent), and the remaining $2.3 billion were below investment grade. The majority of the bonds that are below investment grade are rated at the higher end of the non-investment grade spectrum. These quality characteristics have not materially changed from the prior year and are consistent with our investment strategy. Fixed maturity investments are diversified by issuer, geography, and industry as appropriate. Foreign government obligations are concentrated in Asia, primarily South Korea, consistent with our risk management practice and local regulatory requirements of our international business operations. Corporate fixed maturities include private placement assets of $6 billion. CIGNA CORPORATION - 2018 Form 10-K 61 PART II ITEM 7. Management's Discussion and Analysis of Financial Condition and Results of Operations These investments are generally less marketable than publicly-traded bonds; however yields on these investments tend to be higher than yields on publicly-traded bonds with comparable credit risk. We perform a credit analysis of each issuer, and require financial and other covenants that allow us to monitor issuers for deteriorating financial strength and pursue remedial actions, if warranted. In addition to amounts classified in fixed maturities on our Consolidated Balance Sheets, we participate in an insurance joint venture in China in which we have a 50% ownership interest. We account for this joint venture on the equity basis of accounting and report it in other assets. This entity had an investment portfolio of approximately $6.3 billion supporting this business that is primarily invested in Chinese corporate and government fixed maturities. There were no investments with a material unrealized loss as of December 31, 2018. Commercial Mortgage Loans Our commercial mortgage loans are fixed rate loans, diversified by property type, location and borrower. Loans are secured by high quality commercial properties and are generally made at less than 70% of the property's value at origination of the loan. Property value, debt service coverage, quality, building tenancy and stability of cash flows are all important financial underwriting considerations. We hold no direct residential mortgage loans and do not originate or service securitized mortgage loans. Commercial real estate capital markets remain very active for well-leased, quality commercial real estate located in strong institutional investment markets. The vast majority of properties securing the mortgages in our mortgage loan portfolio possess these characteristics. As of December 31, 2018, the $1.9 billion commercial mortgage loan portfolio consisted of approximately 66 loans that are all in good standing. Given the quality and diversity of the underlying real estate, positive debt service coverage and significant borrower cash investment generally ranging between 30 and 40%, we remain confident that borrowers will continue to perform as expected under their contract terms. Other Long-term Investments Other long-term investments of $1.9 billion included investments in securities limited partnerships and real estate limited partnerships as well as direct investments in real estate joint ventures. These entities typically invest in mezzanine debt or equity of privately held companies (securities partnerships) and equity real estate. Given our subordinate position in the capital structure of these underlying entities, we assume a higher level of risk for higher expected returns. To mitigate risk, these investments are diversified across approximately 135 separate partnerships, and approximately 70 general partners who manage one or more of these partnerships. Also, the underlying investments are diversified by industry sector or property type, and geographic region. No single partnership investment exceeded 4% of our securities and real estate partnership portfolio. Problem and Potential Problem Investments "Problem" bonds and commercial mortgage loans are either delinquent by 60 days or more or have been restructured as to terms, including concessions by us for modification of interest rate, principal payment or maturity date. "Potential problem" bonds and commercial mortgage loans are considered current (no payment is more than 59 days past due), but management believes they have certain characteristics that increase the likelihood that they may become problems. There were no significant problem or potential problem investments at December 31, 2018 and 2017. Investment Outlook Despite the continued strength of the U.S. economy, concerns related to trade and tariffs and rising interest rates contributed to a return of financial market volatility and public equity market declines in 2018. We continue to closely monitor global macroeconomic conditions and trends, including the uncertainty caused by the United Kingdom's decision to exit the European Union, and their potential impact to our investment portfolio. Certain sectors, such as retail, energy and natural gas have been volatile and we expect that to continue. Future realized and unrealized investment results will be driven largely by market conditions that exist when a transaction occurs or at the reporting date. These future conditions are not reasonably predictable; however, we believe that the vast majority of our investments will continue to perform under their contractual terms. Based on our strategy to match the duration of invested assets to the duration of insurance and contractholder liabilities, we expect to hold a significant portion of these assets for the long term. Although future impairment losses resulting from interest rate movements and credit deterioration due to both investment-specific and the global economic uncertainties discussed above remain possible, we do not expect these losses to have a material adverse effect on our financial condition or liquidity. Market Risk Financial Instruments Our assets and liabilities include financial instruments subject to the risk of potential losses from adverse changes in market rates and prices. Consistent with disclosure requirements, the following items have been excluded from this consideration of market risk for financial instruments: • changes in the fair values of insurance-related assets and liabilities because their primary risks are insurance rather than market risk; • changes in the fair values of investments recorded using the equity method of accounting and liabilities for pension and other postretirement and postemployment benefit plans (and related assets); and • changes in the fair values of other significant assets and liabilities such as goodwill, deferred policy acquisition costs, taxes, and various accrued liabilities. Because they are not financial instruments, their primary risks are other than market risk. 62 CIGNA CORPORATION - 2018 Form 10-K PART II ITEM 7. Management's Discussion and Analysis of Financial Condition and Results of Operations Excluding these items, our primary market risk exposures from financial instruments are: •Interest-rate risk on fixed-rate, medium-term instruments. Changes in market interest rates affect the value of instruments that promise a fixed return. •Foreign currency exchange rate risk of the U.S. dollar primarily to the South Korean won, Euro, New Zealand dollar, Chinese yuan renminbi, and Taiwan dollar. An unfavorable change in exchange rates reduces the carrying value of net assets denominated in foreign currencies. Our Management of Market Risks We predominantly rely on three techniques to manage our exposure to market risk: • Investment/liability matching. We generally select investment assets with characteristics (such as duration, yield, currency and liquidity) that correspond to the underlying characteristics of our related insurance and contractholder liabilities so that we can match the investments to our obligations. Shorter-term investments generally support shorter-term life and health liabilities. Medium-term, fixed-rate investments support interest-sensitive and health liabilities. Longer-term investments generally support products with longer pay out periods such as annuities and long-term disability liabilities. • Use of local currencies for foreign operations. We generally conduct our international business through foreign operating entities that maintain assets and liabilities in local currencies. This technique limits exchange rate risk to our net assets. • Use of derivatives. We use derivative financial instruments to minimize certain market risks. See Note 9 to our Consolidated Financial Statements for additional information about derivative financial instruments. Effect of Market Fluctuations Assuming a 100 basis point increase in interest rates and 10% strengthening in the U.S. dollar to foreign currencies, the effect of hypothetical changes in market rates or prices on the fair value of certain financial instruments, subject to the exclusions noted above (particularly insurance liabilities), would have been as follows as of December 31: The effect of a hypothetical increase in interest rates, primarily on fixed maturities and commercial mortgage loans, was determined by estimating the present value of future cash flows using various models, primarily duration modeling. The impact of a hypothetical increase to interest rates at December 31, 2018 is consistent with the impact at December 31, 2017, which has been restated to exclude long-term debt, as discussed below. In the event of a hypothetical 100 basis point increase in interest rates, the fair value of the Company's long-term debt would decrease approximately $2.4 billion at December 31, 2018 and $0.5 billion at December 31, 2017. The impact at December 31, 2018 was greater than that at December 31, 2017 due to additional long-term debt issued in acquiring Express Scripts. Changes in the fair value of our long-term debt do not impact our financial position or operating results. See Note 5 to our Consolidated Financial Statements for additional information about the Company's debt. The effect of a hypothetical strengthening of the U.S. dollar relative to the foreign currencies of certain financial instruments held by us was estimated to be 10% of the U.S. dollar equivalent fair value. Our foreign operations hold investment assets, such as fixed maturities, cash, and cash equivalents, that are generally invested in the currency of the related liabilities. The effect of a hypothetical 10% strengthening in the U.S. dollar to foreign currencies at December 31, 2018 is consistent with that at December 31, 2017. CIGNA CORPORATION - 2018 Form 10-K 63 PART II

<s>[INST] Page Executive Overview Liquidity and Capital Resources Critical Accounting Estimates Segment Reporting Integrated Medical Health Services International Markets Group Disability and Other Corporate Investment Assets Management's Discussion and Analysis of Financial Condition and Results of Operations ("MD&A") is intended to provide information to assist you in better understanding and evaluating our financial condition and results of operations. We encourage you to read this MD&A in conjunction with our Consolidated Financial Statements included in Part II, Item 8 of this Annual Report on Form 10K ("Form 10K") and the "Risk Factors" contained in Part I, Item 1A of this Form 10K. Unless otherwise indicated, financial information in the MD&A is presented in accordance with accounting principles generally accepted in the United States of America ("GAAP"). See Note 2 to our Consolidated Financial Statements for additional information regarding the Company's significant accounting policies. In some of our financial tables in this MD&A, we present either percentage changes or "N/M" when those changes are so large as to become not meaningful. Changes in percentages are expressed in basis points ("bps"). In this MD&A, our consolidated measures "adjusted income from operations," earnings per share on that same basis, and "adjusted revenues" are not determined in accordance with GAAP and should not be viewed as substitutes for the most directly comparable GAAP measures "shareholders' net income," "earnings per share" and "total revenues." As discussed in Note 21, we also use pretax adjusted income from operations and adjusted revenues to measure the results of our segments. We use adjusted income from operations as our principal financial measure of operating performance because management believes it best reflects the underlying results of our business operations and permits analysis of trends in underlying revenue, expenses and profitability. We define adjusted income from operations as shareholders' net income (or income before taxes for the segment metric) excluding realized investment gains and losses, amortization of acquired intangible assets, results of Anthem, Inc. and Coventry Health Care Inc. ("Coventry") (collectively, the "transitioning clients") (see the "Key Transactions and Developments" section of the MD&A for further discussion of transitioning clients) and special items. Beginning in 2018, Cigna's share of certain realized investment results of its joint ventures reported using the equity method of accounting are also excluded. Income or expense amounts excluded from adjusted income from operations because they are not indicative of underlying performance or the responsibility of operating segment management include: Realized investment gains (losses), including changes in market values of certain financial instruments between balance sheet dates, as well as gains and losses associated with invested asset sales. Amortization of acquired intangible assets, because these relate to costs incurred for acquisitions. Results of transitioning clients, because those results are not indicative of ongoing results. Special items, if any, that management believes are not representative of the underlying results of operations due to the nature or size of these matters. See Note 21 to the Consolidated Financial Statements for descriptions of special items. Adjusted revenues is defined as total revenues excluding the following adjustments: revenue contributions from transitioning clients, special items and, beginning in 2018, Cigna's share of certain realized investment results of its joint ventures reported using the equity method of accounting. Executive Overview Cigna Corporation, together with its subsidiaries (either individually or collectively referred to as "Cigna," the "Company," "we," "our" or "us") is a global health service organization dedicated to a mission of helping those we serve improve their health, wellbeing and peace of mind. Our evolved strategy in support of our mission is Go Deeper, Go Local, Go Beyond using a differentiated set of medical, pharmacy, dental, disability, life and accident insurance and related products and services offered by our subsidiaries. For further information on our business and strategy, see Item 1, "Business" in this Form 10K. As described more fully in Note 3 to our Consolidated Financial Statements, on March 8, [/INST] Negative. </s>

Cigna Corp

2020-02-27

2019-12-31

Item 7. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS PAGE Executive Overview Liquidity and Capital Resources Critical Accounting Estimates Segment Reporting Health Services Integrated Medical International Markets Group Disability and Other Corporate Investment Assets Management’s Discussion and Analysis of Financial Condition and Results of Operations (“MD&A”) is intended to provide information to assist you in better understanding and evaluating our financial condition as of December 31, 2019 compared with December 31, 2018 and our results of operations for the year ended December 31, 2019 compared with 2018 and 2017. We encourage you to read this MD&A in conjunction with our Consolidated Financial Statements included in Part II, Item 8 of this Annual Report on Form 10-K (“Form 10-K”) and the Risk Factors contained in Part 1A of this Form 10-K. For comparisons of our results of operations for the year ended December 31, 2018 with 2017 please refer to the previously filed MD&A included in Part II, Item 7 of our Annual Report on Form 10-K for the fiscal year ended December 31, 2018. Unless otherwise indicated, financial information in the MD&A is presented in accordance with accounting principles generally accepted in the United States of America (“GAAP”). See Note 2 to the Consolidated Financial Statements included in this Form 10-K for additional information regarding the Company’s significant accounting policies. In some of our financial tables in this MD&A, we present either percentage changes or “N/M” when those changes are so large as to become not meaningful. Changes in percentages are expressed in basis points (“bps”). In this MD&A, our consolidated measures “adjusted income from operations,” earnings per share on that same basis, and “adjusted revenues” are not determined in accordance with GAAP and should not be viewed as substitutes for the most directly comparable GAAP measures of “shareholders’ net income,” “earnings per share” and “total revenues.” We also use pre-tax adjusted income from operations and adjusted revenues to measure the results of our segments. We use adjusted income from operations as our principal financial measure of operating performance because management believes it best reflects the underlying results of our business operations and permits analysis of trends in underlying revenue, expenses and profitability. We define adjusted income from operations as shareholders’ net income (or income before taxes for the segment metric) excluding realized investment gains and losses, amortization of acquired intangible assets, results of Anthem and Coventry Health Care Inc. (“Coventry”) (collectively, the “transitioning clients”) (see the “Key Transactions and Developments” section of the MD&A for further discussion of transitioning clients) and special items. Cigna’s share of certain realized investment results of its joint ventures reported in the International Markets segment using the equity method of accounting are also excluded. Income or expense amounts excluded from adjusted income from operations because they are not indicative of underlying performance or the responsibility of operating segment management include: Realized investment gains (losses) including changes in market values of certain financial instruments between balance sheet dates, as well as gains and losses associated with invested asset sales. Amortization of acquired intangible assets because these relate to costs incurred for acquisitions. Results of transitioning clients because those results are not indicative of ongoing results. Special items, if any, that management believes are not representative of the underlying results of operations due to the nature or size of these matters. See Note 23 to the Consolidated Financial Statements for descriptions of special items. The term “Adjusted revenues” is defined as total revenues excluding the following adjustments: revenue contributions from transitioning clients, special items and Cigna’s share of certain realized investment results of its joint ventures reported in the International Markets segment using the equity method of accounting. We exclude these items from this measure because management believes they are not indicative of past or future underlying performance of the business. EXECUTIVE OVERVIEW Cigna Corporation, together with its subsidiaries (either individually or collectively referred to as “Cigna,” the “Company,” “we,” “our” or “us”) is a global health service organization dedicated to a mission of helping those we serve improve their health, well-being and peace of mind. Our evolved strategy in support of our mission is Go Deeper, Go Local, Go Beyond using a differentiated set of pharmacy, medical, dental, disability, life and accident insurance and related products and services offered by our subsidiaries. For further information on our business and strategy, see Item 1, “Business” in this Form 10-K. Results for the year ended December 31, 2019 included the results of Express Scripts’ business, whereas results for 2018 only reflected Express Scripts’ results for the period following the acquisition on December 20, 2018 and were not included in 2017. As discussed in Note 23 to the Consolidated Financial Statements, effective in the first quarter of 2019, compensation cost for stock options is now recorded by our segments. Prior year segment information has not been restated for this change. Financial Summary Summarized below are certain key measures of our performance for the years ended December 31: Consolidated Results of Operations (GAAP Basis) Commentary: 2019 versus 2018 Unless indicated otherwise, the commentary presented below, and in the segment discussions that follow, compare results for the year ended December 31, 2019 with results for the year ended December 31, 2018. Earnings and Revenue Shareholders’ net income increased, primarily driven by the earnings contribution from Express Scripts and improved results in the Integrated Medical segment partially offset by interest expense on debt issued to finance the Express Scripts acquisition. Earnings per share also increased, but at a significantly lower rate, reflecting dilution from the shares issued in connection with the Express Scripts acquisition. Adjusted income from operations increased, primarily driven by earnings from Express Scripts’ pharmacy benefits and health management businesses reported in the Health Services segment and improved results in Integrated Medical. These favorable results were partially offset by higher interest expense reported in Corporate from both debt issued to finance the acquisition and debt assumed from Express Scripts. Adjusted income from operations per share also increased, but at a significantly lower rate, reflecting dilution from the shares issued to acquire Express Scripts. Medical customers increased, primarily attributable to growth in the Select and Middle Market segments, partially offset by a decline in the National Accounts and Individual market segments. Revenue growth primarily reflected the addition of Express Scripts and, to a lesser extent, business growth in the Integrated Medical segment. Detailed revenue items are discussed further below. oPharmacy revenues in 2019 reflected the Express Scripts pharmacy benefit management business. In 2018, we reported pharmacy revenues from Express Scripts for the period following the acquisition on December 20, 2018. See the Health Services Segment section of this MD&A for further discussion of pharmacy revenues. oPremiums increased, primarily resulting from: 1) customer growth across all segments, predominantly Integrated Medical 2) rate increases in Integrated Medical reflecting underlying medical cost trends and 3) the addition of Express Scripts’ Medicare Part D business. oFees and other revenues increased primarily driven by contributions from Express Scripts’ health management business reported in the Health Services segment. Higher fees in our Integrated Medical segment primarily driven by growth in our specialty businesses also contributed to the increase. oNet investment income decreased, primarily reflecting the absence of investment income earned in the fourth quarter of 2018 on debt proceeds used to acquire Express Scripts in December 2018. Other Components of Consolidated Results of Operations Pharmacy and other service costs. In 2019, this amount was primarily comprised of the Express Scripts’ pharmacy benefits and health management businesses reported in the Health Services segment. In 2018, we reported activity from Express Scripts for the period following the acquisition on December 20, 2018. Medical costs and other benefit expenses increased, primarily due to medical cost inflation in Integrated Medical, customer growth in the insured business and the addition of Express Scripts’ Medicare Part D business. Selling, general and administrative expenses increased, primarily due to the addition of Express Scripts and, to a lesser extent, volume-related expenses in Integrated Medical. These increases were partially offset by suspension of the health insurance industry tax in 2019. Amortization of acquired intangible assets in 2019 primarily reflected the impact of the Express Scripts acquisition. Interest expense and other increased significantly, primarily due to interest incurred on debt issued in the third quarter of 2018 to finance the Express Scripts acquisition and interest incurred on Express Scripts’ debt assumed upon closing of the acquisition. Realized investment gains (losses). We reported realized investment gains in 2019, compared with losses in 2018. The improvement primarily resulted from gains on sales of real estate joint ventures, higher gains on sales of debt securities and favorable market value adjustments on equity securities. The consolidated effective tax rate declined, primarily due to suspension of the nondeductible health insurance industry tax in 2019 and recognition of incremental state tax benefits in the second quarter of 2019. Key Transactions and Business Developments Merger with Express Scripts As discussed in Note 4 to the Consolidated Financial Statements, Cigna acquired Express Scripts on December 20, 2018 in a cash and stock transaction valued at $52.8 billion. The “Liquidity” section of this MD&A provides further discussion of the impact of the acquisition on our liquidity and capital resources. We continue to incur costs related to this transaction, including costs to integrate the Cigna and Express Scripts operations. These costs are being reported in “integration and transaction-related costs” as a special item and excluded from adjusted income from operations because they are not indicative of future underlying performance of the business. On January 30, 2019, Anthem exercised its early termination right and terminated their pharmacy benefit management services agreement with us, effective March 1, 2019. There is a twelve-month transition period ending March 1, 2020. The transition of Anthem’s customers occurred at various dates, as informed by Anthem’s technology platform migration schedule. In 2019 and 2018, we excluded the results of Express Scripts’ contract with Anthem (and also Coventry) from our non-GAAP reporting metrics “adjusted revenues” and “adjusted income from operations” and referred to these clients as “transitioning clients.” As of December 31, 2019, the transition of customers was substantially complete; therefore, beginning in 2020, we will no longer exclude results of transitioning clients from our reported adjusted revenues and adjusted income from operations. Agreement to sell Group Disability and Life business As discussed in Note 5 to the Consolidated Financial Statements, in December 2019, Cigna entered into a definitive agreement to sell the Group Disability and Life business to New York Life Insurance Company for $6.3 billion. The “Liquidity” section of this MD&A provides further discussion of the impact of the pending divestiture on our liquidity and capital resources. Organizational Efficiency Plan As discussed in Note 15 to the Consolidated Financial Statements, during the fourth quarter of 2019 the Company committed to a plan to increase our organizational alignment and operational efficiency and reduce costs. As a result we recognized a charge in selling, general and administrative expenses of $207 million, pre-tax ($162 million, after-tax) in the fourth quarter of 2019. We expect to realize annualized after-tax savings of approximately $180 million. A substantial portion of the savings is expected to be realized in 2020. Industry Developments and Other Matters The “Business - Regulation” section of this Form 10-K provides a detailed description of The Patient Protection and Affordable Care Act (“ACA”) provisions and other legislative initiatives that impact our health care and pharmacy services businesses, including regulations issued by the Centers for Medicare & Medicaid Services (“CMS”) and the Departments of the Treasury and Health and Human Services (“HHS”). The health care and pharmacy services businesses continue to operate in a dynamic environment, and the laws and regulations applicable to these businesses, including the ACA, continue to be subject to legislative, regulatory and judicial challenges. The table presented below provides an update on the expected impact of these items and other matters as of December 31, 2019. Risk Mitigation Programs - Individual ACA Business In 2016, we recorded an allowance for the entire balance of our ACA risk corridor receivable based on court decisions and the large program deficit. During 2018, the U.S. Court of Appeals for the Federal Circuit ruled that health insurers are not entitled to receive amounts due under the risk corridor program that have been withheld by Congress. The plaintiffs petitioned the U.S. Supreme Court to review this unfavorable decision. During the second quarter of 2019, the U.S. Supreme Court agreed to review the unfavorable lower court rulings in the risk corridor cases, and heard oral arguments on December 10, 2019. We now await a decision, which is expected by June 2020. We continue to carry an allowance for the balance of our ACA risk corridor receivables of $109 million. No other significant updates occurred in 2019 related to the risk corridor legal matters. Risk adjustment balances are subject to audit adjustment by CMS following each program year. In April 2019, CMS published the final Notice of Benefit and Payment Parameters for the 2020 plan year that clarified the 2017 benefit year RADV program. CMS released the 2017 benefit year data validation error rates in May and published the preliminary RADV transfers in August 2019. Based on the information currently available, we adjusted our risk adjustment balance to reflect the expected outcome of the RADV program. The following table presents our balances associated with the risk adjustment program as of December 31, 2019 and December 31, 2018, inclusive of the RADV adjustments recorded in 2019. Charges for the ongoing risk adjustment program and RADV audit adjustments were $162 million pre-tax ($126 million after-tax) in 2019, $147 million pre-tax ($116 million after-tax) in 2018 and $162 million ($105 million after-tax) in 2017. LIQUIDITY AND CAPITAL RESOURCES Liquidity We maintain liquidity at two levels: the subsidiary level and the parent company level. Liquidity requirements at the subsidiary level generally consist of: ·medical costs, pharmacy and other benefit payments; ·expense requirements, primarily for employee compensation and benefits, information technology and facilities costs; income taxes; and debt service. Our subsidiaries normally meet their liquidity requirements by: ·maintaining appropriate levels of cash, cash equivalents and short-term investments; ·using cash flows from operating activities; matching investment durations to those estimated for the related insurance and contractholder liabilities; selling investments; and borrowing from affiliates, subject to applicable regulatory limits. Liquidity requirements at the parent company level generally consist of: ·debt service and dividend payments to shareholders; ·lending to subsidiaries as needed; and pension plan funding. The parent company normally meets its liquidity requirements by: ·maintaining appropriate levels of cash and various types of marketable investments; ·collecting dividends from its subsidiaries; ·using proceeds from issuance of debt and common stock; and borrowing from its subsidiaries, subject to applicable regulatory limits. Dividends from our insurance, Health Maintenance Organization (“HMO”) and foreign subsidiaries are subject to regulatory restrictions. See Note 20 to the Consolidated Financial Statements for additional discussion of these restrictions. Most of Express Scripts’ subsidiaries provide significant financial flexibility to Cigna because they are not subject to regulatory restrictions on paying dividends. Cash flows for the years ended December 31, were as follows The following discussion explains variances in the various categories of cash flows in 2019 compared with 2018. Operating activities Cash flows from operating activities consist principally of cash receipts and disbursements for pharmacy revenues and costs, premiums, fees, investment income, taxes, benefit costs and other expenses. Cash flows from operating activities increased, primarily driven by higher net income adjusted for depreciation and amortization and the settlement timing of payables and accrued liabilities. These increases were partially offset by the timing of accounts receivable collections. Investing and Financing activities Our most significant investing and financing activities in 2018 related to acquiring Express Scripts. See Note 4 to the Consolidated Financial Statements for additional information on the acquisition. Cigna financed a portion of the acquisition in cash, primarily with debt financing as shown above and described more fully in Note 7 to the Consolidated Financial Statements, with the remaining required cash coming from cash on hand. In 2018, Cigna also acquired OnePath Life for approximately $480 million, largely with cash held in our foreign operations. Cash used for investing activities decreased, primarily due to the absence of cash paid to acquire Express Scripts in 2018 and lower net investment purchases, partially offset by higher property and equipment purchases. Cash used for financing activities increased, primarily due to the absence of the Express Scripts acquisition debt financing activities in 2018, higher repayments of long-term debt and share repurchases. We maintain a share repurchase program authorized by our Board of Directors. Under this program, we may repurchase shares from time to time, depending on market conditions and alternate uses of capital. The timing and actual number of shares repurchased will depend on a variety of factors including price, general business and market conditions and alternate uses of capital. The share repurchase program may be effected through open market purchases or privately negotiated transactions in compliance with Rule 10b-18 under the Securities Exchange Act of 1934, as amended, including through Rule 10b5-1 trading plans. The program may be suspended or discontinued at any time. In 2019, we repurchased 11.8 million shares for approximately $2.0 billion. From January 1, 2020 through February 26, 2020 we repurchased 2.0 million shares for approximately $425 million. Share repurchase authority was $3.5 billion as of February 26, 2020. Capital Resources Our capital resources (primarily cash flows from operating activities and proceeds from the issuance of debt and equity securities) provide protection for policyholders, furnish the financial strength to underwrite insurance risks and facilitate continued business growth. Our acquisition of Express Scripts increased our debt and shareholders’ equity in 2018 as follows: Stock. Express Scripts’ shareholders received 0.2434 of a share of common stock of Cigna for every one share of Express Scripts’ common stock. Cigna issued 137.6 million additional shares to Express Scripts’ shareholders. Debt. See Note 7 to the Consolidated Financial Statements for further description of the debt issued to finance the acquisition. Assumption of Express Scripts’ Senior Notes. See Note 7 to the Consolidated Financial Statements for further description of the notes assumed in the acquisition of Express Scripts. At December 31, 2019, our debt-to-capitalization ratio was 45.2%, a decline from 50.9% at December 31, 2018. We have a near-term focus on accelerated debt repayment and expect to continue to deleverage into the upper 30%s by the end of 2020 using cash flows from operating activities. In December 2019, Cigna entered into a definitive agreement to sell the Group Disability and Life business to New York Life Insurance Company for $6.3 billion. The sale is expected to close by the third quarter of 2020 subject to applicable regulatory approvals and other customary closing conditions. Cigna estimates to receive approximately $5.3 billion of net after-tax proceeds from this transaction and expects to use these proceeds for share repurchase and repayment of debt in 2020. In 2018, Cigna entered into a new Revolving Credit Agreement and Term Loan Credit Agreement in financing the Express Scripts acquisition. Cigna had $10 million of letters of credit outstanding under the Revolving Credit Agreement as of December 31, 2019. In 2019, Cigna entered into an additional 364-day revolving credit agreement that matures in October 2020. See Note 7 to the Consolidated Financial Statements for further information on our revolving credit agreements. Management, guided by regulatory requirements and rating agency capital guidelines, determines the amount of capital resources that we maintain. Management allocates resources to new long-term business commitments when returns, considering the risks, look promising and when the resources available to support existing business are adequate. We prioritize our use of capital resources to: provide the capital necessary to support growth and maintain or improve the financial strength ratings of subsidiaries and to fund pension obligations; consider acquisitions that are strategically and economically advantageous; and return capital to investors primarily through share repurchases. Our capital management strategy to support the liquidity and regulatory capital requirements of our foreign operations and certain international growth initiatives is to retain overseas a significant portion of the earnings generated by our foreign operations. This strategy does not materially limit our ability to meet our liquidity and capital needs in the United States. Liquidity and Capital Resources Outlook We maintain sufficient liquidity to meet our cash needs through our cash and cash equivalents balances, cash flows from operations, commercial paper program, credit agreements, and the issuance of long-term debt. As of December 31, 2019, we had approximately $5 billion in cash and short-term investments, approximately $1.1 billion of which was held by the parent company or nonregulated subsidiaries. We actively monitor our debt obligations and engage in issuance or redemption activities as needed in accordance with our capital management strategy. A description of our outstanding debt can be found in Note 7 to the Consolidated Financial Statements. As of December 31, 2019, our unfunded pension liability was $873 million, reflecting an increase of $ 283 million from December 31, 2018, primarily attributable to a decrease in discount rates of approximately 90 basis points and an update to mortality assumptions. We currently expect 2020 and 2021 required contributions to be immaterial. See Note 16 to the Consolidated Financial Statements for additional information regarding our pension plans. Our cash projections may not be realized and the demand for funds could exceed available cash if our ongoing businesses experience unexpected shortfalls in earnings or we experience material adverse effects from one or more risks or uncertainties described more fully in the Risk Factors section in this Form 10-K. Though we believe we have adequate sources of liquidity, significant disruption or volatility in the capital and credit markets could increase costs or affect our ability to access those markets for additional borrowings. In addition to the sources of liquidity discussed above, the parent company can borrow an additional $1.0 billion from its insurance subsidiaries without further state approval. Guarantees and Contractual Obligations We are contingently liable for various contractual obligations entered into in the ordinary course of business. See the “Liquidity and Capital Resources” section of this MD&A for additional background on how we manage our liquidity requirements related to these obligations. The maturities of our primary contractual cash obligations are as follows as of December 31, 2019: On balance sheet: Insurance liabilities. Excluded from the table above are $4 billion of insurance liabilities ($3 billion in contractholder deposit funds; $1 billion in future policy benefits) associated with the sold retirement benefits and individual life insurance and annuity businesses, as well as the reinsured workers’ compensation, personal accident and supplemental benefits businesses as their related net cash flows are not expected to impact our cash flows. Excluding these amounts, the sum of the obligations presented above exceeds the corresponding insurance and contractholder liabilities of $23 billion recorded on the balance sheet (including $6 billion reported in liabilities held for sale) because some of the recorded insurance liabilities reflect discounting for interest and the recorded contractholder liabilities exclude future interest crediting, charges and fees. The timing and amount of actual future cash flows may differ from those presented above. oContractholder deposit funds: see Note 9 to the Consolidated Financial Statements for our accounting policy for this liability. Expected future cash flows presented above also include estimated future interest crediting on current fund balances based on current investment yields less the estimated cost of insurance charges and mortality and administrative fees for universal life policies. oFuture policy benefits and unpaid claims and claim expenses: see Note 9 to the Consolidated Financial Statements for our accounting policies for these liabilities. Expected future cash flows for these liabilities presented in the table above are undiscounted. The expected future cash flows for guaranteed minimum death benefit (“GMDB,” reported in future policy benefits) do not consider any of the related reinsurance arrangements. Long-term debt includes scheduled interest payments and current maturities of long-term debt. See Note 7 to the Consolidated Financial Statements for information regarding long-term debt. Finance leases are included in long-term debt and primarily represent obligations for information technology network storage, servers and equipment. See Note 19 to the Consolidated Financial Statements for information regarding finance leases. Operating leases: See Note 19 to the Consolidated Financial Statements for additional information. Other noncurrent liabilities include estimated payments for guaranteed minimum income benefit (“GMIB”) contracts (without considering any related reinsurance arrangements), pension and other postretirement and postemployment benefit obligations, supplemental and deferred compensation plans, interest rate and foreign currency swap contracts and reinsurance liabilities. Estimated payments of $91 million for deferred compensation, non-qualified and international pension plans and other postretirement and postemployment benefit plans are expected to be paid in less than one year and are included in the table above. We expect to make immaterial contributions to the qualified domestic pension plans during 2020 and they are reflected in the above table. We expect to make payments subsequent to 2020 for these obligations; however, subsequent payments have been excluded from the table as their timing is based on plan assumptions that may materially differ from actual activities. See Note 16 to the Consolidated Financial Statements for further information on pension obligations. The table above excludes the liabilities for uncertain tax positions because we cannot reasonably estimate the timing of such future payments. In the event we are unable to sustain all of our $1 billion of uncertain tax positions it could result in future tax payments of approximately $760 million. See Note 21 to the Consolidated Financial Statements for additional information on uncertain tax positions. Off-Balance Sheet: Purchase obligations. As of December 31, 2019, purchase obligations consisted of estimated payments required under contractual arrangements for future services and investment commitments as follows: Our estimated future service commitments primarily represent contracts for certain outsourced business processes and information technology maintenance and support. We generally have the ability to terminate these agreements, but do not anticipate doing so at this time. Purchase obligations exclude contracts that are cancelable without penalty and those that do not contractually require minimum levels of goods or services to be purchased. Guarantees We are contingently liable for various financial and other guarantees provided in the ordinary course of business. See Note 22 to the Consolidated Financial Statements for additional information on guarantees. CRITICAL ACCOUNTING ESTIMATES The preparation of Consolidated Financial Statements in accordance with GAAP requires management to make estimates and assumptions that affect reported amounts and related disclosures in the Consolidated Financial Statements. Management considers an accounting estimate to be critical if: it requires assumptions to be made that were uncertain at the time the estimate was made; and changes in the estimate or different estimates that could have been selected could have a material effect on our consolidated results of operations or financial condition. Management has discussed how critical accounting estimates are developed and selected with the Audit Committee of our Board of Directors and the Audit Committee has reviewed the disclosures presented below. We regularly evaluate items that may impact critical accounting estimates. In addition to the estimates presented in the following tables, there are other accounting estimates used in preparing our Consolidated Financial Statements, including estimates of liabilities for future policy benefits, as well as estimates with respect to pension and postretirement benefits other than pensions and certain compensation accruals. Management believes the current assumptions used to estimate amounts reflected in our Consolidated Financial Statements are appropriate. However, if actual experience significantly differs from the assumptions used in estimating amounts reflected in our Consolidated Financial Statements, the resulting changes could have a material adverse effect on our consolidated results of operations and in certain situations, could have a material adverse effect on liquidity and our financial condition. The tables below present the adverse impacts of certain possible changes in assumptions. The effect of assumption changes in the opposite direction would be a positive impact to our consolidated results of operations, liquidity or financial condition, except for assessing impairment of goodwill and debt securities carried at fair value below cost. Balance Sheet Caption / Nature of Critical Accounting Estimate Effect if Different Assumptions Used Goodwill and other intangible assets Goodwill represents the excess of the cost of businesses acquired over the fair value of their net assets at the acquisition date. Intangible assets primarily reflect the value of customer relationships and other intangibles acquired in business combinations. Fair values of reporting units are estimated using models and assumptions that we believe a hypothetical market participant would use to determine a current transaction price. The significant assumptions and estimates used in determining fair value include the discount rate and future cash flows. A discount rate is selected to correspond with each reporting unit’s weighted average cost of capital, consistent with that used for investment decisions considering the specific and detailed operating plans and strategies within each reporting unit. Projections of future cash flows for each reporting unit are consistent with our annual planning process for revenues, pharmacy costs, benefits expenses, operating expenses, taxes, capital levels and long-term growth rates. In addition to these assumptions, we consider market data to evaluate the fair value of each reporting unit. The fair value of intangibles and the amortization method were determined using an income approach that relies on projected future cash flows including key assumptions for customer attrition and discount rates. Management revises amortization periods if it believes there has been a change in the length of time that an intangible asset will continue to have value. We completed our normal annual evaluations for impairment of goodwill and intangible assets during the third quarter of 2019. The evaluations indicated that the fair value estimates of our reporting units exceed their carrying values by sufficient margins and no impairments were required. Goodwill and other intangibles as of December 31 were as follows (in millions): 2019 - Goodwill $44,602; Other intangible assets $36,562 2018 - Goodwill $44,505; Other intangible assets $39,003 See Note 18 to the Consolidated Financial Statements for additional discussion of our goodwill and other intangible assets. If we do not achieve our earnings and cash flow projections or our cost of capital rises significantly, the assumptions and estimates underlying the goodwill and intangible asset impairment evaluations could be adversely affected and result in future impairment charges that would negatively impact our operating results and financial position. Specific to the Government reporting unit, future changes in the funding for our Medicare programs by the federal government could materially reduce revenues and profitability and have a significant impact on its fair value. Balance Sheet Caption / Nature of Critical Accounting Estimate Effect if Different Assumptions Used Income taxes - uncertain tax positions We evaluate tax positions to determine whether the benefits are more likely than not to be sustained on audit based on their technical merits. If not, we establish a liability for unrecognized tax benefits. These amounts primarily relate to federal and state uncertain positions of the value and timing of deductions and uncertain positions of attributing taxable income to states. Balances that are included in the Consolidated Balance Sheets are as follows: 2019 - $1.0 billion 2018 - $928 million See Note 21 to the Consolidated Financial Statements for additional discussion around uncertain tax positions and the Liquidity and Capital Resources section of this MD&A for a discussion of their potential impact on liquidity. The factors that could impact our estimates of uncertain tax positions include the likelihood of being sustained upon audit based on the technical merits of the tax position and related assumed interest and penalties. If our positions are upheld upon audit, our net income would increase. Balance Sheet Caption / Nature of Critical Accounting Estimate Effect if Different Assumptions Used Unpaid claims and claim expenses - Integrated Medical Unpaid claims and claim expenses include both reported claims and estimates for losses incurred but not yet reported. Unpaid claims and claim expenses in Integrated Medical are primarily impacted by assumptions related to completion factors and medical cost trend. Variation of actual results from either assumption could impact the unpaid claims balance as noted below. A large number of factors may cause the medical cost trend to vary from the Company’s estimates, including: changes in health management practices, changes in the level and mix of benefits offered and services utilized, and changes in medical practices. Completion factors may be affected if actual claims submission rates from providers differ from estimates (that can be influenced by a number of factors, including provider mix and electronic versus manual submissions), or if changes to the Company’s internal claims processing patterns occur. Unpaid claims and claim expenses for the Integrated Medical segment as of December 31 were as follows (in millions): 2019 - gross $2,892; net $2,589 2018 - gross $2,697; net $2,433 These liabilities are presented above both gross and net of reinsurance and other recoverables. See Note 9 to the Consolidated Financial Statements for additional information regarding assumptions and methods used to estimate this liability. Based on studies of our claim experience, it is reasonably possible that a 100 basis point change in the medical cost trend and a 50 basis point change in completion factors could occur in the near term. A 100 basis point increase in the medical cost trend rate would increase this liability by approximately $40 million, resulting in a decrease in net income of approximately $35 million after-tax, and a 50 basis point decrease in completion factors would increase this liability by approximately $85 million, resulting in a decrease in net income of approximately $70 million after-tax. Balance Sheet Caption / Nature of Critical Accounting Estimate Effect if Different Assumptions Used Unpaid claims and claim expenses - long-term disability reserves The liability for long-term disability reserves is the present value of estimated future benefits payments over the expected disability period and includes estimates for both reported claims and for claims incurred but not yet reported. Key assumptions in the calculation of long-term disability reserves include the discount rate and claim resolution rates, both of which are reviewed annually and updated when experience or future expectations would indicate a necessary change. The discount rate is the interest rate used to discount the projected future benefit payments to their present value. The discount rate assumption is based on the projected investment yield of the assets supporting the reserves. Claim resolution rate assumptions involve many factors including claimant demographics, the type of contractual benefit provided and the time since initially becoming disabled. The Company uses its own historical experience to develop its claim resolution rates. Long-term disability reserves as of December 31 were as follows (in millions): 2019 - gross $4,308; net $4,191 2018 - gross $4,069; net $3,975 These liabilities are presented above both gross and net of reinsurance recoverables and are included in liabilities held for sale in the Consolidated Balance Sheet. See Note 9C. to the Consolidated Financial Statements for additional information regarding assumptions and methods used to estimate this liability. Based on recent and historical resolution rate patterns and changes in investment portfolio yields, it is reasonably possible that a five percent change in claim resolution rates and a 25 basis point change in the discount rate could occur. A five percent decrease in the claim resolution rate would increase long-term disability reserves by approximately $95 million and decrease net income by approximately $75 million after-tax. A 25 basis point decrease in the discount rate would increase long-term disability reserves by approximately $45 million and decrease net income by approximately $35 million after-tax. Balance Sheet Caption / Nature of Critical Accounting Estimate Effect if Different Assumptions Used Valuation of debt security investments Most debt securities are classified as available for sale and are carried at fair value with changes in fair value recorded in accumulated other comprehensive income (loss) within shareholders’ equity. Fair value is defined as the price at which an asset could be exchanged in an orderly transaction between market participants at the balance sheet date. Determining fair value for a financial instrument requires management judgment. The degree of judgment involved generally correlates to the level of pricing readily observable in the markets. Financial instruments with quoted prices in active markets or with market observable inputs to determine fair value, such as public securities, generally require less judgment. Conversely, private placements including more complex securities that are traded infrequently are typically measured using pricing models that require more judgment as to the inputs and assumptions used to estimate fair value. There may be a number of alternative inputs to select based on an understanding of the issuer, the structure of the security and overall market conditions. In addition, these factors are inherently variable in nature as they change frequently in response to market conditions. Approximately two-thirds of our debt securities are public securities, and one-third are private placement securities. Typically, the most significant input in the measurement of fair value is the market interest rate used to discount the estimated future cash flows of the instrument. Such market rates are derived by calculating the appropriate spreads over comparable U.S. Treasury securities, based on the credit quality, industry and structure of the asset. See Notes 11A. and 12 to the Consolidated Financial Statements for a discussion of our fair value measurements, the procedures performed by management to determine that the amounts represent appropriate estimates and our accounting policy regarding unrealized appreciation on debt securities. If the derived interest rates used to calculate fair value increased by 100 basis points, the fair value of the total debt security portfolio of $24 billion would decrease by approximately $1.5 billion, resulting in an after-tax decrease to shareholders’ equity of approximately $0.9 billion. Balance Sheet Caption / Nature of Critical Accounting Estimate Effect if Different Assumptions Used Assessment of “other-than-temporary” impairments on debt securities Certain debt securities with a fair value below amortized cost are carried at fair value with changes in fair value recorded in accumulated other comprehensive income. For these investments, we have determined that the decline in fair value below its amortized cost is temporary. To make this determination, we evaluate the expected recovery in value and our intent to sell or the likelihood of a required sale of the debt security prior to an expected recovery. In making this evaluation, we consider a number of general and specific factors including the regulatory, economic and market environments, length of time and severity of the decline, and the financial health and specific near term prospects of the issuer. The after-tax amounts as of December 31 in accumulated other comprehensive income for debt securities in an unrealized loss position were as follows (in millions): 2019 - ($25) 2018 - ($370) See Note 11 to the Consolidated Financial Statements for additional discussion of our review of declines in fair value, including information regarding our accounting policies for debt securities. If we subsequently determine that the excess of amortized cost over fair value is other-than-temporary for any or all of these debt securities, the amount recorded in accumulated other comprehensive income would be reclassified to shareholders’ net income as an impairment loss. SEGMENT REPORTING The following section of this MD&A discusses the results of each of our segments. See Note 1 to the Consolidated Financial Statements for a description of our segments. In segment discussions, we present adjusted revenues and “pre-tax adjusted income from operations,” defined as income before taxes excluding realized investment gains (losses), amortization of acquired intangible assets, results of transitioning clients, (income) loss attributable to noncontrolling interests and special items. Ratios presented in this segment discussion exclude the same items as pre-tax adjusted income from operations. See Note 23 to the Consolidated Financial Statements for additional discussion of these metrics and a reconciliation of income before income taxes to pre-tax adjusted income from operations, as well as a reconciliation of total revenues to adjusted revenues. Note 23 to the Consolidated Financial Statements also explains two additional items that are important in understanding our segment results: 1) segment revenues include both external revenues and sales between segments that are eliminated in Corporate and 2) beginning in the first quarter of 2019, compensation cost for stock options is recorded by the segments. Prior year segment information was not restated for this change in stock option reporting. In these segment discussions, we also present “pre-tax adjusted margin,” defined as pre-tax adjusted income from operations divided by adjusted revenues. See the MD&A Executive Overview for summarized financial results of each of our segments. Health Services Segment The Health Services segment includes pharmacy benefits management, specialty pharmacy services, clinical solutions, home delivery and health management services. This segment includes Express Scripts’ business from the December 20, 2018 date of acquisition except for Express Scripts’ Medicare Part D business that is reported in the Government operating segment of our Integrated Medical segment. This segment also includes Cigna’s legacy home delivery pharmacy business. Due to the timing of the acquisition, results of operations in 2018 only included results from the Express Scripts’ business for the period following the acquisition on December 20, 2018. The main driver of period over period increases in the financial information presented below was the results from the Express Scripts’ business in 2019. As described in the introduction to Segment Reporting, performance of the Health Services segment is measured using pre-tax adjusted income from operations. The key factors that impact Health Services revenues and costs of revenues are volume, mix and price. These key factors are discussed further below. See Note 2 to the Consolidated Financial Statements for additional information on revenue and cost recognition policies for this segment. As our clients’ claim volumes increase or decrease, our resulting revenues and cost of revenues correspondingly increase or decrease. Our gross profit could also increase or decrease as a result of changes in purchasing discounts. The mix of claims generally considers the type of drug and distribution method used for dispensing and fulfilling. As our mix of drugs changes, our resulting pharmacy revenues and cost of revenues correspondingly may increase or decrease. The primary driver of fluctuations within our mix of claims is the generic fill rate. Generally, higher generic fill rates reduce revenues, as generic drugs are typically priced lower than the branded drugs they replace. However, as ingredient cost paid to pharmacies on generic drugs is incrementally lower than the price charged to our clients, higher generic fill rates generally have a favorable impact on our gross profit. The home delivery generic fill rate is currently lower than the network generic fill rate as fewer generic substitutions are available among maintenance medications (such as therapies for chronic conditions) commonly dispensed from home delivery pharmacies as compared to acute medications that are primarily dispensed by pharmacies in our retail networks. Our client contract pricing is impacted by our ability to negotiate supply chain contracts for pharmacy network, pharmaceutical and wholesaler purchasing and manufacturer rebates. As we seek to improve the effectiveness of our integrated solutions for the benefit of our clients, we are continuously innovating and optimizing the supply chain. Our gross profit could also increase or decrease as a result of supply chain initiatives implemented. Inflation also impacts our pricing because most of our contracts provide that we bill clients and pay pharmacies based on a generally recognized price index for pharmaceuticals. Therefore, the rate of inflation for prescription drugs and our efforts to manage this inflation for our clients can affect our revenues and cost of revenues. In this MD&A, we present revenues and gross profit “excluding transitioning clients” in addition to those metrics including transitioning clients. Pre-tax adjusted income from operations and pre-tax adjusted margin exclude contributions from transitioning clients. See the “Key Transactions and Business Developments” section of this MD&A for further discussion of transitioning clients and why we present this information. Results of Operations (1)Amounts exclude contributions from transitioning clients. (2)Non-specialty network scripts filled through 90-day programs and home delivery scripts are multiplied by three. All other network and specialty scripts are counted as one script. 2019 versus 2018 This segment includes Express Scripts’ business from the date of acquisition by the Company on December 20, 2018 with the exception of Express Scripts’ Medicare Part D business that is reported in the Government operating segment. In the third quarter of 2019, Integrated Medical’s Commercial customers transitioned to Express Scripts’ retail pharmacy network. Results of operations for 2018 reflected the results for the period following the acquisition of Express Scripts on December 20, 2018 along with the legacy Cigna home delivery business. Adjusted revenues. The increase reflected a full year of results from the Express Scripts’ business in 2019. Adjusted revenues in 2019 for the Health Services segment reflected strong performance, including customer growth, adjusted pharmacy scripts volume, specialty pharmacy care and management of supply chain. Pre-tax adjusted income from operations. The increase reflected a full year of results from the Express Scripts’ business in 2019. Results in the Health Services segment in 2019 reflected strong performance, including customer growth, adjusted pharmacy scripts volumes and benefits from the effective management of the supply chain. Integrated Medical Segment The business section of this Form 10-K (see the “Integrated Medical” section) describes the various products and funding solutions offered by this segment, including the various revenue sources. As described in the introduction to Segment Reporting, performance of the Integrated Medical segment is measured using pre-tax adjusted income from operations. Key factors affecting profitability for this segment include: customer growth; revenues from integrated specialty products, including pharmacy services sold to clients and customers across all funding solutions; percentage of Medicare Advantage customers in plans eligible for quality bonus payments; benefit expenses as a percentage of premiums (medical care ratio or “MCR”) for our insured commercial and government businesses; and selling, general and administrative expense as a percentage of adjusted revenues (expense ratio). Results of Operations 2019 versus 2018 Adjusted revenues. The increase reflected Commercial customer growth in our insured business as well as higher premium rates due to underlying medical cost trend and the addition of Express Scripts’ Medicare Part D business. Pre-tax adjusted income from operations. The increase reflected strong ongoing performance in our Commercial segment, including increased contributions from our commercial health insurance business and specialty products, partially offset by lower margins in our Individual business. Medical care ratio. As expected, the medical care ratio increased, reflecting a reduction in premiums from the pricing impact of the suspension of the health insurance industry tax in 2019 and business mix related to the addition of Express Scripts’ Medicare Part D business, as well as a higher Individual medical care ratio. Expense ratio. The expense ratio decreased primarily reflecting higher revenues in our insurance business and the suspension of the health insurance industry tax in 2019. Other Items Affecting Integrated Medical Results Unpaid Claims and Claim Expenses Our unpaid claims and claim expenses liability was higher as of December 31, 2019 compared with December 31, 2018, primarily due to customer growth. Medical Customers Our medical customer base was higher at December 31, 2019 compared with the same period in 2018, primarily reflecting growth in our Select and Middle Market segments partially offset by a lower customer base in our National Accounts and Individual market segments. A medical customer is defined as a person meeting any one of the following criteria: is covered under a medical insurance policy, managed care arrangement or service agreement issued by us; has access to our provider network for covered services under their medical plan; or has medical claims that are administered by us. International Markets Segment As described in the introduction to Segment Reporting, performance of the International Markets segment is measured using pre-tax adjusted income from operations. Key factors affecting pre-tax adjusted income from operations for this segment are: premium growth, including new business and customer retention; benefit expenses as a percentage of premiums (loss ratio); selling, general and administrative expense and acquisition expense as a percentage of revenues (expense ratio and acquisition cost ratio); and the impact of foreign currency movements. Results of Operations 2019 versus 2018 Adjusted revenues. The increase reflected business growth in Asia, Europe, and the Middle East and the acquisition of OnePath Life in New Zealand in the fourth quarter of 2018. These increases were partially offset by unfavorable foreign currency movements. Pre-tax adjusted income from operations. The increase reflected business growth in Asia and the acquisition of OnePath Life, partially offset by unfavorable foreign currency movements. The segment’s loss ratio was essentially flat. The acquisition cost ratio decreased due to lower spending in certain markets and the acquisition of OnePath Life, partially offset by higher acquisition expenses in South Korea and Taiwan. The increase in the expense ratio (excluding acquisition costs) was driven primarily by strategic investments for long-term growth and integration of OnePath Life. Other Items Affecting International Markets Results South Korea is the single largest geographic market for our International Markets segment. In 2019, South Korea generated 37% of the segment’s adjusted revenues and 63% of the segment’s pre-tax adjusted income from operations. Group Disability and Other As described in the introduction of Segment Reporting, performance of Group Disability and Other is measured using pre-tax adjusted income from operations. Key factors affecting pre-tax adjusted income from operations are: premium growth, including new business and customer retention; net investment income; benefit expenses as a percentage of premiums (loss ratio); and selling, general and administrative expense as a percentage of revenues excluding net investment income (expense ratio). Results of Operations 2019 versus 2018 Adjusted revenues. The increase reflected business growth in the group disability, life and voluntary businesses, partially offset by the continued run-off of international business and lower investment income. Pre-tax adjusted income from operations and Pre-tax adjusted margin. The decreases resulted from unfavorable disability claims experience. Corporate Corporate reflects amounts not allocated to operating segments, including net interest expense (defined as interest on corporate debt less net investment income on investments not supporting segment and other operations), certain litigation matters, expense associated with our frozen pension plans, charitable contributions, severance, certain overhead and project costs and intersegment eliminations for products and services sold between segments. As discussed in the introduction to Segment Reporting, beginning in the first quarter of 2019, compensation cost for stock options is now recorded by the segments. Prior year results for Corporate were not restated to reflect this change. 2019 versus 2018 Pre-tax adjusted loss from operations. The increase reflected higher interest expense on debt issued in the third quarter of 2018 to finance the Express Scripts acquisition and debt assumed from Express Scripts. INVESTMENT ASSETS The following table presents our investment asset portfolio excluding separate account assets as of December 31, 2019 and 2018. Additional information regarding our investment assets is included in Notes 11, 12, 13 and 14 to the Consolidated Financial Statements. Debt Securities Investments in debt securities include publicly-traded and privately-placed bonds, mortgage and other asset-backed securities and preferred stocks redeemable by the investor. These investments are classified as available for sale and are carried at fair value on our balance sheet. Additional information regarding valuation methodologies, key inputs and controls is included in Note 12 to the Consolidated Financial Statements. More detailed information about debt securities by type of issuer and maturity dates is included in Note 11 to the Consolidated Financial Statements. The following table reflects our portfolio of debt securities by type of issuer as of December 31, 2019 and 2018. The table below includes investments held for sale as of December 31, 2019. Our debt securities portfolio increased during 2019 reflecting increased valuations due to decreases in market yields, partially offset by net sales and maturities. As of December 31, 2019, $21.2 billion, or 90% of the debt securities in our investment portfolio were investment grade (Baa and above, or equivalent) and the remaining $2.5 billion were below investment grade. The majority of the bonds that are below investment grade are rated at the higher end of the non-investment grade spectrum. These quality characteristics have not materially changed from the prior year and are consistent with our investment strategy. Investments in debt securities are diversified by issuer, geography and industry as appropriate. Foreign government obligations are concentrated in Asia, primarily South Korea, consistent with our risk management practice and local regulatory requirements of our international business operations. Corporate debt securities include private placement assets of $7.5 billion. These investments are generally less marketable than publicly-traded bonds; however yields on these investments tend to be higher than yields on publicly-traded bonds with comparable credit risk. We perform a credit analysis of each issuer and require financial and other covenants that allow us to monitor issuers for deteriorating financial strength and pursue remedial actions, if warranted. In addition to amounts classified as debt securities in our Consolidated Balance Sheets, we participate in an insurance joint venture in China with a 50% ownership interest. This entity had an investment portfolio of approximately $8.1 billion supporting its business that is primarily invested in Chinese corporate and government debt securities. We account for this joint venture on the equity method of accounting and report it in other assets. There were no investments with a material unrealized loss as of December 31, 2019. Commercial Mortgage Loans Our commercial mortgage loans are fixed rate loans, diversified by property type, location and borrower. Loans are secured by high quality commercial properties and are generally made at less than 70% of the property’s value at origination of the loan. Property value, debt service coverage, quality, building tenancy and stability of cash flows are all important financial underwriting considerations. We hold no direct residential mortgage loans and do not originate or service securitized mortgage loans. Commercial real estate capital markets remain very active for well-leased, quality commercial real estate located in strong institutional investment markets. The vast majority of properties securing the mortgages in our mortgage loan portfolio possess these characteristics. As of December 31, 2019, the $1.9 billion commercial mortgage loan portfolio consisted of approximately 65 loans that are in good standing. Given the quality and diversity of the underlying real estate, positive debt service coverage and significant borrower cash investment generally ranging between 30 and 40%, we remain confident that borrowers will continue to perform as expected under their contract terms. Other Long-term Investments Other long-term investments of $ 2.4 billion as of December 31, 2019 included investments in securities limited partnerships and real estate limited partnerships as well as direct investments in real estate joint ventures. These entities typically invest in mezzanine debt or equity of privately-held companies (securities partnerships) and equity real estate. Given our subordinate position in the capital structure of these underlying entities, we assume a higher level of risk for higher expected returns. To mitigate risk, these investments are diversified across approximately 160 separate partnerships and approximately 80 general partners who manage one or more of these partnerships. Also, the underlying investments are diversified by industry sector or property type and geographic region. No single partnership investment exceeded 5% of our securities and real estate partnership portfolio. Problem and Potential Problem Investments “Problem” bonds and commercial mortgage loans are either delinquent by 60 days or more or have been restructured as to terms, including concessions by us for modification of interest rate, principal payment or maturity date. “Potential problem” bonds and commercial mortgage loans are considered current (no payment is more than 59 days past due), but management believes they have certain characteristics that increase the likelihood that they may become problems. The amount of problem or potential problem investments as of December 31, 2019 and 2018 was not material. Investment Outlook Public equity markets rallied during 2019, reflecting the continued strength of the U.S. economy. However, concerns related to trade and tariffs continue to contribute to financial market volatility. We continue to closely monitor global macroeconomic conditions and trends, including uncertainty caused by the United Kingdom’s process of exiting the European Union, and their potential impact on our investment portfolio. We expect continued volatility in certain sectors, such as retail, energy and natural gas. Future realized and unrealized investment results will be driven largely by market conditions that exist when a transaction occurs or at the reporting date. These future conditions are not reasonably predictable; however, we believe that the vast majority of our investments will continue to perform under their contractual terms. Based on our strategy to match the duration of invested assets to the duration of insurance and contractholder liabilities, we expect to hold a significant portion of these assets for the long term. Although future impairment losses resulting from interest rate movements and credit deterioration due to both investment-specific and the global economic uncertainties discussed above remain possible, we do not expect these losses to have a material adverse effect on our financial condition or liquidity. MARKET RISK Financial Instruments Our assets and liabilities include financial instruments subject to the risk of potential losses from adverse changes in market rates and prices. Consistent with disclosure requirements, the following items have been excluded from this consideration of market risk for financial instruments: changes in the fair values of insurance-related assets and liabilities because their primary risks are insurance rather than market risk; changes in the fair values of investments recorded using the equity method of accounting and liabilities for pension and other postretirement and postemployment benefit plans (and related assets); and changes in the fair values of other significant assets and liabilities such as goodwill, deferred policy acquisition costs, taxes, and various accrued liabilities. Because they are not financial instruments, their primary risks are other than market risk. Excluding these items, our primary market risk exposures from financial instruments are: Interest-rate risk on fixed-rate, medium-term instruments. Changes in market interest rates affect the value of instruments that promise a fixed return. Foreign currency exchange rate risk of the U.S. dollar primarily to the South Korean won, Chinese yuan renminbi, New Zealand dollar, and Taiwan dollar. An unfavorable change in exchange rates reduces the carrying value of net assets denominated in foreign currencies. Our Management of Market Risks We predominantly rely on three techniques to manage our exposure to market risk: Investment/liability matching. We generally select investment assets with characteristics (such as duration, yield, currency and liquidity) that correspond to the underlying characteristics of our related insurance and contractholder liabilities so that we can match the investments to our obligations. Shorter-term investments generally support shorter-term life and health liabilities. Medium-term, fixed-rate investments support interest-sensitive and health liabilities. Longer-term investments generally support products with longer pay out periods such as annuities and long-term disability liabilities. Use of local currencies for foreign operations. We generally conduct our international business through foreign operating entities that maintain assets and liabilities in local currencies. This technique limits exchange rate risk to our net assets. Use of derivatives. We use derivative financial instruments to reduce our primary market risks. See Note 11 to the Consolidated Financial Statements for additional information about derivative financial instruments. Effect of Market Fluctuations Assuming a 100 basis point increase in interest rates and 10% strengthening in the U.S. dollar to foreign currencies, the effect of hypothetical changes in market rates or prices on the fair value of certain financial instruments, subject to the exclusions noted above (particularly insurance liabilities), would have been as follows as of December 31: The effect of a hypothetical increase in interest rates, primarily on debt securities and commercial mortgage loans, was determined by estimating the present value of future cash flows using various models, primarily duration modeling. In the event of a hypothetical 100 basis point increase in interest rates, the fair value of the Company’s long-term debt would decrease approximately $2.5 billion at December 31, 2019 and $2.4 billion at December 31, 2018. Changes in the fair value of our long-term debt do not impact our financial position or operating results. See Note 7 to the Consolidated Financial Statements for additional information about the Company’s debt. The effect of a hypothetical strengthening of the U.S. dollar relative to the foreign currencies of certain financial instruments held by us was estimated to be 10% of the U.S. dollar equivalent fair value. Our foreign operations hold investment assets, such as debt securities, cash, and cash equivalents that are generally invested in the currency of the related liabilities.

<s>[INST] Executive Overview Liquidity and Capital Resources Critical Accounting Estimates Segment Reporting Health Services Integrated Medical International Markets Group Disability and Other Corporate Investment Assets Management’s Discussion and Analysis of Financial Condition and Results of Operations (“MD&A”) is intended to provide information to assist you in better understanding and evaluating our financial condition as of December 31, 2019 compared with December 31, 2018 and our results of operations for the year ended December 31, 2019 compared with 2018 and 2017. We encourage you to read this MD&A in conjunction with our Consolidated Financial Statements included in Part II, Item 8 of this Annual Report on Form 10K (“Form 10K”) and the Risk Factors contained in Part 1A of this Form 10K. For comparisons of our results of operations for the year ended December 31, 2018 with 2017 please refer to the previously filed MD&A included in Part II, Item 7 of our Annual Report on Form 10K for the fiscal year ended December 31, 2018. Unless otherwise indicated, financial information in the MD&A is presented in accordance with accounting principles generally accepted in the United States of America (“GAAP”). See Note 2 to the Consolidated Financial Statements included in this Form 10K for additional information regarding the Company’s significant accounting policies. In some of our financial tables in this MD&A, we present either percentage changes or “N/M” when those changes are so large as to become not meaningful. Changes in percentages are expressed in basis points (“bps”). In this MD&A, our consolidated measures “adjusted income from operations,” earnings per share on that same basis, and “adjusted revenues” are not determined in accordance with GAAP and should not be viewed as substitutes for the most directly comparable GAAP measures of “shareholders’ net income,” “earnings per share” and “total revenues.” We also use pretax adjusted income from operations and adjusted revenues to measure the results of our segments. We use adjusted income from operations as our principal financial measure of operating performance because management believes it best reflects the underlying results of our business operations and permits analysis of trends in underlying revenue, expenses and profitability. We define adjusted income from operations as shareholders’ net income (or income before taxes for the segment metric) excluding realized investment gains and losses, amortization of acquired intangible assets, results of Anthem and Coventry Health Care Inc. (“Coventry”) (collectively, the “transitioning clients”) (see the “Key Transactions and Developments” section of the MD&A for further discussion of transitioning clients) and special items. Cigna’s share of certain realized investment results of its joint ventures reported in the International Markets segment using the equity method of accounting are also excluded. Income or expense amounts excluded from adjusted income from operations because they are not indicative of underlying performance or the responsibility of operating segment management include: Realized investment gains (losses) including changes in market values of certain financial instruments between balance sheet dates, as well as gains and losses associated with invested asset sales. Amortization of acquired intangible assets because these relate to costs incurred for acquisitions. Results of transitioning clients because those results are not indicative of ongoing results. Special items, if any, that management believes are not representative of the underlying results of operations due to the nature or size of these matters. See Note 23 to the Consolidated Financial Statements for descriptions of special items. The term “Adjusted revenues” is defined as total revenues excluding the following adjustments: revenue contributions from transitioning clients, special items and Cigna’s share of certain realized investment results of its joint ventures reported in the International Markets segment using the equity method of accounting. We exclude these items from this measure because management believes they are not indicative of past or future underlying performance of the business. EXECUTIVE OVERVIEW Cigna Corporation, together with [/INST] Positive. </s>

New Fortress Energy LLC

2019-03-26

2018-12-31

Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations. Certain information contained in this discussion and analysis, including information with respect to our plans, strategy, projections and expected timeline for our business and related financing, includes forward-looking statements that involve risks and uncertainties. Forward-looking statements are estimates based upon current information and involve a number of risks and uncertainties. Actual events or results may differ materially from the results anticipated in these forward-looking statements as a result of a variety of factors. You should read “Part 1, Item 1A. Risk Factors” and “Cautionary Statement on Forward-Looking Statements” elsewhere in this Annual Report on Form 10-K (“Annual Report”) for a discussion of important factors that could cause actual results to differ materially from the results described in or implied by the forward-looking statements contained in the following discussion and analysis. The following information should be read in conjunction with our audited consolidated financial statements and accompanying notes included elsewhere in this Annual Report. Our financial statements have been prepared in accordance with GAAP. This information is intended to provide investors with an understanding of our past performance and our current financial condition and is not necessarily indicative of our future performance. Please refer to “-Factors Impacting Comparability of Our Financial Results” for further discussion. Unless otherwise indicated, dollar amounts are presented in thousands. Unless the context otherwise requires, references to “Company,” “NFE,” “we,” “our,” “us” or like terms refer to New Fortress Energy LLC and its subsidiaries. When used in a historical context that is prior to the completion of NFE’s initial public offering (“IPO”), “Company,” “we,” “our,” “us” or like terms refer to New Fortress Energy Holdings LLC, a Delaware limited liability company (“New Fortress Energy Holdings”), our predecessor for financial reporting purposes. Overview We are engaged in providing energy and logistical services to end users worldwide seeking to convert their operating assets from diesel or heavy fuel oil (“HFO”) to liquefied natural gas (“LNG”). The Company currently has liquefaction and regasification operations in the United States and Jamaica. We currently source LNG from a combination of our own liquefaction facility in Miami, Florida and purchases from third party suppliers. We are developing the infrastructure necessary to supply all of our existing and future customers with LNG produced primarily at our own facilities. We expect that control of our vertical supply chain, from liquefaction to delivery of LNG, will help to reduce our exposure to future LNG price variations and enable us to supply our existing and future customers with LNG at a price that reflects production at our own facilities, reinforcing our competitive standing in the LNG market. Our strategy is simple: we seek to manufacture our own LNG at attractive prices, using fixed-price feedstock, and we seek to sell natural gas (delivered through LNG infrastructure) or gas-fired power to customers that sign long-term, take-or-pay contracts. Our Current Operations Our management team has successfully employed our strategy to secure long-term, take-or-pay contracts with Jamaica Public Service Company Limited (“JPS”), the sole public utility in Jamaica, South Jamaica Power Company Limited (“JPC”), an affiliate of JPS, and Jamalco, a joint venture between General Alumina Jamaica Limited (“GAJ”), a subsidiary of Noble Group, and Clarendon Alumina Production Limited, an entity owned by the Government of Jamaica, with a focus on bauxite mining and alumina production in Jamaica (“Jamalco”), each of which is described in more detail below. Certain assets built to service JPS have, and the assets built to service JPC and Jamalco will have, capacity to service other customers. We currently procure our LNG either by purchasing it under a multi-cargo contract from a supplier or by manufacturing it in our natural gas liquefaction, storage and production facility located in Miami-Dade County, Florida (the “Miami Facility”). In the future, we intend to develop the infrastructure necessary to supply our existing and future customers with LNG produced primarily at our own facilities, including our expanded delivery logistics chain in Northern Pennsylvania (the “Pennsylvania Facility”). Montego Bay Terminal Our storage and regasification terminal in Montego Bay, Jamaica (the “Montego Bay Terminal”) serves as our supply hub for the north side of Jamaica, providing gas to JPS to fuel the 145MW Bogue Power Plant in Montego Bay, Jamaica (the “Bogue Power Plant”). The Montego Bay Terminal commenced commercial operations on October 30, 2016 and stores approximately two million gallons of LNG in seven storage tanks. The Montego Bay Terminal also consists of an ISO loading facility that can transport LNG to all of our industrial and manufacturing (“small-scale”) customers across the island. The small-scale business provides these users with an alternative fuel to support their business operations and limit reliance on monopolistic utilities. Miami Facility Our Miami Facility began operations in April 2016. This facility enables us to produce LNG for our customers and reduces our dependence on other suppliers for LNG. The Miami Facility is the first plant to successfully export domestically produced LNG from the lower 48 states to a non-FTA country and it employs one of the largest ISO container fleets in the world. The Miami Facility provides LNG to small-scale customers in Southern Florida including Florida East Coast Railway via our train loading facility and other customers throughout the Caribbean using ISO containers. Results of Operations - Year Ended December 31, 2018 compared to Year Ended December 31, 2017 Revenues Operating revenue from LNG and natural gas sales for the year ended December 31, 2018 was $96,906 which increased by $14,802 from $82,104 for the year ended December 31, 2017, primarily due to additional small scale customers commencing operations in the fourth quarter of 2017 and in the first quarter of 2018. The delivered volume from the Miami Facility to our small-scale customers increased by 2.3 million gallons (190,330 MMBtu) from 8.3 million gallons (688,879 MMBtu) in 2017 to 10.6 million gallons (879,209 MMBtu) in 2018. The increase in operating revenue was also attributable to additional sales at the Montego Bay Terminal. The delivered volume increased by 12.9 million gallons (1.1 TBtu) from 86.3 million gallons (7.0 TBtu) in 2017 to 99.2 million gallons (8.1 TBtu) in 2018. Of the delivered volumes, 0.6 million gallons (46,065 MMBtu) and 3.1 million gallons (247,029 MMBtu) were delivered to small-scale networks in 2017 and 2018, respectively. Other revenue for the year ended December 31, 2018 was $15,395 which increased $237 from $15,158 for the year ended December 31, 2017. The Company leases certain facilities and equipment, including the Montego Bay Terminal, to its customers which are accounted for either as direct financing leases or operating leases. We currently generate a majority of other revenue from interest recognized from direct financing leases or leasing revenue from operating leases. Cost of sales Cost of sales for the year ended December 31, 2018 was $95,742 which increased $17,050 from $78,692 for the year ended December 31, 2017. The increase in Cost of sales was attributable to increased LNG cost from $0.51 per gallon ($6.18 per MMBtu) in 2017 to $0.57 per gallon ($6.84 per MMBtu) in 2018, as well as an increase in charter costs due to more shipments in 2018 compared to 2017 and an increase in volumes sold to small-scale customers. Cost of sales includes the procurement of feedgas or LNG as applicable, shipping and logistics costs to deliver LNG to our facilities and regasification and terminal operating expenses to supply LNG to our customers. Our LNG and natural gas supply are purchased from third parties or converted in our Miami Facility. Costs to convert natural gas to LNG, including labor and other direct costs to operate our Miami Facility are also included in Cost of sales. Operations and maintenance Operations and maintenance relates to costs of operating our Miami Facility as well as our Montego Bay Terminal exclusive of conversion costs reflected in Cost of sales. Operations and maintenance for the year ended December 31, 2018 was $9,589, which increased $2,133 from $7,456 for the year ended December 31, 2017. The increase is primarily a result of an increase in headcount and general maintenance costs at these facilities. Selling, general and administrative Selling, general and administrative includes employee travel costs, insurance, and costs associated with development activities for projects that are in initial stages and development is not yet probable. Selling, general and administrative also includes compensation expenses for our corporate employees, including our executives, as well as professional fees for our advisors. Selling, general and administrative for the year ended December 31, 2018, was $62,137 which increased $28,794 from $33,343 for the year ended December 31, 2017 primarily as a result of increased development activities, headcount and professional fees. Depreciation and amortization Depreciation and amortization for the year ended December 31, 2018 was $3,321, which increased $560 from $2,761 for the year ended December 31, 2017. The increase is primarily a result of additional equipment purchases placed in service for small-scale customers. Interest expense Interest expense for the year ended December 31, 2018 was $11,248, which increased $4,792 from $6,456 for the year ended December 31, 2017, primarily as a result of financing costs expensed and amortized for the Term Loan Facility (as defined below). Other (income), net Other income, net for the year ended December 31, 2018 was ($784), which increased $483 from ($301) for the year ended December 31, 2017, primarily as a result of interest income partially offset by realized foreign currency loss. Loss on extinguishment of debt Loss on extinguishment of debt for the year ended December 31, 2018 was $9,568, primarily as a result of the extinguishment of the MoBay Loan (as defined below) and the write-off of deferred financing costs associated with lenders in the Miami Loan (as defined below) and the Term Loan Facility that were treated as an extinguishment, as well as additional financing costs paid to such lenders. Tax provision (benefit) Tax benefit for the year ended December 31, 2018 was ($338), which increased $864 from a tax provision of $526 for the year ended December 31, 2017 due to losses incurred during 2018 in Jamaican entities. Results of Operations - Year Ended December 31, 2017 compared with Year Ended December 31, 2016 Revenues Operating revenue from LNG and natural gas sales for the year ended December 31, 2017 was $82,104, which increased by $63,489 from $18,615 for the year ended December 31, 2016. The increase in revenue was primarily attributable to 12 months of operations at the Miami Facility and Montego Bay Terminal during the year ended December 31, 2017, whereas the Miami Facility and Montego Bay Terminal were operating for eight and two months, respectively, during the year ended December 31, 2016. The delivered volume from the Miami Facility to our small-scale customers increased by 6.7 million gallons (554,415 MMBtu) from 1.6 million gallons (134,464 MMBtu) in 2016 to 8.3 million gallons (688,879 MMBtu) in 2017. We executed three contracts in 2016 and three contracts in 2017 to provide customers with LNG from our Miami Facility. The increase in operating revenue was also attributable to additional sales at the Montego Bay Terminal. The delivered volume increased by 86.7 million gallons (5.9 TBtu) from 12.5 million gallons (1.1 TBtu) in 2016 to 99.2 million gallons (7.0 TBtu) in 2017. Other revenue for the year ended December 31, 2017 was $15,158, which increased $12,378 from $2,780 for the year ended December 31, 2016. The increase is attributable to 12 months of operations at the Montego Bay Terminal during the year ended December 31, 2017, whereas the Montego Bay Terminal operated for two months in 2016. The Company leases certain facilities and equipment, including the Montego Bay Terminal, to its customers, which are accounted for as direct financing leases or operating leases. We currently generate a majority of Other revenue from interest recognized from these direct financing leases or leasing revenue from operating leases. Cost of sales Cost of sales includes the procurement of feedgas or LNG as applicable, shipping and logistics costs to deliver LNG to our facilities and regasification and terminal operating expenses to provide product to our customers. Our LNG and natural gas supply are purchased from third parties or converted in our Liquefaction Facilities. Costs to convert natural gas to LNG include labor and other direct costs to operate our Liquefaction Facilities and are also included in Cost of sales. Cost of sales for the year ended December 31, 2017 was $78,692, which increased $55,945 from $22,747 for the year ended December 31, 2016. The increase in Cost of sales was attributable to increased LNG cost from $0.41 per gallon ($4.95 per MMBtu) in 2016 to $0.51 per gallon ($6.18 per MMBtu) in 2017. Also, there were 12 months of operations at the Miami Facility and Montego Bay Terminal for the year ended December 31, 2017, whereas the Miami Facility and Montego Bay Terminal were operating for eight and two months, respectively, for the year ended December 30, 2016. Operations and maintenance Operations and maintenance relates to costs of operating our Miami Facility, as well as our Montego Bay Terminal, exclusive of conversion costs reflected in Cost of sales. Operations and maintenance for the year ended December 31, 2017 was $7,456, which increased $2,251 from $5,205 for the year ended December 31, 2016. The increase is primarily a result of the Miami Facility operating for 12 months in 2017 in comparison to operating for eight months in 2016. Selling, general and administrative Selling, general and administrative includes employee travel costs, insurance, and costs associated with development activities for projects that are in initial stages and development is not yet probable. Selling, general and administrative also includes compensation expenses for our corporate employees, including our executives, as well as professional fees for our advisors. Selling, general and administrative for the year ended December 31, 2017 was $33,343, which increased $15,183 from $18,160 for the year ended December 31, 2016 primarily as a result of increased development activities and employee travel as well as increased headcount. Depreciation and amortization Depreciation and amortization for the year ended December 31, 2017 was $2,761, which increased $420 from $2,341 for the year ended December 31, 2016. The increase is primarily a result of 12 months of operations at the Miami Facility and the purchase of additional equipment and vehicles which were placed into service during 2017. Interest expense Interest expense for the year ended December 31, 2017 was $6,456, which increased $1,351 from $5,105 for the year ended December 31, 2016, primarily as a result of interest on the MoBay Loan of $3,611 and $643 and Miami Loan of $2,845 and $1,803 for the years ended December 31, 2017 and December 31, 2016, respectively, net of capitalized interest recognized during construction in the year ended December 31, 2016. During 2017, we raised equity capital, which funded a majority of our capital expenditures resulting in a decrease in capitalized interest compared to 2016. The increase in interest expense is partially offset by the reduction of interest expense on our corporate loan, which was repaid at maturity in June 2016. Other (income), net Other income, net for the year ended December 31, 2017 was ($301), which increased $248 from ($53) for the year, ended December 31, 2016, primarily as a result of an increase in interest income and realized foreign currency gain. Loss on extinguishment of debt Loss on extinguishment of debt for the year ended December 31, 2016 was $1,177, which was recognized as a result of the extinguishment of the corporate loan on June 3, 2016. Tax provision (benefit) Tax provision (benefit) for the year ended December 31, 2017 was $526, which increased $887 from ($361) for the year ended December 31, 2016 due to a decrease in net taxable losses in a foreign jurisdiction when comparing year ended 2017 to year ended 2016. Factors Impacting Comparability of Our Financial Results Our historical results of operations and cash flows are not indicative of results of operations and cash flows to be expected in the future, principally for the following reasons: • Our historical financial results only include our Miami Facility and our Montego Bay Terminal. Our historical financial statements only include our Miami Facility and our Montego Bay Terminal and do not include future revenue resulting from long-term, take-or-pay contracts with downstream customers expected from projects under development, including the 190MW Old Harbour power plant operated by JPC in Old Harbour, Jamaica (the “Old Harbour Power Plant,”) the dual-fired CHP facility in Clarendon, Jamaica (the “CHP Plant”), the multi-fuel handling facility located in the Port of San Juan, Puerto Rico (the “San Juan Facility”), the LNG regasification terminal in La Paz, Baja California Sur, Mexico (the “La Paz Terminal”), the LNG terminal on the Shannon Estuary near Ballylongford, Ireland (the “Ireland Terminal”) and the Pennsylvania Facility. The Old Harbour Power Plant completed construction in December 2018 and commercial operations will begin in the second quarter of 2019. In addition, we currently purchase the majority of our supply of LNG from third parties. For the years ended December 31, 2018 and December 31, 2017, we sourced 92.5% and 94.1%, respectively, of our LNG volumes from third parties. NFE is in the process of developing in-basin liquefaction facilities that will vertically integrate our supply and substantially reduce the need to source LNG from third parties, which, when combined with lower cost production, should significantly impact our results of operations and cash flows from both contracted and expected downstream sales. • Our organizational structure has changed as a result of reorganization transactions completed at the time of our IPO. Our historical financial statements presented in this Annual Report, including this discussion and analysis, are the financial statements of New Fortress Energy Holdings, our predecessor. We completed our IPO on February 4, 2019, and proceeds from the IPO were used to purchase limited liability company units (“LLC Units”) in New Fortress Intermediate LLC (“NFI”), an entity formed in conjunction with the IPO. In addition, New Fortress Energy Holdings contributed all of its interests in consolidated subsidiaries that comprised substantially all of its historic operations, as well its limited assets and liabilities, to NFI in exchange for LLC Units. NFE is a holding company whose principal asset is a controlling equity interest in NFI. As the sole managing member of NFI, the Company operates and controls all of the business and affairs of NFI, and through NFI and its subsidiaries, conducts the Company’s historical business. The contribution of the assets of New Fortress Energy Holdings and net proceeds from the IPO to NFI was treated as a reorganization of entities under common control. NFE will retrospectively present the consolidated financial statements of New Fortress Energy Holdings for all current and comparative periods presented beginning with its first quarter 2019 financial statements. The financial statements of NFE that will be presented beginning in first quarter 2019 will allocate a significant portion of the results of operations to New Fortress Energy Holdings, through its non-controlling interest in NFI. The results of operations and earnings allocated to holders of Class A shares of NFE issued in the IPO will be less than historically presented within earnings per share. • We expect to incur incremental, selling, general and administrative expenses related to our transition to a publicly traded company. We completed our IPO on February 4, 2019, and we expect to incur direct, incremental general and administrative expenses as a result of being a publicly traded company, including costs associated with the employment of additional personnel, compliance under the Securities Exchange Act of 1934, as amended (the “Exchange Act”), annual and quarterly reports to our common shareholders, registrar and transfer agent fees, national stock exchange fees, the costs associated with the initial implementation of our Sarbanes-Oxley Act of 2002 (“Sarbanes-Oxley Act”) Section 404 internal controls and testing, audit fees, incremental director and officer liability insurance costs and director and officer compensation. These direct, incremental general and administrative expenses are not included in our historical results of operations. Liquidity and Capital Resources We believe we will have sufficient liquidity, cash flow from operations and access to additional capital sources, to fund our capital expenditures and working capital needs for the next 12 months. We expect to fund our current operations and continued development of additional facilities through a combination of cash on hand, additional borrowings from the Term Loan Facility, as defined below, and the proceeds from our IPO. The IPO was completed on February 4, 2019, and we issued and sold 20,000,000 Class A shares at an IPO price of $14.00 per share, raising net proceeds of $257,600. On March 1, 2019, the underwriters exercised their option to purchase an additional 837,272 Class A shares at the IPO price of $14.00 per share, less underwriting discounts, raising additional net proceeds of $11,048. We have assumed total expenditures for all completed and existing projects to be approximately $500,000, with approximately $333,000 having already been spent through December 31, 2018. This estimate represents the complete construction of projects in Jamaica and Miami. Borrowings under the Term Loan Facility will be used to make significant capital expenditures to build out our Terminals, including the Old Harbour Power Plant and the CHP Plant, as well as for small-scale customer capital expenditures for storage and regasification operations. We are currently exploring opportunities to expand our business into new markets, including the Caribbean and Mexico and we will require significant additional capital to implement our strategy. Cash Flows The following table summarizes the changes to our cash flows for the year ended December 31: Cash (used in) operating activities Our cash flow used in operating activities was $93,227 for the year ended December 31, 2018, which increased by $38,335 from $54,892 for the year ended December 31, 2017. For both years ended December 31, 2018 and 2017, we had net loss that comprised a significant portion of cash used in operating activities due to the continued expansion of our business activities. Cash flows used in operating activities for the year ended December 31, 2018 was also significantly impacted by increases in other asset accounts, primarily due to the acquisition of port access rights. Cash (used in) investing activities Our cash flow used in investing activities was $177,486 for the year ended December 31, 2018, which increased by $125,090 from $52,396 for the year ended December 31, 2017. The increase in cash flow used in investing activities is due to the increase in capital expenditures to complete the Old Harbour Power Plant, as well as, the Pennsylvania Facility and the CHP Plant. Cash provided by financing activities Our cash flow provided by financing activities was $264,306 for the year ended December 31, 2018, which increased by $252,960 from $11,346 for the year ended December 31, 2017. The increase in cash flow provided by financing activities is due to additional borrowings under the Term Loan Facility of $280,600. Additionally, the Company received $50,000 from the additional capital raised in December 2017, undertook an additional equity capital raise of $20,150 and received the cash during the year. The increase was offset by the repayment of the Miami Loan and the MoBay Loan in full. The following table summarizes the changes to our cash flows for the years ended December 31: Cash (used in) operating activities Our cash flow used in operating activities was $54,892 in 2017, which increased by $11,399 from $43,493 in 2016. For both the years ended December 31, 2017 and 2016, we had net loss that comprised a significant portion of cash used in operating activities due to the continued expansion of our operations in Jamaica. A significant portion of cash used in operations for the year ended December 31, 2017 was attributed to an increase in deposits attributed to a prepayment for LNG supply. Cash (used in) investing activities Our cash flow used in investing activities was $52,396 for the year ended December 31, 2017, which decreased by $51,644 from $104,040 for the year ended December 31, 2016. The decrease in cash flow used in investing activities is due to significant cash expenditures incurred in 2016 as the Company completed construction of its Miami Facility and its Montego Bay Terminal. The decrease was offset by construction that began in 2017 on the Old Harbour Power Plant resulting in approximately $28,500 in capital expenditures. The decrease was also partially offset by a restriction of $15,000 as collateral posted for performance under a GSA with a customer, and $7,000 of collateral posted with LNG suppliers for an upcoming delivery. Cash provided by financing activities Our cash flow provided by financing activities was $11,346 for the year ended December 31, 2017, which decreased by $266,353 from $277,699 for the year ended December 31, 2016. The decrease in cash flow provided by financing activities is due to the Company issuing shares in June 2016 in exchange for $300,505. The Company also received additional borrowings under the MoBay Loan of $44,000. The receipt of debt and equity capital in 2016 was offset by the repayment of corporate loan of $65,000. In December 2017, the Company undertook an additional capital raise of $70,100 of which $20,100 of cash was received in 2017, and the remainder in January 2018. This capital contribution was offset by principal payments on the Miami Loan and the MoBay Loan of $5,828. Long-Term Debt Term Loan Facility On August 16, 2018, the Company entered into a Term Loan Facility (as may be amended, from time to time, the “Term Loan Facility”) to borrow term loans, available in three draws, up to an aggregate principal amount of $240,000. On December 31, 2018, the Company amended its Term Loan Facility to, among other things, (i) increase the amount available for borrowing thereunder from $240,000 to $500,000, (ii) extend the initial maturity date to December 31, 2019, (iii) modify certain provisions relating to restrictive covenants and existing financial covenants, and (iv) remove the mandatory prepayment required with the net proceeds received in connection with an IPO. Borrowings under the Term Loan Facility bear interest at a rate selected by the Company of either (i) a LIBOR based rate, plus a spread of 4.0%, or (ii) subject to a floor of 1%, a Base Rate equal to the highest of (a) the Prime Rate, (b) the Federal Funds Rate plus 1 ⁄2 of 1% or (c) the 1-month LIBOR rate plus the difference between the applicable LIBOR margin and Base Rate margin, plus a spread of 3.0%. The Term Loan Facility contains certain covenants that require additional contracted revenue to be obtained within certain time periods, and an event of default or additional fee payments may result if those targets are not met in the future. The Term Loan Facility is set to mature on December 31, 2019 and is repayable in quarterly installments of $1,250, with a balloon payment due on the maturity date. The Company has the option to extend the maturity date for two additional six-month periods; upon the exercise of each extension option, the interest rate spread on LIBOR and Base Rate increases by 0.5%. To exercise each extension option, the Company must pay a fee equal to 1.0% of the outstanding principal balance at the time of the exercise of the option. The Term Loan Facility is secured by mortgages on certain properties owned by the Company’s subsidiaries, in addition to other collateral. The Company is required to comply with certain financial covenants and other restrictive covenants customary for facilities of this type, including restrictions on indebtedness, liens, acquisitions and investments, restricted payments and dispositions. The Term Loan Facility also provides for customary events of default, prepayment and cure provisions. As of December 31, 2018, the total principal amount outstanding under the Term Loan Facility was $280,000. On March 21, 2019, the Company drew an additional $220 million on the Term Loan Facility. Total principal amounts outstanding after this draw are $500 million. The Company used the net proceeds of the Term Loan Facility to repay the Miami Loan and the MoBay Loan in full during August 2018 and September 2018, respectively. The proceeds of the Term Loan Facility funded on December 31, 2018 will be used to make capital expenditures to complete the San Juan Facility, as well as for additional storage and regasification facilities for small-scale customers. The MoBay Loan was extinguished and the unamortized deferred financing costs at the time of repayment of $1,404, as well as a prepayment fee of $345, were recorded within Loss on extinguishment of debt in the consolidated statements of operations and comprehensive loss. The outstanding principal balance of the Miami Loan at the time of repayment was $38,707; the Company agreed to repay lenders $37,255 to extinguish the liability, and as such, a gain on extinguishment of $1,452 was recorded within Loss on extinguishment of debt in the consolidated statements of operations and consolidated loss. When the Term Loan Facility was amended in December 2018, refinanced borrowings and associated fees from one lender were accounted for as a debt modification, while refinanced borrowings and associated fees from one lender were accounted for as a debt extinguishment. Financing costs of $9,200 were written off to Loss on extinguishment of debt in the consolidated statements of operations and comprehensive loss including $2,820 of unamortized deferred financing costs and $6,380 of financing fees incurred in connection with the amendment of the Term Loan Facility. Montego Bay Loan Agreement In June 2016, NFE North Holdings Limited , a wholly owned subsidiary of the Company entered into a syndicated loan agreement providing for a $44,000 term loan facility (the “MoBay Loan”) in connection with the construction and development of the Montego Bay Terminal and related infrastructure. The maturity date for each loan drawn under the MoBay Loan was the day immediately preceding the seventh anniversary of the drawdown date of such loan. Outstanding amounts under the MoBay Loan accrued interest at a per annum rate of 8.10%. The MoBay Loan was required to be repaid in advance of the maturity date in consecutive, equal monthly payments, with the remaining outstanding amount due on the maturity date. The MoBay Loan could be prepaid at any time, upon 30 days’ prior written notice to the agent, subject to a prepayment fee of 2% of any amount being prepaid during the one year period from the date of the first loan drawdown of the MoBay Loan, or 1% of any amount being prepaid during the period commencing one year from the date of the first loan drawdown of the MoBay Loan and expiring on the fifth anniversary of such date. During the construction period of certain projects in 2016, related interest expense and borrowings costs were capitalized. Interest expense, inclusive of amortized debt fees for the years ended December 31, 2018, 2017, and 2016 totaled $2,402, $3,611, and $1,990 of which $1,732, $0 and $1,347 was capitalized as a finance lease, respectively. The Company used the net proceeds of the Term Loan Facility entered into in August 2018 to repay the MoBay Loan in full in September 2018. Miami Loan Agreement In November 2014, LNG Holdings (Florida) LLC (“LHFL”), a controlled subsidiary, entered into a credit agreement (the “Miami Loan”) with a bank for an initial aggregate amount of $40,000, maturing on May 24, 2018, in connection with the construction of the Miami Facility. Borrowings under the loan bore interest at a rate selected by LHFL of either (i) a LIBOR based rate, with a floor of 1.00%, plus a spread of 5.00%, or (ii) subject to a floor of 2%, a Base Rate equal to the higher of (a) the Prime Rate, (b) the Federal Funds Rate plus ½ of 1% or (c) the 1-month LIBOR rate plus the difference between the applicable LIBOR margin and Base Rate margin, plus a spread of 4.00%. Subject to certain conditions, the Miami Loan could be extended for an additional term of up to 18 months. On May 16, 2018, the Company extended the maturity to November 2019. To execute the extension option, the Company paid an extension fee of $388, equating to 1% of the outstanding principal at that time. The Miami Loan required periodic payments of interest on either a monthly, quarterly or semi-annual basis where LHFL selected the monthly interest rate option. In addition, with respect to LIBOR based borrowings, LHFL, at its option, could elect to defer up to ten interest periods outstanding at any point in time. The Miami Loan also required annual amortization in an amount equal to 1% of the amount outstanding. The Miami Loan could be prepaid without penalty after the first anniversary of the closing of the Miami Loan. At the time of the extinguishment of the debt in August 2018, and as of the years ended December 31, 2017 and 2016, interest was calculated on the borrowing based on a 1-month LIBOR rate (1% floor) plus a spread of 5%, bearing a total interest rate of 7.58%, 6.57% and 6.00%, as of the end of each respective period. Interest expense, inclusive of amortized debt fees for the years ended December 31, 2018, 2017 and 2016, totaled $1,987, $2,845 and $2,740 respectively. The Company used the net proceeds of the Term Loan Facility entered into in August 2018 to repay the Miami Loan in full in August 2018. Off Balance Sheet Arrangements As of December 31, 2018 and 2017, we had no transactions that met the definition of off-balance sheet arrangements that may have a current or future material effect on our consolidated financial position or operating results. Contractual Obligations We are committed to make cash payments in the future pursuant to certain of our contracts. The following table summarizes certain contractual obligations in place as of December 31, 2018: Long-Term debt obligations For information on our long-term debt obligations, see “-Liquidity and Capital Resources-Long-Term Debt.” The amounts included in the table above are based on the total debt balance, scheduled maturities and interest rates in effect as of December 31, 2018. Purchase obligations The Company is party to contractual purchase commitments with terms of 38 months and 81 months, including commitments entered into subsequent to December 31, 2018. These contracts are principally take-or-pay contracts, which require the purchase of minimum quantities of natural gas, and these commitments are designed to assure sources of supply and are not expected to be in excess of normal requirements. In December 2018, the Company entered into a contract with Centrica LNG Company Limited for the purchase of 29 firm cargoes of 1.05 million gallons of LNG (86.7 million MMBtu) scheduled for delivery between June 2019 and December 2021. The amounts disclosed excludes the two optional cargoes. Payment for each cargo is due in advance of each shipment. The Company currently has two contracts in place for the purchase of natural gas under take-or-pay minimum volume obligations. These commitments are structured to assure the Miami Facility has uninterrupted supply and the minimum volumes are not expected to be in excess of normal requirements. Subsequent to the year ended December 31, 2018, the Company entered into a contract with Peninsula Energy Services Company Inc. (“PESCO”) for the purchase of 0.2 million gallons of natural gas (12.6 million MMBtu) per day scheduled for delivery between March 2019 and November 2025. In March 2018, the Company entered into a 15-year agreement with an affiliate of Chesapeake Energy Corporation (“Chesapeake”), a large production company for gas supply to our Pennsylvania Facility, which was subsequently amended and restated in September 2018. This agreement provides for 100% of the required supply of feedgas to the facility, inclusive of all support functions of the plant, including transportation and power supply. The terms of the agreement require the Company to obtain all requisite permits and make a final investment decision before the agreement is effective. A final investment decision has not yet been made, and as such, this commitment is excluded from the table above. In addition to the above disclosed commitments, in September 2016 the Company made a commitment of up to an estimated $180,000 to build a gas-fired combined heat and power plant in Jamaica under a Joint Development Agreement with a third party prior to commercial agreements being finalized. In August and October 2017 respectively, a PPA and SSA were executed, obligating the Company to complete the development subject to the conditions set forth in those agreements. Operating Lease obligations Future minimum lease payments under non-cancellable operating leases are noted in the above table. The Company’s lease obligations are primarily related to LNG vessel time charters, office space, a land site lease, and a marine port berth lease. Office space includes a newly fabricated space shared with affiliated companies in New York with a month to month lease, and an office space under construction in downtown Miami, with a lease term of 84 months. The land site lease is held with an affiliate of the Company and has an initial term up to five years, and the marine port berth lease had an initial term up to 10 years. Both leases contain renewal options. The Company entered into several lease agreements during 2018 in Mexico and Puerto Rico. Such agreements include securing certain facilities, wharf areas, office space and specified port areas for development of terminals. Terms for these leases range from 20 to 30 years, and certain of these leases contain extension terms. Upfront fees paid subsequent to December 31, 2017 to secure leases were $21,871. Fixed lease payments under these leases are expected to be approximately $106 and some of these leases contain variable components based on LNG processed. The Company has entered into an agreement to lease a floating storage regasification unit for an initial term of 15 years with an option to renew for an additional five years. The leased asset is currently undergoing acceptance procedures. Once the acceptance procedures are completed, which is expected to occur in 2019, the lease term will commence. Subsequent to December 31, 2018, the Company entered into two additional LNG vessel time charters for contract terms ranging from three to five years. Summary of Critical Accounting Estimates The preparation of consolidated financial statements in conformity with GAAP requires management to make certain estimates and assumptions that affect the amounts reported in the consolidated financial statements and the accompanying notes. Changes in facts and circumstances or additional information may result in revised estimates, and actual results may differ from these estimates. Management evaluates its estimates and related assumptions regularly, and will continue to do so as we further launch and grow our business. We believe that the accounting policies discussed below are critical to understanding our historical and future performance, as these policies relate to the more significant areas involving management’s judgments and estimates. Revenue recognition Operating revenue from the sales of LNG and natural gas are recognized when the LNG or natural gas is delivered to the customer, either when the natural gas arrives at the customer’s flange or at the time that title to the LNG is transferred to the customer. Title typically transfers either when shipped or delivered to the customers’ storage facilities, depending on the terms of the contract. The Company’s contracts with customers to supply LNG may also contain a lease of equipment. The Company allocates consideration received from customers between lease and non-lease components based on the relative fair value of each component. The fair value of the lease component is estimated based on the market value of the same or similar equipment leased to the customer. The estimated fair value of the non-lease component is based on estimated volumes to be delivered at an estimated price or contractual price. The estimated fair value of the leased equipment, as a percentage of the estimated total revenue from LNG and leased equipment at inception, will establish the allocation percentage to determine the minimum lease payments and the amount to be accounted for under the revenue recognition guidance. The Company leases certain facilities and equipment to its customers which are accounted for as direct financing leases or operating leases. Direct financing leases, net on our consolidated balance sheet represents the minimum lease payments due, net of unearned revenue. The lease payments are segregated into principal and interest components similar to a loan. Unearned revenue is recognized on an effective interest method over the lease term and is recorded within Other revenue in the consolidated statement of operations and comprehensive loss. The principal components of the lease payment is reflected as a reduction to the net investment in the finance lease. For the Company’s operating leases, the amount allocated to the leasing component is recognized over the lease term as Other revenue in the consolidated statements of operations and comprehensive loss. Impairment LNG liquefaction facilities, and other long-lived assets held and used by the Company are reviewed periodically for potential impairment whenever events or changes in circumstances indicate that a particular assets carrying value may not be recoverable. Recoverability generally is determined by comparing the carrying value for the asset to the expected undiscounted future cash flows of the asset. If the carrying value of the asset is not recoverable, the amount of impairment loss is measured as the excess, if any, of the carrying value of the asset over its estimated fair value. The estimated undiscounted future cash flows are based on projections of future operating results; these projections contain estimates of the value of future contracts that have not yet been obtained, future commodity pricing and our future cost structure, among others. Projections of future operating results and cash flows may vary significantly from actual results. Management reviews its estimates of cash flows on an ongoing basis using historical experience, business plans, overall market conditions and other factors. JOBS Act In April 2012, the Jumpstart Our Business Startups Act of 2012, or the JOBS Act, was enacted. Section 107 of the JOBS Act provides that an “emerging growth company,” or EGC, can take advantage of the extended transition period provided in Section 7(a)(2)(B) of the Securities Act of 1933, as amended, or the Securities Act, for complying with new or revised accounting standards. Thus, an EGC can delay the adoption of certain accounting standards until those standards would otherwise apply to private companies. We have taken advantage of the exemptions discussed above. Accordingly, the information contained herein may be different than the information you receive from other public companies. Subject to certain conditions, as an EGC, we have elected to rely on certain of these exemptions, including without limitation, (1) providing an auditor’s attestation report on our system of internal controls over financial reporting pursuant to Section 404(b) of the Sarbanes-Oxley Act and (2) complying with any requirement that may be adopted by the Public Company Accounting Oversight Board, or PCAOB, regarding mandatory audit firm rotation or a supplement to the auditor’s report providing additional information about the audit and the financial statements, known as the auditor discussion and analysis. We will remain an EGC until the earlier of (i) the last day of the fiscal year in which we have total annual gross revenues of $1.07 billion or more; (ii) the last day of the fiscal year following the fifth anniversary of the date of the completion of our IPO, December 31, 2024; (iii) the date on which we have issued more than $1.00 billion in nonconvertible debt during the previous three years; or (iv) the date on which we are deemed to be a large accelerated filer under the rules of the Securities and Exchange Commission or SEC. Recent Account Standards For descriptions of recently issued accounting standards, see “Note 3 - Adoption of new and revised standards” to our notes to consolidated financial statements included elsewhere in this Annual Report.

<s>[INST] You should read “Part 1, Item 1A. Risk Factors” and “Cautionary Statement on ForwardLooking Statements” elsewhere in this Annual Report on Form 10K (“Annual Report”) for a discussion of important factors that could cause actual results to differ materially from the results described in or implied by the forwardlooking statements contained in the following discussion and analysis. The following information should be read in conjunction with our audited consolidated financial statements and accompanying notes included elsewhere in this Annual Report. Our financial statements have been prepared in accordance with GAAP. This information is intended to provide investors with an understanding of our past performance and our current financial condition and is not necessarily indicative of our future performance. Please refer to “Factors Impacting Comparability of Our Financial Results” for further discussion. Unless otherwise indicated, dollar amounts are presented in thousands. Unless the context otherwise requires, references to “Company,” “NFE,” “we,” “our,” “us” or like terms refer to New Fortress Energy LLC and its subsidiaries. When used in a historical context that is prior to the completion of NFE’s initial public offering (“IPO”), “Company,” “we,” “our,” “us” or like terms refer to New Fortress Energy Holdings LLC, a Delaware limited liability company (“New Fortress Energy Holdings”), our predecessor for financial reporting purposes. Overview We are engaged in providing energy and logistical services to end users worldwide seeking to convert their operating assets from diesel or heavy fuel oil (“HFO”) to liquefied natural gas (“LNG”). The Company currently has liquefaction and regasification operations in the United States and Jamaica. We currently source LNG from a combination of our own liquefaction facility in Miami, Florida and purchases from third party suppliers. We are developing the infrastructure necessary to supply all of our existing and future customers with LNG produced primarily at our own facilities. We expect that control of our vertical supply chain, from liquefaction to delivery of LNG, will help to reduce our exposure to future LNG price variations and enable us to supply our existing and future customers with LNG at a price that reflects production at our own facilities, reinforcing our competitive standing in the LNG market. Our strategy is simple: we seek to manufacture our own LNG at attractive prices, using fixedprice feedstock, and we seek to sell natural gas (delivered through LNG infrastructure) or gasfired power to customers that sign longterm, takeorpay contracts. Our Current Operations Our management team has successfully employed our strategy to secure longterm, takeorpay contracts with Jamaica Public Service Company Limited (“JPS”), the sole public utility in Jamaica, South Jamaica Power Company Limited (“JPC”), an affiliate of JPS, and Jamalco, a joint venture between General Alumina Jamaica Limited (“GAJ”), a subsidiary of Noble Group, and Clarendon Alumina Production Limited, an entity owned by the Government of Jamaica, with a focus on bauxite mining and alumina production in Jamaica (“Jamalco”), each of which is described in more detail below. Certain assets built to service JPS have, and the assets built to service JPC and Jamalco will have, capacity to service other customers. We currently procure our LNG either by purchasing it under a multicargo contract from a supplier or by manufacturing it in our natural gas liquefaction, storage and production facility located in MiamiDade County, Florida (the “Miami Facility”). In the future, we intend to develop the infrastructure necessary to supply our existing and future customers with LNG produced primarily at our own facilities, including our expanded delivery logistics chain in Northern Pennsylvania (the “Pennsylvania Facility”). Montego Bay Terminal Our storage and regasification terminal in Montego Bay, Jamaica (the “Montego Bay Terminal”) serves as our supply hub for the north side of Jamaica, providing gas to JPS to fuel the 145MW Bogue Power Plant in Montego Bay, Jamaica (the “Bogue Power Plant”). The Montego Bay Terminal commenced commercial operations on October 30, 2016 and stores approximately two million gallons of LNG in seven storage tanks. The Montego Bay Terminal also consists of an ISO loading [/INST] Negative. </s>

New Fortress Energy LLC

2020-03-04

2019-12-31

Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations. Certain information contained in this discussion and analysis, including information with respect to our plans, strategy, projections and expected timeline for our business and related financing, includes forward-looking statements. Forward-looking statements are estimates based upon current information and involve a number of risks and uncertainties. Actual events or results may differ materially from the results anticipated in these forward-looking statements as a result of a variety of factors. You should read “Part 1, Item 1A. Risk Factors” and “Cautionary Statement on Forward-Looking Statements” elsewhere in this Annual Report on Form 10-K (“Annual Report”) for a discussion of important factors that could cause actual results to differ materially from the results described in or implied by the forward-looking statements contained in the following discussion and analysis. The comparison of the years ended December 31, 2018 and 2017 can be found in our Annual Report on Form 10-K for the year ended December 31, 2018 located within “Part II, Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations.” The following information should be read in conjunction with our audited consolidated financial statements and accompanying notes included elsewhere in this Annual Report. Our financial statements have been prepared in accordance with GAAP. This information is intended to provide investors with an understanding of our past performance and our current financial condition and is not necessarily indicative of our future performance. Please refer to “-Factors Impacting Comparability of Our Financial Results” for further discussion. Unless otherwise indicated, dollar amounts are presented in thousands. Unless the context otherwise requires, references to “Company,” “NFE,” “we,” “our,” “us” or like terms refer to New Fortress Energy LLC and its subsidiaries. When used in a historical context that is prior to the completion of NFE’s initial public offering (“IPO”), “Company,” “we,” “our,” “us” or like terms refer to New Fortress Energy Holdings LLC, a Delaware limited liability company (“New Fortress Energy Holdings”), our predecessor for financial reporting purposes. Overview We are a global integrated gas-to-power infrastructure company that seeks to use natural gas to satisfy the world’s large and growing power needs. We deliver targeted energy solutions to customers around the world, thereby reducing their energy costs and diversifying their energy resources, while also reducing pollution and generating compelling margins. Our near-term mission is to provide modern infrastructure solutions to create cleaner, reliable energy while generating a positive economic impact worldwide. Our long-term mission is to become one of the world’s leading carbon emission-free independent power providing companies. We discuss this important goal in more detail in “Items 1 and 2: Business and Properties” under “Toward a Carbon-Free Future”. As an integrated gas-to-power energy infrastructure company, our business model spans the entire production and delivery chain from natural gas procurement and liquefaction to logistics, shipping, terminals and conversion or development of natural gas-fired generation. We currently source LNG from long-term supply agreements with third party suppliers and from our own liquefaction facility in Miami, Florida. We expect that control of our vertical supply chain, from procurement to delivery of LNG, will help to reduce our exposure to future LNG price variations and enable us to supply our existing and future customers with LNG at a price that reinforces our competitive standing in the LNG market. Our strategy is simple: we seek to procure LNG at attractive prices using long-term agreements and through our own production, and we seek to sell natural gas (delivered through LNG infrastructure) or gas-fired power to customers that sign long-term, take-or-pay contracts. Our Current Operations Our management team has successfully employed our strategy to secure long-term contracts with significant customers in Jamaica and Puerto Rico, including Jamaica Public Service Company Limited (“JPS”), the sole public utility in Jamaica, South Jamaica Power Company Limited (“JPC”), an affiliate of JPS, Jamalco, a bauxite mining and alumina production in Jamaica, and the Puerto Rico Electric Power Authority (“PREPA”), each of which is described in more detail below. Our assets built to service these significant customers have been designed with capacity to service other customers. We currently procure our LNG either by purchasing it under a contract from a supplier or by manufacturing it in our natural gas liquefaction and storage facility located in Miami-Dade County, Florida (the “Miami Facility”). Our long-term goal is to develop the infrastructure necessary to supply our existing and future customers with LNG produced primarily at our own facilities, including our expanded delivery logistics chain in Northern Pennsylvania (the “Pennsylvania Facility”). Montego Bay Terminal Our storage and regasification terminal in Montego Bay, Jamaica (the “Montego Bay Terminal”) serves as our supply hub for the north side of Jamaica, providing natural gas to JPS to fuel the 145MW Bogue Power Plant in Montego Bay, Jamaica. Our Montego Bay Terminal commenced commercial operations in October 2016 and is capable of processing up to 740,000 LNG gallons (61,000 MMBtu) per day and features approximately 7,000 cubic meters of onsite storage. The Montego Bay Terminal also consists of an ISO loading facility that can transport LNG to numerous on-island industrial users. Old Harbour Terminal Our marine LNG storage and regasification terminal in Old Harbour, Jamaica (the “Old Harbour Terminal”) commenced commercial operations in June 2019 and is capable of processing approximately six million gallons of LNG (500,000 MMBtu) per day. The Old Harbour Terminal supplies natural gas to the new 190MW Old Harbour power plant (the “Old Harbour Power Plant”) operated by JPC. The Old Harbour Terminal is also supplying natural gas to our dual-fired combined heat and power facility in Clarendon, Jamaica (the “CHP Plant”). The CHP Plant will supply electricity to JPS under a long-term power purchase agreement. The CHP Plant will also provide steam to Jamalco under a long-term take-or-pay steam supply agreement. We expect that the CHP Plant will begin to deliver energy capacity under the power purchase agreement and steam under the steam supply agreement in the first quarter of 2020. San Juan Facility We are finalizing the development of the micro-fuel handling facility in the Port of San Juan, Puerto Rico (the “San Juan Facility”). The San Juan Facility is currently being developed near the San Juan Power Plant and will serve as our supply hub for the San Juan Power Plant and other industrial end-user customers in Puerto Rico. We expect to begin to deliver natural gas under the Fuel Sale and Purchase Agreement with PREPA in the first quarter of 2020. Miami Facility Our Miami Facility began operations in April 2016. This facility has liquefaction capacity of approximately 100,000 gallons of LNG (8,300 MMBtu) per day and enables us to produce LNG for sales directly to industrial end-users in southern Florida, including Florida East Coast Railway via our train loading facility, and other customers throughout the Caribbean using ISO containers. Other Development Projects We are in the process of developing an LNG regasification terminal at the Port of Pichilingue in Baja California Sur, Mexico (the “La Paz Terminal”). Our La Paz Terminal is expected to supply approximately 455,000 gallons of LNG (37,565 MMBtu) per day, and we have received all necessary permits for onshore construction of the power plant that is expected to produce up to 135 MW. In February 2020, we entered into a 25-year power purchase agreement with Nicaragua’s electricity distribution companies, and we expect to construct a new approximately 300 MW natural gas-fired power plant that will consume approximately 700,000 gallons of LNG (60,000 MMBtus) per day. In 2019, we signed a memorandum of understanding to develop a terminal in Angola to supply natural gas for power generation, and we are in active discussions to secure a definitive agreement in 2020. Results of Operations - Year Ended December 31, 2019 compared to Year Ended December 31, 2018 (in thousands) Revenues Operating revenue from LNG and natural gas sales for the year ended December 31, 2019 was $145,500 which increased by $48,594 from $96,906 for the year ended December 31, 2018. The increase was primarily driven by volumes sold from the Old Harbour Terminal and increases in volumes sold to industrial end-users in Jamaica. During the second quarter of 2019, the Old Harbour Terminal commenced commercial operations, and we began to recognize revenue from our contract with JPC, adding $41,229 in operating revenue for the year ended December 31, 2019. The increase in operating revenue was also attributable to additional sales at the Montego Bay Terminal. The delivered volume at the Montego Bay Terminal increased by 12.3 million gallons (1.0 TBtu) from 98.2 million gallons (8.1 TBtu) in 2018 to 110.5 million gallons (9.1 TBtu) in 2019. The increase in volumes delivered at the Montego Bay Terminal was primarily attributable to an increase in industrial end-user customers as well as an increase in consumption at an existing customer due to the customer’s installation of a new gas turbine that consumes approximately 60,500 gallons (5,000 MMBtu) per day. Of the delivered volumes, 8.8 million gallons (0.8 TBtu) and 3.1 million gallons (0.2 TBtu) were delivered to industrial end-users in 2019 and 2018, respectively. Other revenue for the year ended December 31, 2019 was $43,625 which increased $28,230 from $15,395 for the year ended December 31, 2018. The increase was primarily due to the recognition of development services revenue of $27,308 for the year ended December 31, 2019, and this increase included $11,933 of revenue recognized for the completion of infrastructure projects for customers of the CHP Plant and $15,375 for the conversion of our customer’s infrastructure in Puerto Rico. Development services revenue is recognized from the construction and installation of equipment to transform customers’ facilities to operate utilizing natural gas or to allow customers to receive power or other outputs from our power generation facilities, and such services are included within certain long-term contracts to supply these customers with natural gas or outputs from our gas-fired facilities. We did not have any such projects during the year ended December 31, 2018. The Company also leases certain facilities and equipment, including the Montego Bay Terminal, to its customers which are accounted for either as direct financing leases or operating leases, and the interest recognized from direct financing leases or leasing revenue from operating leases is recognized within Other revenue. The remaining increase in Other revenue for the year ended December 31, 2019 was primarily driven by additional operating leases for equipment by industrial end-users. Cost of sales Cost of sales includes the procurement of feedgas or LNG, as well as shipping and logistics costs to deliver LNG or natural gas to our facilities or our customers. Our LNG and natural gas supply are purchased from third parties or converted in our Miami Facility. Costs to convert natural gas to LNG, including labor, depreciation, and other direct costs to operate our Miami Facility are also included in Cost of sales. Cost of sales for the year ended December 31, 2019 was $183,359 which increased $87,617 from $95,742 for the year ended December 31, 2018. The increase in Cost of sales was primarily attributable to increased costs to purchase LNG from third parties, costs associated with development services, and increased charter costs; costs to produce LNG at our Miami Facility were substantially consistent with the prior year. The weighted-average cost of LNG purchased from third parties increased from $0.64 per gallon ($7.72 per MMBtu) in 2018 to $0.73 per gallon ($8.81 per MMBtu) in 2019, which is inclusive of boil-off gas. The weighted-average cost of our inventory balance as of December 31, 2019 and 2018 was $0.64 per gallon ($7.69 per MMBtu) and $0.73 per gallon ($8.84 per MMBtu), respectively. The increase was also attributable to the increase in volumes delivered of 32% compared to the year ended December 31, 2018. The costs recognized associated with development services were $24,228 for the year ended December 31, 2019; these costs included $10,541 of costs associated with the completion of infrastructure projects for customers of the CHP Plant and $13,687 of costs associated with the conversion of our customer’s infrastructure in Puerto Rico. We did not have any such costs during the year ended December 31, 2018. The Company also incurred an increase in charter costs associated with our expanded charter fleet. Such charter costs increased Cost of sales by $14,328 for the year ended December 31, 2019 as compared with the year ended December 31, 2018. Operations and maintenance Operations and maintenance relates to costs of operating our Montego Bay Terminal, as well as our Miami Facility and Old Harbour Terminal, exclusive of costs to convert that are reflected in Cost of sales. Operations and maintenance for the year ended December 31, 2019 was $26,899, which increased $17,310 from $9,589 for the year ended December 31, 2018. The increase was primarily a result of higher costs associated with the operations of charter vessels, including a storage vessel for Puerto Rico, of $9,612 in the year ended December 31, 2019, as well as increased operating costs, including higher payroll and insurance expenses, as we continue to expand our operations. Selling, general and administrative Selling, general and administrative includes employee travel costs, insurance, and costs associated with development activities for projects that are in initial stages and development is not yet probable. Selling, general and administrative also includes compensation expenses for our corporate employees as well as professional fees for our advisors. Selling, general and administrative for the year ended December 31, 2019, was $152,922 which increased $90,785 from $62,137 for the year ended December 31, 2018. The increase was primarily attributable to share-based compensation expense of $40,594, as well as increased headcount as compared to the prior year. The increase was also due to development costs incurred at the Pennsylvania Facility of approximately $19,500, as well as other development projects that currently do not qualify for capitalization. Such costs incurred in connection with the Pennsylvania Facility may be capitalizable in future periods once we issue a final notice to proceed to our engineering, procurement, and construction contractors. Costs incurred in future periods for other such projects may be capitalizable once we determine that we are fully committed to complete these projects. The remaining change was primarily due to increases in professional fees, payroll, and travel expenses. Loss on mitigation sales Loss on mitigation sales for the year ended December 31, 2019 was $5,280 which was attributable to losses incurred associated with undelivered quantities of LNG under firm purchase commitments due to storage capacity constraints. In these situations, our supplier will attempt to sell the undelivered quantity through a mitigation sale, and the losses incurred under the firm purchases are partially offset by this sale of the undelivered amount to third parties for amounts lower than the contracted price, which resulted in a loss of $5,280. We did not have such transactions during the year ended December 31, 2018. Depreciation and amortization Depreciation and amortization for the year ended December 31, 2019 was $7,940, which increased $4,619 from $3,321 for the year ended December 31, 2018. The increase is primarily a result of the depreciation of the Old Harbour Terminal which was placed in service in the second quarter of 2019, as well as a full year of amortization of intangible assets from the acquisition of Shannon LNG in November 2018. Interest expense Interest expense for the year ended December 31, 2019 was $19,412, which increased $8,164 from $11,248 for the year ended December 31, 2018, primarily as a result of the additional principal balance outstanding since March 2019 under the Term Loan Facility (as defined below). The increase in interest expense was partially offset by an increase in capitalized interest in the amount of $23,440 for the year ended December 31, 2019 as compared to the year ended December 31, 2018. All additional interest expense incurred in 2019 due to issuance of the Senior Secured Bonds and the Senior Unsecured Bonds (both defined below) was capitalized as part of our construction projects. Other income, net Other income, net for the year ended December 31, 2019 was ($2,807), which increased $2,023 from ($784) for the year ended December 31, 2018, primarily as a result of interest income partially offset by the unrealized loss on our investment in equity securities. Loss on extinguishment of debt, net Loss on extinguishment of debt was $0 for the year ended December 31, 2019 as we did not have any such transactions during the year. Loss on extinguishment of debt for the year ended December 31, 2018 was $9,568 which was primarily a result of the amendment to the Term Loan Facility on December 31, 2018. Tax expense (benefit) Tax expense for the year ended December 31, 2019 was $439, which increased $777 from a tax benefit of ($338) for the year ended December 31, 2018 due to decrease in taxable losses in a foreign jurisdiction. Factors Impacting Comparability of Our Financial Results Our historical results of operations and cash flows are not indicative of results of operations and cash flows to be expected in the future, principally for the following reasons: • Our historical financial results do not include significant projects that are near completion. Our historical financial statements only include our Montego Bay Terminal, Miami Facility, and certain industrial end-users. The Old Harbour Terminal commenced commercial operations during 2019, and a significant downstream customer of the Old Harbour Terminal, the Old Harbour Power Plant, is expected to be fully operational in 2020. As such, we expect this customer to purchase significant volumes on a take-or-pay basis from the Old Harbour Terminal throughout 2020 and future years. We also expect that the CHP Plant and the San Juan Facility will be fully operational beginning in 2020, and we expect to generate significant revenue from customers of these facilities under long-term contracts beginning in 2020. Our current results also do not include revenue and operating results from other projects under development including the La Paz Terminal, the LNG regasification terminal and power plant in Puerto Sandino, Nicaragua (the “Puerto Sandino Terminal”), the LNG terminal in Angola (the “Angola Terminal”), and the LNG terminal on the Shannon Estuary near Ballylongford, Ireland (the “Ireland Terminal”). • Our historical financial results do not reflect the long term LNG supply agreement that will lower the cost of our LNG supply from 2022 to 2030. We currently purchase the majority of our supply of LNG from third parties. For the years ended December 31, 2019 and 2018, we sourced 93% and 91%, respectively, of our LNG volumes from third parties. Our cost of sales for the year-ended December 31, 2019 reflected an average cost of LNG purchased from third parties of $0.73 per gallon ($8.81 per MMBtu), predominately purchased under a firm purchase commitment entered into in December 2018. During 2019, the market price for LNG dropped significantly, and we have executed a firm commitment to purchase 27.5 TBtus annually beginning in 2022 at prices that are expected to be significantly lower than inventory purchased in 2019. Further, we believe that we will take advantage of the current market pricing for LNG to supply our expanding operations, resulting in an overall lower average cost of LNG in future periods. • We continue to incur incremental selling, general and administrative expenses related to our transition to a publicly traded company. We completed our IPO on February 4, 2019, and throughout 2019 we have incurred direct, incremental general and administrative expenses as a result of being a publicly traded company, including costs associated with the employment of additional personnel, compliance with Securities and Exchange Commission rules and regulations, annual and quarterly reports to our common shareholders, registrar and transfer agent fees, national stock exchange fees, audit fees, incremental director and officer liability insurance costs, and director and officer compensation. Additionally, we have incurred costs associated with the initial implementation of our Sarbanes-Oxley Act of 2002 (“Sarbanes-Oxley Act”) Section 404 internal controls. However, at the point that we no longer qualify as an emerging growth company under the JOBS Act (defined below), we expect to incur additional costs associated with providing an auditor’s attestation report on our system of internal controls over financial reporting pursuant to Section 404(b) of the Sarbanes-Oxley Act, as well as additional audit costs resulting from PCAOB requirements. Liquidity and Capital Resources We believe we will have sufficient liquidity, cash flow from operations, and access to additional capital sources to fund our capital expenditures and working capital needs for the next 12 months. We expect to fund our current operations and continued development of additional facilities through a combination of cash on hand and additional borrowings from the Senior Secured Bonds, Senior Unsecured Bonds, and the Credit Agreement (all defined below). Our IPO was completed on February 4, 2019, and we raised net proceeds of $268,010, inclusive of additional net proceeds raised from the exercise of the underwriter’s option to purchase additional shares and after deducting underwriting discounts and commissions and transaction costs. On March 21, 2019, we drew the remaining availability on our Term Loan Facility (defined below) and had $495,000 of outstanding principal as of December 31, 2019. On September 5, 2019, we issued approximately $117,000 in Senior Secured Bonds and Senior Unsecured Bonds, and in December 2019, we issued an additional $63,000 in Senior Secured Bonds, which was fully funded by January 2020. In January 2020, we borrowed $800,000 under the Credit Agreement, and repaid the Term Loan Facility in full. No principal payments are due under the Senior Secured and Senior Unsecured Bonds for at least seven years; no principal payments are due under the Credit Agreement until maturity in January 2023. We have assumed total expenditures for all completed and existing projects to be approximately $858 million, with approximately $618 million having already been spent through December 31, 2019. This estimate represents the expenditures necessary to complete construction of the CHP Plant, the San Juan Facility, and the La Paz Terminal, as well as expected expenditures to serve new industrial end-users. We except to be able to fund all such committed projects with a combination of cash on hand, as well as the proceeds from the Credit Agreement, Senior Secured Bonds, and Senior Unsecured Bonds received after year-end of approximately $311 million. Through December 31, 2019, we have spent approximately $165 million to develop the Pennsylvania Facility. Approximately $20 million of construction and development costs have been expensed as we have not issued a final notice to proceed to our engineering, procurement, and construction contractors. Cost for land, as well as engineering and equipment that could be deployed to other facilities of approximately $145 million, has been capitalized. Cash Flows The following table summarizes the changes to our cash flows for the years ended December 31, 2019 and 2018, respectively: Cash (used in) operating activities Our cash flow used in operating activities was $234,261 for the year ended December 31, 2019, which increased by $141,034 from $93,227 for the year ended December 31, 2018. For both the years ended December 31, 2019 and 2018, we had net losses that comprised a significant portion of cash used in operating activities due to the continued expansion of our business activities. The loss in the year ended December 31, 2019 reflects non-cash share-based compensation expense, which was excluded from the cash used in operating activities. Cash flows used in operating activities for the year ended December 31, 2019 was also significantly impacted by increases in inventories and receivables. The increase in receivables was primarily due to higher LNG and natural gas sales comparing to the year ended December 31, 2018. The remaining increase was mainly attributable to the increases in Other assets related to costs to deliver development services to our customers. These increases were partially offset by increases in other liabilities, partially due to increases in contract liabilities related to a significant customer contract. Cash (used in) investing activities Our cash flow used in investing activities was $376,164 for the year ended December 31, 2019, which increased by $191,709 from $184,455 for the year ended December 31, 2018. The increase in cash flow used in investing activities was due to the increase in capital expenditures to complete the Old Harbour Terminal, as well as construction of the CHP Plant, the San Juan Facility, the La Paz Terminal, and the Pennsylvania Facility. Cash provided by financing activities Our cash flow provided by financing activities was $602,607 for the year ended December 31, 2019, which increased by $342,403 from $260,204 for the year ended December 31, 2018. The increase in cash flow provided by financing activities is due to the issuance of Senior Secured Bonds and Senior Unsecured Bonds of $127,856 in September 2019 and December 2019, additional borrowings under the Term Loan Facility of $220,000 in March 2019, and the net proceeds received from our IPO in February 2019. Long-Term Debt The Credit Agreement On January 10, 2020, the Company entered into a credit agreement to borrow $800,000 in term loans (the “Credit Agreement”). The Credit Agreement will mature in January 2023 with the full principal balance due upon maturity. Interest is payable quarterly and is based on a LIBOR rate divided by one minus the applicable reserve requirement, subject to a floor of 1.50%, plus a margin of 6.25%. The interest rate margin increases each year of the term by 1.50%. Loans may be prepaid, at the option of the Company, at any time without premium. We have used a portion of the proceeds received to extinguish the Term Loan Facility (defined below). The Company will be required to comply with certain financial covenants as well as usual and customary affirmative and negative covenants, including limitations on liens and incurring additional indebtedness. The facility also provides for customary events of default and cure provisions. Proceeds received were net of upfront and structuring fees, which, together with other third party fees and expenses paid in connection with obtaining this financing, will be recorded as a reduction to the principal balance on the consolidated balance sheet. Term Loan Facility On August 16, 2018, the Company entered into a credit agreement with a syndicate of two lenders to borrow up to an aggregate principal amount of $240,000. On December 31, 2018, the Company amended this credit agreement (as amended, the “Term Loan Facility”) to, among other things, (i) increase the amount available for borrowing thereunder from $240,000 to $500,000, (ii) extend the initial maturity date to December 31, 2019, (iii) modify certain provisions relating to restrictive covenants and existing financial covenants, and (iv) remove the mandatory prepayment required with the net proceeds received in connection with an IPO. As of December 31, 2018, the outstanding principal balance under the Term Loan Facility was $280,000. On March 21, 2019, the Company drew an additional $220,000, bringing our total outstanding borrowings to $500,000 under the Term Loan Facility, and as of December 31, 2019, the total principal amount outstanding under the Term Loan Facility was $495,000. All borrowings under the Term Loan Facility bore interest at a rate selected by us of either (i) LIBOR divided by one minus the applicable reserve requirement plus a spread of 4% or (ii) subject to a floor of 1%, a Base Rate equal to the higher of (a) the Prime Rate, (b) the Federal Funds Rate plus 1/2 of 1% or (c) the 1-month LIBOR rate plus 1.00% plus a spread of 3.0%. The Term Loan Facility was repayable in quarterly installments of $1,250 with a balloon payment due at maturity. The Term Loan Facility was secured by mortgages on certain properties owned by our subsidiaries, in addition to other collateral. The Term Loan Facility was amended in the third quarter of 2019 to allow certain properties of a consolidated subsidiary to secure the Senior Secured Bonds (defined below). We were also required to comply with certain financial covenants and other restrictive covenants customary for facilities of this type, including restrictions on indebtedness, liens, acquisitions and investments, restricted payments, and dispositions. In connection with obtaining the Term Loan Facility and the extinguishment of our prior debt facilities, we recognized a loss on extinguishment of debt of $9,568 in the consolidated statements of operations and comprehensive loss. The total unamortized deferred financing costs as of December 31, 2018 were $7,808. In 2019, we paid $4,400 of additional fees in connection with the $220,000 draw on the Term Loan Facility. These fees were capitalized as a reduction to the Term Loan Facility on the consolidated balance sheets, and all deferred financing costs associated with the Term Loan Facility were amortized over the term of the Term Loan Facility, through December 31, 2019. As such, there were no unamortized deferred financing costs as of December 31, 2019. The Term Loan Facility had a maturity date of December 31, 2019 with an option to extend the maturity date for two additional six-month periods. Upon the exercise of each extension option, we would pay a fee equal to 1.0% of the outstanding principal balance at the time of the exercise, and the spread on LIBOR and Base Rate would increase by 0.5%. On December 30, 2019, the Company entered into an amendment with the lenders to extend the maturity to January 21, 2020. Prior to this new maturity date, we repaid the full amount outstanding, using proceeds from the Credit Agreement to extinguish the Term Loan Facility. South Power Senior Secured Bonds and Senior Unsecured Bonds On September 2, 2019, NFE South Power Holdings Limited (“South Power”), a consolidated subsidiary of the Company, entered into a facility for the issuance of secured and unsecured bonds (the “Senior Secured Bonds” and “Senior Unsecured Bonds”, respectively) and subsequently issued $73,317 and $43,683 in Senior Secured Bonds and Senior Unsecured Bonds, respectively. The Senior Secured Bonds are secured by the CHP Plant and related receivables and assets, and the proceeds will be used to fund the completion of the CHP Plant and to reimburse shareholder advances. In the fourth quarter of 2019, South Power issued an additional $63,000 in Senior Secured Bonds. We received $10,856 of the proceeds in 2019 and received the remaining proceeds of $52,144 in January 2020. The Senior Secured Bonds bear interest at an annual fixed rate of 8.25% and will mature 15 years from the closing date of each issuance. No principal payments will be due for the first seven years. After seven years, quarterly principal payments of approximately 1.6% of the original principal amount will be due, with a 50% balloon payment due upon maturity. Interest payments on outstanding principal balances will be due quarterly. The Senior Unsecured Bonds bear interest at an annual fixed rate of 11.00% and will mature in September 2036. No principal payments will be due for the first nine years. Beginning in 2028, principal payments will be due quarterly on an escalating schedule. Interest payments on outstanding principal balances will be due quarterly. South Power will be required to comply with certain financial covenants as well as customary affirmative and negative covenants, including limitations on incurring additional indebtedness. The facility also provides for customary events of default, prepayment, and cure provisions. The Company paid approximately $3,892 of fees in connection with the issuance of Senior Secured Bonds and Senior Unsecured Bonds. These fees were capitalized on a pro-rata basis as a reduction of the Senior Secured Bonds and Senior Unsecured Bonds on the consolidated balance sheets. The total unamortized deferred financing costs as of December 31, 2019 was $3,799. Off Balance Sheet Arrangements As of December 31, 2019 and 2018, we had no transactions that met the definition of off-balance sheet arrangements that may have a current or future material effect on our consolidated financial position or operating results. Contractual Obligations We are committed to make cash payments in the future pursuant to certain contracts. The following table summarizes certain contractual obligations in place as of December 31, 2019: Long-Term debt obligations For information on our long-term debt obligations, see “-Liquidity and Capital Resources-Long-Term Debt.” The amounts included in the table above are based on the total debt balance, scheduled maturities, and interest rates in effect as of December 31, 2019. We repaid the Term Loan Facility in January 2020, including the full principal amount outstanding of $495,000 and accrued interest of $1,196. The amounts disclosed in the contractual obligations above include the outstanding principal and accrued interest as of the date the Term Loan Facility was extinguished. In 2019, we issued $180,000 of Senior Secured Bonds and Senior Unsecured Bonds. Principal payments do not begin to become due until 2026. A portion of the proceeds for bonds issued was not received until January 2020, however, the amounts disclosed in the contractual obligations table above includes the $180,000 principal balance and associated interest for the Senior Secured Bonds and Senior Unsecured Bonds after the receipt of all proceeds. On January 10, 2020, the Company borrowed $800,000 in term loans under the Credit Agreement. The amounts disclosed in the contractual obligations table above do not include the Credit Agreement as we entered into the Credit Agreement subsequent to December 31, 2019. Purchase obligations The Company is party to contractual purchase commitments. These contracts are principally take-or-pay contracts, which require the purchase of minimum quantities of LNG and natural gas, and these commitments are designed to assure sources of supply and are not expected to be in excess of normal requirements. In 2018, the Company entered into a 15-year agreement with an affiliate of Chesapeake Energy Corporation for gas supply to our Pennsylvania Facility. The terms of the agreement are subject to certain conditions precedent under our control before the agreement is effective. These conditions have not yet been met, and as such, this commitment is excluded from the table above. The Company currently has two contracts in place for the purchase of feedgas under take-or-pay minimum volume obligations. These commitments are structured to assure the Miami Facility has uninterrupted supply and the minimum volumes are not expected to be in excess of normal requirements. Deliveries under these contracts are scheduled between March 2019 and November 2025. In December 2018, the Company entered into a contract with Centrica LNG Company Limited for the purchase of 29 firm cargoes of 1.1 billion gallons of LNG (86.7 million MMBtu) scheduled for delivery between June 2019 and December 2021. Payment for each cargo is due in advance of each shipment. As of December 31, 2019, the Company is committed to purchase 25 remaining cargoes with 13 scheduled for delivery in 2020 and the remaining 12 cargoes scheduled for delivery in 2021. On February 7, 2020, the Company entered into a long-term natural gas supply agreement for the purchase of 27.5 TBtu per year of LNG at a price indexed to Henry Hub from January 2022 to January 2030. Using the Henry Hub index as of December 31, 2019, we will be committed to LNG purchases of approximately $150 million per year from January 2022 to January 2030. Operating Lease obligations Future minimum lease payments under non-cancellable operating leases are noted in the above table. The Company’s lease obligations are primarily related to LNG vessel time charters, marine port leases, office space, and a land lease. The Company currently has four vessels under time charter leases with non-cancellable terms ranging from two to seven years. The lease commitments in the table above include only the lease component of these arrangements due over the non-cancellable term and does not include any operating services. We have leases for port space and a land site for the development of our facilities. Terms for leases of port space range from 20 to 25 years. The land site lease is held with an affiliate of the Company and has a remaining term of approximately five years. Office space includes a space shared with affiliated companies in New York with a month to month lease, and an office space in downtown Miami with a lease term of 84 months. Summary of Critical Accounting Estimates The preparation of consolidated financial statements in conformity with GAAP requires management to make certain estimates and assumptions that affect the amounts reported in the consolidated financial statements and the accompanying notes. Changes in facts and circumstances or additional information may result in revised estimates, and actual results may differ from these estimates. Management evaluates its estimates and related assumptions regularly and will continue to do so as we further grow our business. We believe that the accounting policies discussed below are critical to understanding our historical and future performance, as these policies relate to the more significant areas involving management’s judgments and estimates. Revenue recognition The Company’s primary revenue stream is the sale of LNG and natural gas to customers, which is presented as Operating revenue in the consolidated statements of operations and comprehensive loss. Natural gas is typically delivered by pipeline into the customer’s power generation facilities, and LNG is typically delivered in containers transported by truck to customer sites. Revenue from sales of natural gas delivered by pipeline to a power generation facility is recognized over time under the output method, as the customer takes control of the natural gas. Revenue from sales of LNG delivered by truck is recognized at the point in time at which physical possession and the risks and rewards of ownership transfer to the customer, either when the containers are shipped or delivered to the customers’ storage facilities, depending on the terms of the contract. The Company has concluded that variable consideration included in these agreements meets the exception for allocating variable consideration to each unit sold under the contract. As such, the variable consideration for these contracts is allocated to each distinct unit of LNG or natural gas delivered and recognized when that distinct unit of LNG or natural gas is delivered to the customer. The Company’s contracts with customers to supply LNG or natural gas may contain a lease of equipment. The Company allocates consideration received from customers between lease and non-lease components based on the relative fair value of each component. The fair value of the lease component is estimated based on the estimated standalone selling price of the same or similar equipment leased to the customer. The Company estimates the fair value of the non-lease component by forecasting volumes and pricing of gas to be delivered to the customer over the lease term. The estimated fair value of the leased equipment, as a percentage of the estimated total revenue from LNG or natural gas and leased equipment at inception, will establish the allocation percentage to determine the minimum lease payments and the amount to be accounted for under the revenue recognition guidance. The leases of certain facilities and equipment to customers are accounted for as direct financing or operating leases. Finance leases, net represents the minimum lease payments due, net of unearned revenue. The lease payments are segregated into principal and interest components similar to a loan. Unearned revenue is recognized on an effective interest method over the lease term and is included in Other revenue in the consolidated statements of operations and comprehensive loss. The principal components of the lease payment are reflected as a reduction to the net investment in the finance lease. For the Company’s operating leases, the amount allocated to the leasing component is recognized over the lease term as Other revenue in the consolidated statements of operations and comprehensive loss. In addition to the revenue recognized from the leasing components of agreements with customers, Other revenue includes development services revenue recognized from the construction and installation of equipment to transform customers’ facilities to operate utilizing natural gas or to allow customers to receive power or other outputs from our power generation facilities. Revenue from these development services is recognized over time as the Company transfers control of the asset to the customer, unless the customer is not able to obtain control over the asset under development until such services are completed, in which case, revenue is recognized when the services are completed and the customer has control of the infrastructure. Such agreements may also include a significant financing component, and the Company recognizes revenue for the interest income component over the term of the financing as Other revenue. Development services are typically included in arrangements that include other distinct performance obligations, and the Company allocates the transaction price to each performance obligation based on its standalone selling price (“SSP”) in relation to the aggregate value of the SSP of all performance obligations in the arrangement. Some of our performance obligations have observable inputs that are used to determine the SSP of those distinct performance obligations. Where SSP is not directly observable, the Company primarily determines the SSP using the cost-plus approach. In the circumstances when available information to determine SSP is highly variable or uncertain, the Company uses the residual approach. Impairment of long-lived assets We perform a recoverability assessment of long-lived assets whenever events or changes in circumstances indicate that the carrying amount of an asset may not be recoverable. Indicators may include, but are not limited to, adverse changes in the regulatory environment in a jurisdiction where we operate, unfavorable events impacting the supply chain for LNG to our operations, a decision to discontinue the development of a long-lived asset, early termination of a significant customer contract, or the introduction of newer technology. We exercise judgment in determining if any of these events represent an impairment indicator requiring a recoverability assessment. Our business model requires investments in infrastructure often concurrently with our customer’s investments in power generation or other assets to utilize LNG. Our costs to transport and store LNG are based upon our customer’s contractual commitments once their assets are fully operational. We expect revenue under these contracts to exceed construction and operational costs, based on the expected term and revenue of these contracts. Additionally, our infrastructure assets are strategically located to provide critical inputs to our committed customer’s operations and our locations allow us to expand to additional opportunities within existing markets. We have considered that the market price of LNG can vary widely, including recent decreases throughout 2019. Due to the decline in LNG prices, we executed a firm commitment to purchase 27.5 TBtus annually beginning in 2022 at prices that are expected to be significantly lower than inventory purchased in 2019. Further, we believe that we will take advantage of the current market pricing for LNG to supply our expanding operations, resulting in an overall lower average cost of LNG in future periods. Our long-term, take-or pay contracts to deliver natural gas or LNG to our customers also limit our exposure to fluctuations in natural gas and LNG as our pricing is based on the Henry Hub index plus a contractual spread. Based on the nature of our contracts and the market value of the underlying assets, we do not believe that changes in the price of LNG indicate that a recoverability assessment of our assets is necessary. Further, we plan to utilize our own liquefaction facilities to manufacture our own LNG at attractive prices, and secure LNG to supply our expanding operations and reduce our exposure to future LNG price variations in the long term. When performing a recoverability assessment, the Company measures whether the estimated future undiscounted net cash flows expected to be generated by the asset exceeds its carrying value. In the event that an asset does not meet the recoverability test, the carrying value of the asset will be adjusted to fair value resulting in an impairment charge. Management develops the assumptions used in the recoverability assessment based on active contracts, current and future expectations of the global demand for LNG and natural gas, as well as information received from third party industry sources. Share-based compensation The Company estimates the fair value of RSUs granted to employees and non-employees on the grant date based on the closing price of the underlying shares on the grant date and other fair value adjustments to account for a post-vesting holding period. These fair value adjustments were estimated based on the Finnerty model. JOBS Act In April 2012, the Jumpstart Our Business Startups Act of 2012, or the JOBS Act, was enacted. Section 107 of the JOBS Act provides that an “emerging growth company,” or EGC, can take advantage of the extended transition period provided in Section 7(a)(2)(B) of the Securities Act of 1933, as amended, or the Securities Act, for complying with new or revised accounting standards. Thus, an EGC can delay the adoption of certain accounting standards until those standards would otherwise apply to private companies. We have taken advantage of the exemptions discussed above. Accordingly, the information contained herein may be different than the information you receive from other public companies. Subject to certain conditions, as an EGC, we have elected to rely on certain of these exemptions, including without limitation, (1) providing an auditor’s attestation report on our system of internal controls over financial reporting pursuant to Section 404(b) of the Sarbanes-Oxley Act and (2) complying with any requirement that may be adopted by the Public Company Accounting Oversight Board, or PCAOB, regarding mandatory audit firm rotation or a supplement to the auditor’s report providing additional information about the audit and the financial statements, known as the auditor discussion and analysis. We will remain an EGC until the earlier of (i) the last day of the fiscal year in which we have total annual gross revenues of $1.07 billion or more; (ii) the last day of the fiscal year following the fifth anniversary of the date of the completion of our IPO, December 31, 2024; (iii) the date on which we have issued more than $1.00 billion in nonconvertible debt during the previous three years; or (iv) the date on which we are deemed to be a large accelerated filer under the rules of the Securities and Exchange Commission or SEC. Recent Accounting Standards For descriptions of recently issued accounting standards, see “Note 3 - Adoption of new and revised standards” to our notes to consolidated financial statements included elsewhere in this Annual Report.

<s>[INST] Certain information contained in this discussion and analysis, including information with respect to our plans, strategy, projections and expected timeline for our business and related financing, includes forwardlooking statements. Forwardlooking statements are estimates based upon current information and involve a number of risks and uncertainties. Actual events or results may differ materially from the results anticipated in these forwardlooking statements as a result of a variety of factors. You should read “Part 1, Item 1A. Risk Factors” and “Cautionary Statement on ForwardLooking Statements” elsewhere in this Annual Report on Form 10K (“Annual Report”) for a discussion of important factors that could cause actual results to differ materially from the results described in or implied by the forwardlooking statements contained in the following discussion and analysis. The comparison of the years ended December 31, 2018 and 2017 can be found in our Annual Report on Form 10K for the year ended December 31, 2018 located within “Part II, Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations.” The following information should be read in conjunction with our audited consolidated financial statements and accompanying notes included elsewhere in this Annual Report. Our financial statements have been prepared in accordance with GAAP. This information is intended to provide investors with an understanding of our past performance and our current financial condition and is not necessarily indicative of our future performance. Please refer to “Factors Impacting Comparability of Our Financial Results” for further discussion. Unless otherwise indicated, dollar amounts are presented in thousands. Unless the context otherwise requires, references to “Company,” “NFE,” “we,” “our,” “us” or like terms refer to New Fortress Energy LLC and its subsidiaries. When used in a historical context that is prior to the completion of NFE’s initial public offering (“IPO”), “Company,” “we,” “our,” “us” or like terms refer to New Fortress Energy Holdings LLC, a Delaware limited liability company (“New Fortress Energy Holdings”), our predecessor for financial reporting purposes. Overview We are a global integrated gastopower infrastructure company that seeks to use natural gas to satisfy the world’s large and growing power needs. We deliver targeted energy solutions to customers around the world, thereby reducing their energy costs and diversifying their energy resources, while also reducing pollution and generating compelling margins. Our nearterm mission is to provide modern infrastructure solutions to create cleaner, reliable energy while generating a positive economic impact worldwide. Our longterm mission is to become one of the world’s leading carbon emissionfree independent power providing companies. We discuss this important goal in more detail in “Items 1 and 2: Business and Properties” under “Toward a CarbonFree Future”. As an integrated gastopower energy infrastructure company, our business model spans the entire production and delivery chain from natural gas procurement and liquefaction to logistics, shipping, terminals and conversion or development of natural gasfired generation. We currently source LNG from longterm supply agreements with third party suppliers and from our own liquefaction facility in Miami, Florida. We expect that control of our vertical supply chain, from procurement to delivery of LNG, will help to reduce our exposure to future LNG price variations and enable us to supply our existing and future customers with LNG at a price that reinforces our competitive standing in the LNG market. Our strategy is simple: we seek to procure LNG at attractive prices using longterm agreements and through our own production, and we seek to sell natural gas (delivered through LNG infrastructure) or gasfired power to customers that sign longterm, takeorpay contracts. Our Current Operations Our management team has successfully employed our strategy to secure longterm contracts with significant customers in Jamaica and Puerto Rico, including Jamaica Public Service Company Limited (“JPS”), the sole public utility in Jamaica, South Jamaica Power Company Limited (“JPC”), an affiliate of JPS, Jamalco, a bauxite mining and alumina production in Jamaica, and the Puerto Rico Electric Power Authority (“PREPA”), each of which is described in more detail below. Our assets built to service these significant customers have been designed with capacity to service other customers. We currently procure our LNG either by purchasing it under a contract from a [/INST] Positive. </s>

Rubius Therapeutics, Inc.

2019-03-28

2018-12-31

Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations The following discussion and analysis of our financial condition and results of operations should be read in conjunction with our consolidated financial statements and related notes appearing at the end of this Annual Report on Form 10-K. Some of the information contained in this discussion and analysis or set forth elsewhere in this Annual Report on Form 10-K, including information with respect to our plans and strategy for our business, includes forward-looking statements that involve risks and uncertainties. As a result of many factors, including those factors set forth in the “Risk Factors” section of this Annual Report on Form 10-K, our actual results could differ materially from the results described in, or implied by, the forward-looking statements contained in the following discussion and analysis. Overview We are developing a new class of cellular medicines, Red Cell Therapeutics, or RCTs. Based on our vision that human red blood cells are the foundation of the next significant innovation in medicine, we have designed a proprietary platform to genetically engineer and culture RCTs that are selective, potent and ready-to-use cellular therapies. We believe that our RCTs will provide life-changing or life-saving benefits for patients with severe diseases across multiple therapeutic areas. We have generated hundreds of RCTs using our RED PLATFORM®, a highly versatile and proprietary cellular therapy platform. We are utilizing our universal engineering and manufacturing processes to advance a broad pipeline of RCT product candidates into clinical trials in rare diseases, cancer and autoimmune diseases. Common design and manufacturing elements of our RCTs should enable us to achieve significant advantages in product development. We are establishing end to end manufacturing capabilities and plan to develop commercial infrastructure to further establish Rubius Therapeutics as a leading, fully integrated cellular therapy company. Since our inception, we have focused substantially all of our resources on building our proprietary RED PLATFORM, establishing and protecting our intellectual property portfolio, conducting research and development activities, developing our manufacturing process and manufacturing drug product material, organizing and staffing our company, business planning, raising capital and providing general and administrative support for these operations. We do not have any products approved for sale and have not generated any revenue from product sales. To date, we have funded our operations with proceeds from the sale of preferred stock and issuance of debt and, most recently, with proceeds from our initial public offering, or IPO. On July 20, 2018, we completed our IPO, pursuant to which we issued and sold 12,055,450 shares of common stock, inclusive of 1,572,450 shares pursuant to the full exercise of the underwriters’ option to purchase additional shares. We received proceeds of $254.3 million after deducting underwriting discounts and commissions and other offering costs. Since our inception, we have incurred significant operating losses. Our ability to generate any product revenue or product revenue sufficient to achieve profitability will depend on the successful development and eventual commercialization of one or more of our product candidates. We reported net losses of $89.2 million for the year ended December 31, 2018, $43.8 million for the year ended December 31, 2017 and $11.0 million for the year ended December 31, 2016. As of December 31, 2018, we had an accumulated deficit of $150.1 million. We expect to continue to incur significant expenses and increasing operating losses for at least the next several years. We expect that our expenses and capital requirements will increase substantially in connection with our ongoing activities, particularly if and as we: conduct clinical trials for our product candidates; further develop our RED PLATFORM; continue to discover and develop additional product candidates; maintain, expand and protect our intellectual property portfolio; hire additional clinical, scientific manufacturing and commercial personnel; expand in-house manufacturing capabilities, including through the renovation, customization and operation of our recently purchased manufacturing facility; establish a commercial manufacturing source and secure supply chain capacity sufficient to provide commercial quantities of any product candidates for which we may obtain regulatory approval; acquire or in-license other product candidates and technologies; seek regulatory approvals for any product candidates that successfully complete clinical trials; establish a sales, marketing and distribution infrastructure to commercialize any products for which we may obtain regulatory approval; and add operational, financial and management information systems and personnel, including personnel to support our product development and planned future commercialization efforts, as well as to support our transition to a public company. We will not generate revenue from product sales unless and until we successfully complete clinical development and obtain regulatory approval for our product candidates. If we obtain regulatory approval for any of our product candidates, we expect to incur significant expenses related to developing our commercialization capability to support product sales, marketing and distribution. Further, we expect to incur additional costs associated with operating as a public company. As a result, we will need substantial additional funding to support our continuing operations and pursue our growth strategy. Until such time as we can generate significant revenue from product sales, if ever, we expect to finance our operations through a combination of equity offerings, debt financings, collaborations, strategic alliances and marketing, distribution or licensing arrangements. We may be unable to raise additional funds or enter into such other agreements or arrangements when needed on favorable terms, or at all. If we fail to raise capital or enter into such agreements as, and when, needed, we may have to significantly delay, scale back or discontinue the development and commercialization of one or more of our product candidates. Because of the numerous risks and uncertainties associated with pharmaceutical product development, we are unable to accurately predict the timing or amount of increased expenses or when, or if, we will be able to achieve or maintain profitability. Even if we are able to generate product sales, we may not become profitable. If we fail to become profitable or are unable to sustain profitability on a continuing basis, then we may be unable to continue our operations at planned levels and be forced to reduce or terminate our operations. As of December 31, 2018, we had cash, cash equivalents and investments of $404.1 million. We believe that our existing cash, cash equivalents and investments will enable us to fund our operating expenses, capital expenditure requirements, including the renovation and customization of our recently purchased manufacturing facility, and debt service payments into 2021. See “-Liquidity and Capital Resources.” Components of our Results of Operations Revenue To date, we have not generated any revenue from product sales and do not expect to generate any revenue from the sale of products in the near future. If our development efforts for our product candidates are successful and result in regulatory approval or license or collaboration agreements with third parties, we may generate revenue in the future from product sales, payments from collaboration or license agreements that we may enter into with third parties, or any combination thereof. Operating Expenses Research and Development Expenses Research and development expenses consist primarily of costs incurred for our research activities, including our drug discovery efforts, and the development of our product candidates, which include: •employee-related expenses, including salaries, related benefits and stock-based compensation expense for employees engaged in research and development functions; •expenses incurred in connection with the preclinical and clinical development of our product candidates and research programs, including under agreements with third parties, such as consultants, contractors and contract research organizations, or CROs; •the cost of developing and scaling our manufacturing process and manufacturing drug products for use in our preclinical studies and clinical trials, including under agreements with third parties, such as consultants, contractors and contract manufacturing organizations, or CMOs; •laboratory supplies and research materials; •facilities, depreciation and other expenses, which include direct and allocated expenses for rent and maintenance of facilities and insurance; and •payments made under third-party licensing agreements. We expense research and development costs as incurred. Advance payments that we make for goods or services to be received in the future for use in research and development activities are recorded as prepaid expenses. The prepaid amounts are expensed as the related goods are delivered or the services are performed. Our direct external research and development expenses are tracked on a program-by-program basis for clinical candidates and consist of costs that include fees, reimbursed materials and other costs paid to consultants, contractors, CMOs and CROs in connection with our preclinical and clinical development and manufacturing activities. We do not allocate employee costs, costs associated with our discovery efforts, laboratory supplies and facilities expenses, including depreciation or other indirect costs, to specific product development programs because these costs are deployed across multiple programs and our platform technology and, as such, are not separately classified. Product candidates in later stages of clinical development generally have higher development costs than those in earlier stages of clinical development, primarily due to the increased size and duration of later-stage clinical trials. We expect that our research and development expenses will increase substantially in connection with our planned preclinical and clinical development activities in the near term and in the future. At this time, we cannot accurately estimate or know the nature, timing and costs of the efforts that will be necessary to complete the preclinical and clinical development of any of our product candidates. The successful development and commercialization of our product candidates is highly uncertain. This is due to the numerous risks and uncertainties associated with product development and commercialization, including the following: •the timing and progress of preclinical and clinical development activities; •the number and scope of preclinical and clinical programs we decide to pursue; •raising additional funds necessary to complete preclinical and clinical development of and commercialize our drug candidates; •the progress of the development efforts of parties with whom we may enter into collaboration arrangements; •our ability to maintain our current research and development programs and to establish new ones; •our ability to establish new licensing or collaboration arrangements; •the successful initiation and completion of clinical trials with safety, tolerability and efficacy profiles that are satisfactory to the U.S. Food and Drug Administration, or FDA, or any comparable foreign regulatory authority; •the receipt and related terms of regulatory approvals from applicable regulatory authorities; •the availability of specialty raw materials for use in production of our product candidates; •our ability to consistently manufacture our product candidates for use in clinical trials; •our ability to establish and operate a manufacturing facility, or secure manufacturing supply through relationships with third parties; •our ability to obtain and maintain patents, trade secret protection and regulatory exclusivity, both in the United States and internationally; •our ability to protect our rights in our intellectual property portfolio; •the commercialization of our product candidates, if and when approved; •obtaining and maintaining third-party insurance coverage and adequate reimbursement; •the acceptance of our product candidates, if approved, by patients, the medical community and third-party payors; •competition with other products; and •a continued acceptable safety profile of our therapies following approval. A change in the outcome of any of these variables with respect to the development of any of our product candidates could significantly change the costs and timing associated with the development of that product candidate. We may never succeed in obtaining regulatory approval for any of our product candidates. General and Administrative Expenses General and administrative expenses consist primarily of salaries and related costs, including stock-based compensation, for personnel in executive, finance and administrative functions. General and administrative expenses also include direct and allocated facility-related costs as well as professional fees for legal, patent, consulting, investor and public relations, accounting and audit services. We anticipate that our general and administrative expenses will increase in the future as we increase our headcount and infrastructure to support the expansion of our research activities and development of our product candidates. We also anticipate that we will incur increased accounting, audit, legal, regulatory, compliance and director and officer insurance costs as well as investor and public relations expenses associated with operating as a public company. Other Income (Expense) Change in Fair Value of Preferred Stock Warrant Liability In connection with our 2015 loan and security agreement with Pacific Western Bank, we issued warrants to purchase Series A and Series B preferred stock. We classified these warrants as a liability on our consolidated balance sheet that we remeasured to fair value at each reporting date, and we recognized changes in the fair value of the warrant liability as a component of other income (expense) in our consolidated statements of operations and comprehensive loss. Upon the closing of our IPO in July 2018, the preferred stock warrants became exercisable for common stock instead of preferred stock and were concurrently exercised by the holders. As a result, the fair value of the warrants was reclassified to additional paid-in capital and we no longer have a warrant liability to remeasure. Interest Expense Interest expense consists of interest expense on outstanding borrowings under our loan and security agreements, as well as amortization of debt discount and debt issuance costs. Interest Income and Other Expense, Net Interest income consists of interest earned on our invested cash balances. We expect our interest income to increase as a result of investing the cash received from the sale of Series C preferred stock in February 2018 and our IPO in July 2018. Other income (expense) consists of miscellaneous income and expense unrelated to our core operations. Income Taxes Since our inception, we have not recorded any income tax benefits for the net losses we have incurred in each year or for our research and development tax credits generated, as we believe, based upon the weight of available evidence, that it is more likely than not that all of our net operating loss, or NOL, carryforwards and tax credits will not be realized. As of December 31, 2018, we had U.S. federal and state net operating loss carryforwards of $93.2 million and $93.9 million, respectively, which may be available to offset future taxable income. The federal NOLs include $37.2 million which expire at various dates through 2037 and $56.0 million which carryforward indefinitely. The state NOLs expire at various dates through 2038. As of December 31, 2018, we also had U.S. federal and state research and development tax credit carryforwards of $3.0 million and $1.1 million, respectively, which may be available to offset future tax liabilities and begin to expire in 2034 and 2031, respectively. We have recorded a full valuation allowance against our net deferred tax assets at each balance sheet date. On December 22, 2017, the Tax Cuts and Jobs Act, or the TCJA, was signed into United States law. The TCJA includes a number of changes to existing tax law, including, among other things, a permanent reduction in the federal corporate income tax rate from a top marginal tax rate of 35% to a flat rate of 21%, effective as of January 1, 2018, as well as limitation of the deduction for net operating losses to 80% of annual taxable income and elimination of net operating loss carrybacks, in each case, for losses arising in taxable years beginning after December 31, 2017 (though any such net operating losses may be carried forward indefinitely). The federal tax rate change resulted in a reduction in the gross amount of our deferred tax assets and liabilities recorded as of December 31, 2017, and a corresponding reduction in our valuation allowance. As a result, no income tax expense or benefit was recognized as of the enactment date of the TCJA. Results of Operations Comparison of the Years Ended December 31, 2018 and 2017 The following table summarizes our results of operations for the years ended December 31, 2018 and 2017: Research and Development Expenses Research and development expenses were $51.8 million for the year ended December 31, 2018, compared to $21.2 million for the year ended December 31, 2017. The increase in direct costs related to our RTX-134 program of $8.3 million was primarily due to contract manufacturing costs incurred and IND-enabling activities in preparation for our planned Phase 1b clinical trial of RTX-134 in patients with phenylketonuria. The increases in personnel-related costs and stock-based compensation expense of $8.7 million and $2.0 million, respectively, were due primarily to increased headcount in our research and development function. The increase in laboratory supplies and research materials of $4.2 million was primarily due to increases in platform development, manufacturing process and scale-up and drug discovery activities. The increase in facility-related and other expenses of $4.2 million was primarily due to an increase in facilities costs resulting from entering into two leases of office and laboratory space in July 2017 and May 2018, as well as additional laboratory services to support increased headcount. General and Administrative Expenses General and administrative expenses for the year ended December 31, 2018 were $39.9 million, compared to $22.0 million for the year ended December 31, 2017. The increase in general and administrative expenses of $17.9 million was primarily due to an increase in stock-based compensation expense of $7.6 million. The increase in stock-based compensation expense was primarily due to the recognition of compensation expense of $7.3 million for the year ended December 31, 2018 for stock-based awards granted to new employees during the years ended December 31, 2018 and 2017 as compared to $0.3 million of compensation expense recognized in the same period in 2017, as well as the recognition of compensation expense of $2.0 million for option awards with performance-based vesting conditions that were achieved during the year ended December 31, 2018, offset by a decrease of $2.0 million in compensation expense for stock-based awards granted to the chairman of our board of directors. Personnel-related costs increased by $4.5 million as a result of an increase in headcount in our general and administrative function as we prepared for our IPO and began to operate as a public company. Professional and consultant fees increased by $3.5 million primarily due to increased patent costs as we expanded our patent portfolio, consulting fees paid to the chairman of our board of directors for his services as a consultant and increases in accounting, public relations, investor relations, audit, legal, board fees and other consulting fees incurred as we began to operate as a public company. The increase in facility related and other expenses of $2.3 million was primarily due to an increase in facilities costs resulting from entering into two leases of office and laboratory space in July 2017 and May 2018, office costs to support increased headcount, as well as additional insurance costs resulting from operating as a public company. Change in Fair Value of Preferred Stock Warrant Liability The change in the fair value of our preferred stock warrant liability was due to the increase in the value of our preferred stock prior to the warrant becoming a warrant for common stock upon the closing of our IPO. Interest Expense Interest expense was $0.5 million for the year ended December 31, 2018, compared to $0.3 million for the year ended December 31, 2017. The increase in interest expense was due to higher interest rates applicable to outstanding borrowings during the year ended December 31, 2018, as well as a loss of less than $0.1 million on the extinguishment of our 2015 loan and security agreement. Interest Income and Other Income (Expense), Net Interest income for the year ended December 31, 2018 was $5.1 million compared to $0.6 million in the year ended December 31, 2017. Interest income increased primarily as a result of higher invested balances due to cash proceeds received from our Series C preferred stock financing in February 2018 and our IPO in July 2018. Other income (expense), net was not significant during the year ended December 31, 2018 or 2017. Comparison of the Years Ended December 31, 2017 and 2016 The following table summarizes our results of operations for the years ended December 31, 2017 and 2016: Research and Development Expenses Research and development expenses were $21.2 million for the year ended December 31, 2017, compared to $8.4 million for the year ended December 31, 2016. The increase in direct costs related to our RTX-134 program of $0.8 million was primarily due to contract manufacturing costs incurred with a supplier of lentiviral vectors. The increases in personnel-related costs and stock-based compensation expense of $2.5 million and $1.6 million, respectively, were primarily due to increased headcount in our research and development function, as well as an increase in the number of awards granted and the per share fair value of such awards. The increase in external manufacturing and research costs of $3.1 million was primarily due to our efforts to improve and scale our manufacturing capabilities, preparation for clinical-scale production and an expansion of our in vivo testing to support clinical candidate selection. The increase in laboratory supplies and research materials of $3.0 million was primarily due to increases in platform development, manufacturing process and drug discovery activities, as well as an increase in the volume and cost of bioprocessing materials as we scale up our manufacturing process. The increase in facility-related and other expenses of $1.8 million was primarily due to an increase in facilities costs resulting from entering into leases of office and laboratory space in September 2016 and July 2017. General and Administrative Expense General and administrative expenses for the year ended December 31, 2017 were $22.0 million, compared to $2.4 million for the year ended December 31, 2016. The increase in general and administrative expenses of $19.6 million was primarily due to an increase in stock-based compensation expense of $16.1 million. The increase in stock-based compensation expense was primarily due to the recognition of compensation expense of $15.7 million for stock-based awards granted to the chairman of our board of directors during the year ended December 31, 2017. All of the stock-based awards issued to the chairman of our board of directors were for his services as a consultant and were being accounted for as non-employee stock-based awards. At the end of each reporting period prior to completion of the services, we remeasured the fair value of any unvested portion of the awards and adjusted the expense accordingly. As a result, changes in the fair value of our common stock impacted the amount of stock-based compensation expense that we recognized for these awards during the year ended December 31, 2017. The stock-based compensation expense recognized for these awards during 2017 reflects the vesting of approximately one-half of the awards. Stock-based compensation expense related to the unvested portion of the awards will be recognized over the remaining two-year service period of the awards. The remaining increase in stock-based compensation expense in 2017 was primarily due to increased headcount in our general and administrative function, as well as an increase in the number of awards granted and the per share grant-date fair value of such awards. Personnel-related costs increased by $1.7 million as a result of the increase in headcount in our general and administrative function. Professional and consultant fees increased by $1.7 million primarily due to consulting fees paid to the chairman of our board of directors for his services as a consultant, as well as increased patent costs and professional fees relating to accounting, audit and legal fees and costs associated with ongoing business activities and our preparations to operate as a public company. Change in Fair Value of Preferred Stock Warrant Liability The change in the fair value of our preferred stock warrant liability was $0.8 million during the year ended December 31, 2017 and was due primarily to the increase in the value of our preferred stock. Interest Expense Interest expense was $0.3 million for the year ended December 31, 2017, compared to $0.1 million for the year ended December 31, 2016. The increase in interest expense was due to an increase of $1.5 million in outstanding borrowings under our 2015 loan and security agreement during the year ended December 31, 2017 as well as higher interest rates applicable to outstanding borrowings during the year ended December 31, 2017. Interest Income and Other Income (Expense), Net Interest income for the year ended December 31, 2017 was $0.6 million due to interest earned on invested cash balances. We did not invest our cash balances during the year ended December 31, 2016. Other expense was not significant for the years ended December 31, 2017 and 2016. Liquidity and Capital Resources Since our inception, we have incurred significant operating losses. We have not yet commercialized any of our product candidates and we do not expect to generate revenue from sales of any product candidates for several years, if at all. To date, we have funded our operations with proceeds from the sale of preferred stock and issuance of debt and, most recently, with proceeds from our initial public offering, or IPO. As of December 31, 2018, we had cash, cash equivalents and investments of $404.1 million. In July 2018, we completed our IPO, pursuant to which we issued and sold 12,055,450 shares of common stock, inclusive of 1,572,450 shares pursuant to the full exercise of the underwriters’ option to purchase additional shares. We received proceeds of $254.3 million, after deducting underwriting discounts and commissions and other offering costs. In December 2018, the company repaid all borrowings under its 2015 loan and security agreement and entered into a new loan and security agreement for an aggregate principal amount of $75.0 million, of which $25.0 million was drawn as of December 31, 2018. Cash Flows The following table summarizes our sources and uses of cash for each of the periods presented: Operating Activities During the year ended December 31, 2018, operating activities used $58.3 million of cash, primarily resulting from our net loss of $89.2 million, partially offset by net non-cash charges of $30.7 million, primarily consisting of stock-based compensation expense. Changes in our operating assets and liabilities for the year ended December 31, 2018 provided net cash of $0.1 million, which consisted primarily of a $9.2 million increase in accounts payable and accrued expenses and other current liabilities, offset by a $9.1 million increase in prepaid expenses and other current assets and others assets. During the year ended December 31, 2017, operating activities used $21.9 million of cash, primarily resulting from our net loss of $43.8 million, partially offset by net non-cash charges of $19.2 million, primarily consisting of stock-based compensation expense, and net cash provided by changes in our operating assets and liabilities of $2.7 million. Net cash provided by changes in our operating assets and liabilities for the year ended December 31, 2017 consisted primarily of a $3.4 million increase in accounts payable and accrued expenses and other current liabilities, partially offset by a $0.6 million increase in prepaid expenses and other current assets. During the year ended December 31, 2016, operating activities used $9.5 million of cash, primarily resulting from our net loss of $11.0 million, partially offset by net non-cash charges of $0.4 million and net cash provided by changes in our operating assets and liabilities of $1.1 million. Net cash provided by changes in our operating assets and liabilities for the year ended December 31, 2016 consisted primarily of a $1.2 million increase in accounts payable and accrued expenses and other current liabilities. Changes in accounts payable, accrued expenses and other current liabilities and prepaid expenses and other assets in both periods were generally due to growth in our business, the advancement of our research programs and the timing of vendor invoicing and payments. Investing Activities During the year ended December 31, 2018, net cash used in investing activities was $111.6 million, consisting of purchases of investments of $161.0 million and purchases of property, plant and equipment of $15.0 million, offset by sales and maturities of investments of $64.3 million. Our purchases of property, plant and equipment primarily consisted of $8.0 million for the acquisition of and subsequent design and demolition activities associated with our recently purchased manufacturing facility in Smithfield, Rhode Island and $4.4 million for the purchase of laboratory equipment as we expanded our discovery and manufacturing activities. During the years ended December 31, 2017 and 2016, net cash used in investing activities was $2.3 million and $0.4 million, respectively, due to purchases of property and equipment. The purchases of property and equipment during the year ended December 31, 2017 related to equipment purchases as we expanded our discovery and manufacturing activities. Financing Activities During the year ended December 31, 2018, net cash provided by financing activities of $374.8 million consisted primarily of $257.9 million of proceeds from our IPO in July 2018, $101.0 million of proceeds from the issuance of preferred stock in February 2018, and $25.0 million of proceeds received from borrowings under a loan and security agreement entered in December 2018, net of financing costs paid in 2018. We used cash of $5.5 million to repay outstanding borrowings under our 2015 loan and security agreement. During the year ended December 31, 2017, net cash provided by financing activities was $121.7 million, consisting primarily of proceeds from the issuance of preferred stock of $120.1 million and borrowings of $1.5 million under our 2015 loan and security agreement. During the year ended December 31, 2016, net cash provided by financing activities was $15.4 million, consisting primarily of proceeds from the issuance of preferred stock of $11.4 million and borrowings of $4.0 million under our 2015 loan and security agreement. Loan and Security Agreements In November 2018, we entered into a loan and security agreement, as amended, or the 2015 Credit Facility, with Pacific Western Bank under which we borrowed an aggregate of $5.5 million. In December 2018, we repaid all borrowings under the 2015 Credit Facility and terminated it. The aggregate principal amount of the loan outstanding at the time of repayment was $5.5 million and we did not incur any penalties as a result of the repayment. We recognized a loss on the extinguishment of the 2015 Credit Facility of less than $0.1 million related to the unamortized debt discount at the time of repayment. The loss on extinguishment was recorded as additional interest expense. In December 2018, or the Closing Date, we entered into a loan and security agreement, or the Loan Agreement, with Solar Capital Ltd. as collateral agent for the lenders party thereto for an aggregate principal amount of $75.0 million, or the 2018 Credit Facility. The aggregate principal amount will be funded in three tranches of term loans of $25.0 million each. On the Closing Date, we made an initial draw of $25.0 million. The second tranche will be available to us through June 30, 2019, subject to certain conditions including the satisfaction of certain financial covenants. The third tranche will be available to us through June 30, 2020, subject to certain conditions including the Food and Drug Administration’s acceptance of at least one of our investigational new drug applications and the satisfaction of certain financial covenants. Interest on the outstanding loan balance will accrue at a rate of the one-month U.S. LIBOR rate plus 5.50%. Monthly principal payments will commence 36 months after the Closing Date and will be amortized over the following 24 months. The term loans are subject to a prepayment fee of 1.00% in the first year, 0.50% in the second year and 0.25% in the third year. In conjunction with 2018 Credit Facility, the company incurred issuance costs of $0.8 million. The Loan Agreement contains financial covenants that require us to maintain either a certain minimum cash balance or a minimum market capitalization threshold. We were in compliance with all such covenants as of December 31, 2018. The Loan Agreement contains customary representations, warranties and covenants and also includes customary events of default, including payment defaults, breaches of covenants, change of control and a material adverse change default. Upon the occurrence of an event of default, a default interest rate of an additional 4.00% per annum may be applied to the outstanding loan balances, and the lenders may declare all outstanding obligations immediately due and payable. Borrowings under the Loan Agreement are collateralized by substantially all of the company’s assets, other than its intellectual property. Funding Requirements We expect our expenses to increase substantially in connection with our ongoing activities, particularly as we advance the preclinical activities and clinical trials for our product candidates in development. In addition, upon the closing of this offering, we expect to incur additional costs associated with operating as a public company. The timing and amount of our operating and capital expenditures will depend largely on: •the timing and progress of preclinical and clinical development activities; •the commencement, enrollment or results of the planned clinical trials of our product candidates or any future clinical trials we may conduct, or changes in the development status of our product candidates; •the timing and outcome of regulatory review of our product candidates; •our decision to initiate a clinical trial, not to initiate a clinical trial or to terminate an existing clinical trial; •changes in laws or regulations applicable to our product candidates, including but not limited to clinical trial requirements for approvals; •developments concerning our CMOs; •our ability to obtain materials to produce adequate product supply for any approved product or inability to do so at acceptable prices; •the costs and timing associated with the renovation, customization and operation of our planned multi-suite manufacturing facility that we purchased in July 2018; •our ability to establish collaborations if needed; •the costs and timing of future commercialization activities, including product manufacturing, marketing, sales and distribution, for any of our product candidates for which we obtain marketing approval; •the legal patent costs involved in prosecuting patent applications and enforcing patent claims and other intellectual property claims; •additions or departures of key scientific or management personnel; •unanticipated serious safety concerns related to the use of our product candidates; and •the terms and timing of any collaboration, license or other arrangement, including the terms and timing of any milestone payments thereunder. We believe that our existing cash, cash equivalents and investments, will enable us to fund our operating expenses, capital expenditure requirements, including the renovation and customization of the manufacturing facility we purchased in July 2018, and debt service payments into 2021. We have based this estimate on assumptions that may prove to be wrong, and we could utilize our available capital resources sooner than we expect. Until such time, if ever, as we can generate substantial product revenue, we expect to finance our operations through a combination of equity offerings, debt financings, collaborations, strategic alliances and marketing, distribution or licensing arrangements. To the extent that we raise additional capital through the sale of equity or convertible debt securities, investors’ ownership interest will be diluted, and the terms of these securities may include liquidation or other preferences that adversely affect investors’ rights as a common stockholder. Debt financing and preferred equity financing, if available, may involve agreements that include covenants limiting or restricting our ability to take specific actions, such as incurring additional debt, making acquisitions or capital expenditures or declaring dividends. If we raise additional funds through collaborations, strategic alliances or marketing, distribution or licensing arrangements with third parties, we may have to relinquish valuable rights to our technologies, future revenue streams, research programs or drug candidates, or grant licenses on terms that may not be favorable to us. If we are unable to raise additional funds through equity or debt financings or other arrangements when needed, we may be required to delay, limit, reduce or terminate our research, product development or future commercialization efforts, or grant rights to develop and market drug candidates that we would otherwise prefer to develop and market ourselves. Contractual Obligations and Commitments The following table summarizes our contractual obligations as of December 31, 2018 and the effects that such obligations are expected to have on our liquidity and cash flows in future periods: (1)Amounts in table reflect payments due for our leases of office and laboratory space in Cambridge, Massachusetts under four operating lease agreements that expire in February 2019, February 2019, September 2021 and July 2028. (2)Amounts in table reflect the contractually required principal and interest payments payable under the 2018 Credit Facility. For purposes of this table, the interest due under the 2018 Credit Facility was calculated using an assumed interest rate of 8.02% per annum, which was the interest rate in effect as of December 31, 2018. We enter into contracts in the normal course of business with CROs, CMOs and other third parties for preclinical research studies, clinical trials and testing and manufacturing services. These contracts do not contain minimum purchase commitments and are cancelable by us upon prior written notice. Payments due upon cancellation consist only of payments for services provided or expenses incurred, including noncancelable obligations of our service providers, up to the date of cancellation. These payments are not included in the table above as the amount and timing of such payments are not known. We have also entered into a license agreement with the Whitehead Institute for Biomedical Research (“WIBR”), as amended, under which the company has been granted an exclusive, sublicensable, nontransferable license under certain patent families related to the development of the company’s red cell therapeutics (the “WIBR License”). We are obligated to pay to WIBR low single-digit royalties based on annual net sales by us, our affiliates and our sublicensees of licensed products and licensed services that are covered by a valid claim of the licensed patent rights at the time and in the country of sale. Based on the progress the company makes in the advancement of products covered by the licensed patent rights, the company is required to make aggregate milestone payments of up to $1.6 million upon the achievement of specified preclinical, clinical and regulatory milestones. In addition, the company is required to pay to WIBR a percentage of the non-royalty payments that it receives from sublicensees of the patent rights licensed by WIBR. This percentage varies from low single-digit to low double-digit percentages and will be based upon the clinical stage of the product that is the subject of the sublicense. Royalties shall be paid by the company on a licensed product-by-licensed product and country-by-country basis, beginning on the first commercial sale of such licensed product in such country until expiration of the last valid patent claim covering such licensed product in such country. The company has the right to terminate the WIBR License in its entirety, on a patent-by-patent or country-by-country basis, at will upon three months’ notice to WIBR. WIBR may terminate the agreement upon breach of contract or in the event of the company’s bankruptcy, liquidation, insolvency or cessation of business related to the license. For additional information, see “Business-Licenses.” Critical Accounting Policies and Significant Judgments and Estimates Our consolidated financial statements are prepared in accordance with generally accepted accounting principles in the United States, or GAAP. The preparation of our consolidated financial statements and related disclosures requires us to make estimates, assumptions and judgments that affect the reported amounts of assets, liabilities, revenue, costs and expenses, and related disclosures. We base our estimates on historical experience, known trends and events and various other factors that we believe are reasonable under the circumstances, the results of which form the basis for making judgments about the carrying values of assets and liabilities that are not readily apparent from other sources. We evaluate our estimates and assumptions on an ongoing basis. Our actual results may differ from these estimates under different assumptions or conditions. While our significant accounting policies are described in more detail in Note 2 to our consolidated financial statements, we believe that the following accounting policies are those most critical to the judgments and estimates used in the preparation of our financial statements. Accrued Research and Development Expenses As part of the process of preparing our consolidated financial statements, we are required to estimate our accrued research and development expenses. This process involves reviewing open contracts and purchase orders, communicating with our applicable personnel to identify services that have been performed on our behalf and estimating the level of service performed and the associated cost incurred for the service when we have not yet been invoiced or otherwise notified of actual costs. The majority of our service providers invoice us in arrears for services performed, on a pre-determined schedule or when contractual milestones are met; however, some require advance payments. We make estimates of our accrued expenses as of each balance sheet date in the consolidated financial statements based on facts and circumstances known to us at that time. We periodically confirm the accuracy of the estimates with the service providers and make adjustments if necessary. Examples of estimated accrued research and development expenses include fees paid to: •vendors in connection with preclinical development activities; •CMOs in connection with process development and scale-up activities and the production of preclinical and clinical trial materials; and •CROs in connection with clinical trials. We base the expense recorded related to contract research and manufacturing on our estimates of the services received and efforts expended pursuant to quotes and contracts with multiple CMOs and CROs that supply materials and conduct services. The financial terms of these agreements are subject to negotiation, vary from contract to contract and may result in uneven payment flows. There may be instances in which payments made to our vendors will exceed the level of services provided and result in a prepayment of the expense. In accruing service fees, we estimate the time period over which services will be performed and the level of effort to be expended in each period. If the actual timing of the performance of services or the level of effort varies from the estimate, we adjust the accrual or prepaid expense accordingly. Although we do not expect our estimates to be materially different from amounts actually incurred, our understanding of the status and timing of services performed relative to the actual status and timing of services performed may vary and may result in reporting amounts that are too high or too low in any particular period. To date, there have not been any material adjustments to our prior estimates of accrued research and development expenses. Stock-based Compensation We measure stock-based awards with service-based and performance-based vesting conditions granted to employees and directors and, commencing January 1, 2018, to non-employees based on their fair value on the date of the grant using the Black-Scholes option-pricing model for options or the difference between the purchase price per share of the award, if any, and the fair value of our common stock for restricted common stock awards. Compensation expense for those awards is recognized over the requisite service period, which is generally the vesting period of the respective award. We use the straight-line method to record the expense of awards with service-based vesting conditions. We use the graded-vesting method to record the expense of awards with both service-based and performance-based vesting conditions, commencing when achievement of the performance condition becomes probable. Prior to the adoption of ASU 2018-07, which was effective January 1, 2018, we measured the fair value of stock-based awards granted to non-employees on the date that the related service is complete, which was generally the vesting date of the award. Prior to the service completion date, compensation expense was recognized over the period during which services were rendered by such non-employees. At the end of each financial reporting period prior to the service completion date, the fair value of these awards was remeasured using the then-current fair value of our common stock and updated assumption inputs in the Black-Scholes option-pricing model for options or the difference between the purchase price per share of the award, if any, and the then-current fair value of our common stock for restricted common stock awards. In addition, for restricted stock awards under which restricted common stock was purchased by the holder with a promissory note treated as a nonrecourse note for accounting purposes, we measured the fair value of the award using the Black-Scholes option-pricing model. The Black-Scholes option-pricing model uses as inputs the fair value of our common stock and assumptions we make for the volatility of our common stock, the expected term of our common stock options, the risk-free interest rate for a period that approximates the expected term of our common stock options, and our expected dividend yield. We measure the fair value of stock-based awards with market-based vesting conditions on the date of grant using a Monte Carlo simulation model. When service-based vesting conditions also exist, we recognize stock-based compensation expense using the graded-vesting method over the longer of the derived service period from the market condition or the required service period. In accordance with accounting guidance for awards with market conditions, the stock-based compensation expense will be recognized over the appropriate period regardless of whether the award achieves the market condition and will only be adjusted to the extent the service condition is not met. When an award contains a market-based vesting condition and a performance-based vesting condition where both must be achieved to earn the award, we recognize stock-based compensation expense over the longer of the derived service period from the market condition or the period estimated for the performance-based vesting condition to be achieved. We begin recording stock based compensation expense for this type of award when the achievement of the performance-based vesting condition becomes probable regardless of whether the market condition has been achieved. Off-Balance Sheet Arrangements We did not have during the periods presented, and we do not currently have, any off-balance sheet arrangements, as defined in the rules and regulations of the SEC. Recently Issued Accounting Pronouncements A description of recently issued accounting pronouncements that may potentially impact our financial position, results of operations or cash flows are disclosed in Note 2 to our consolidated financial statements. Emerging Growth Company Status The Jumpstart Our Business Startups Act of 2012 permits an “emerging growth company” such as us to take advantage of an extended transition period to comply with new or revised accounting standards applicable to public companies until those standards would otherwise apply to private companies. We have elected not to “opt out” of such extended transition period, which means that when a standard is issued or revised and it has different application dates for public or private companies, we will adopt the new or revised standard at the time private companies adopt the new or revised standard and will do so until such time that we either (i) irrevocably elect to “opt out” of such extended transition period or (ii) no longer qualify as an emerging growth company. While we have not made such an irrevocable election, we have not delayed the adoption of any applicable accounting standards.

<s>[INST] Overview We are developing a new class of cellular medicines, Red Cell Therapeutics, or RCTs. Based on our vision that human red blood cells are the foundation of the next significant innovation in medicine, we have designed a proprietary platform to genetically engineer and culture RCTs that are selective, potent and readytouse cellular therapies. We believe that our RCTs will provide lifechanging or lifesaving benefits for patients with severe diseases across multiple therapeutic areas. We have generated hundreds of RCTs using our RED PLATFORM®, a highly versatile and proprietary cellular therapy platform. We are utilizing our universal engineering and manufacturing processes to advance a broad pipeline of RCT product candidates into clinical trials in rare diseases, cancer and autoimmune diseases. Common design and manufacturing elements of our RCTs should enable us to achieve significant advantages in product development. We are establishing end to end manufacturing capabilities and plan to develop commercial infrastructure to further establish Rubius Therapeutics as a leading, fully integrated cellular therapy company. Since our inception, we have focused substantially all of our resources on building our proprietary RED PLATFORM, establishing and protecting our intellectual property portfolio, conducting research and development activities, developing our manufacturing process and manufacturing drug product material, organizing and staffing our company, business planning, raising capital and providing general and administrative support for these operations. We do not have any products approved for sale and have not generated any revenue from product sales. To date, we have funded our operations with proceeds from the sale of preferred stock and issuance of debt and, most recently, with proceeds from our initial public offering, or IPO. On July 20, 2018, we completed our IPO, pursuant to which we issued and sold 12,055,450 shares of common stock, inclusive of 1,572,450 shares pursuant to the full exercise of the underwriters’ option to purchase additional shares. We received proceeds of $254.3 million after deducting underwriting discounts and commissions and other offering costs. Since our inception, we have incurred significant operating losses. Our ability to generate any product revenue or product revenue sufficient to achieve profitability will depend on the successful development and eventual commercialization of one or more of our product candidates. We reported net losses of $89.2 million for the year ended December 31, 2018, $43.8 million for the year ended December 31, 2017 and $11.0 million for the year ended December 31, 2016. As of December 31, 2018, we had an accumulated deficit of $150.1 million. We expect to continue to incur significant expenses and increasing operating losses for at least the next several years. We expect that our expenses and capital requirements will increase substantially in connection with our ongoing activities, particularly if and as we: conduct clinical trials for our product candidates; further develop our RED PLATFORM; continue to discover and develop additional product candidates; maintain, expand and protect our intellectual property portfolio; hire additional clinical, scientific manufacturing and commercial personnel; expand inhouse manufacturing capabilities, including through the renovation, customization and operation of our recently purchased manufacturing facility; establish a commercial manufacturing source and secure supply chain capacity sufficient to provide commercial quantities of any product candidates for which we may obtain regulatory approval; acquire or inlicense other product candidates and technologies; seek regulatory approvals for any product candidates that successfully complete clinical trials; establish a sales, marketing and distribution infrastructure to commercialize any products for which we may obtain regulatory approval; and add operational, financial and management information systems and personnel, including personnel to support our product development and planned future commercialization efforts, as well as to support our transition to a public company. We will not generate revenue from product sales unless and until we successfully complete clinical development and obtain regulatory approval for our product candidates. If we obtain regulatory approval for any of our product candidates, we expect to incur significant expenses related to developing our commercialization capability to support product sales, [/INST] Negative. </s>

Rubius Therapeutics, Inc.

2020-03-12

2019-12-31

Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations The following discussion and analysis of our financial condition and results of operations should be read in conjunction with our consolidated financial statements and related notes appearing at the end of this Annual Report on Form 10-K. Some of the information contained in this discussion and analysis or set forth elsewhere in this Annual Report on Form 10-K, including information with respect to our plans and strategy for our business, includes forward-looking statements that involve risks and uncertainties. As a result of many factors, including those factors set forth in the “Risk Factors” section of this Annual Report on Form 10-K, our actual results could differ materially from the results described in, or implied by, the forward-looking statements contained in the following discussion and analysis. Overview We are developing a new class of cellular medicines, Red Cell Therapeutics, or RCTs. Based on our vision that human red blood cells are the foundation of the next significant innovation in medicine, we have designed a proprietary platform to genetically engineer and culture RCTs that are selective, potent and ready-to-use cellular therapies. We believe that our RCTs will provide life-changing or life-saving benefits for patients with severe diseases across multiple therapeutic areas. We have generated hundreds of RCTs using our RED PLATFORM®, a highly versatile and proprietary cellular therapy platform. We are utilizing our universal engineering and manufacturing processes to advance a broad pipeline of RCT product candidates into clinical trials in cancer and autoimmune diseases. Common design and manufacturing elements of our RCTs should enable us to achieve significant advantages in product development. We are establishing end to end manufacturing capabilities and plan to develop commercial infrastructure to further establish Rubius Therapeutics as a leading, fully integrated cellular therapy company. During 2019, the IND for a Phase 1b clinical trial evaluating RTX-134 for the treatment of phenylketonuria, or PKU, was allowed to proceed by the FDA and in January 2020, we dosed the first patient in the trial. In March 2020, we announced that we are discontinuing the Phase 1b clinical trial for RTX-134 and deprioritizing our rare disease programs in order to primarily focus on our oncology and autoimmunity pipeline. Future capital investments and improvements in manufacturing efficiency, together with enhancements to the RED PLATFORM®, may enable us to revisit chronic, high-dose rare diseases in the future. The IND for our second product candidate, RTX-240 has been allowed to proceed by the FDA and we plan to submit an IND for RTX-321 by the end of 2020. Since our inception, we have focused substantially all of our resources on building our proprietary RED PLATFORM, establishing and protecting our intellectual property portfolio, conducting research and development activities, developing our manufacturing process and manufacturing drug product material, organizing and staffing our company, business planning, raising capital and providing general and administrative support for these operations. We do not have any products approved for sale and have not generated any revenue from product sales. To date, we have funded our operations with proceeds from the sale of preferred stock and issuance of debt and with proceeds from our initial public offering, or IPO. On July 20, 2018, we completed our IPO pursuant to which we issued and sold 12,055,450 shares of common stock, inclusive of 1,572,450 shares pursuant to the full exercise of the underwriters’ option to purchase additional shares. We received proceeds of $254.3 million after deducting underwriting discounts and commissions and other offering costs. In August 2019, we entered into a Distribution Agreement with J.P. Morgan Securities LLC, Jefferies LLC and SVB Leerink LLC with respect to an at-the-market, or ATM, offering program under which we may offer and sell, from time to time at our sole discretion, shares of our common stock, having aggregate gross proceeds of up to $100.0 million. We have not yet sold any shares of our common stock under the ATM offering program. Since our inception, we have incurred significant operating losses. Our ability to generate any product revenue or product revenue sufficient to achieve profitability will depend on the successful development and eventual commercialization of one or more of our product candidates. We reported net losses of $163.5 million for the year ended December 31, 2019, $89.2 million for the year ended December 31, 2018 and $43.8 million for the year ended December 31, 2017. As of December 31, 2019, we had an accumulated deficit of $312.7 million. We expect to continue to incur significant expenses and increasing operating losses for at least the next several years. We expect that our expenses and capital requirements will increase substantially in connection with our ongoing activities, particularly if and as we: · conduct clinical trials for our product candidates; · further develop our RED PLATFORM; · continue to discover and develop additional product candidates; · maintain, expand and protect our intellectual property portfolio; · hire additional clinical, scientific manufacturing and commercial personnel; · expand in-house manufacturing capabilities, including through the operation and future renovation or expansion of our manufacturing facility; · establish a commercial manufacturing source and secure supply chain capacity sufficient to provide commercial quantities of any product candidates for which we may obtain regulatory approval; · acquire or in-license other product candidates and technologies; · seek regulatory approvals for any product candidates that successfully complete clinical trials; · establish a sales, marketing and distribution infrastructure to commercialize any products for which we may obtain regulatory approval; and · add operational, financial and management information systems and personnel, including personnel to support our product development and planned future commercialization efforts, as well as to continue to support the requirements of a public company. We will not generate revenue from product sales unless and until we successfully complete clinical development and obtain regulatory approval for our product candidates. If we obtain regulatory approval for any of our product candidates, we expect to incur significant expenses related to developing our commercialization capability to support product sales, marketing and distribution. Further, we expect to incur additional costs associated with operating as a public company. As a result, we will need substantial additional funding to support our continuing operations and pursue our growth strategy. Until such time as we can generate significant revenue from product sales, if ever, we expect to finance our operations through a combination of equity offerings, debt financings, collaborations, strategic alliances and marketing, distribution or licensing arrangements. We may be unable to raise additional funds or enter into such other agreements or arrangements when needed on favorable terms, or at all. If we fail to raise capital or enter into such agreements as, and when, needed, we may have to significantly delay, scale back or discontinue the development and commercialization of one or more of our product candidates. Because of the numerous risks and uncertainties associated with pharmaceutical product development, we are unable to accurately predict the timing or amount of increased expenses or when, or if, we will be able to achieve or maintain profitability. Even if we are able to generate product sales, we may not become profitable. If we fail to become profitable or are unable to sustain profitability on a continuing basis, then we may be unable to continue our operations at planned levels and be forced to reduce or terminate our operations. As of December 31, 2019, we had cash, cash equivalents and investments of $283.3 million. We believe that our existing cash, cash equivalents and investments will enable us to fund our operating expenses, capital expenditure requirements and debt service payments into 2022. See “-Liquidity and Capital Resources.” Components of Our Results of Operations Revenue To date, we have not generated any revenue from product sales and do not expect to generate any revenue from the sale of products in the near future. If our development efforts for our product candidates are successful and result in regulatory approval or license or collaboration agreements with third parties, we may generate revenue in the future from product sales, payments from collaboration or license agreements that we may enter into with third parties, or any combination thereof. Operating Expenses Research and Development Expenses Research and development expenses consist of costs incurred for our research activities, including our drug discovery efforts, and the development and manufacturing of our product candidates, which include: · employee-related expenses, including salaries, related benefits and stock-based compensation expense for employees engaged in research and development functions; · expenses incurred in connection with the preclinical and clinical development of our product candidates and research programs, including under agreements with third parties, such as consultants, contractors and contract research organizations, or CROs; · the cost of developing and scaling our manufacturing process and manufacturing drug products for use in our preclinical studies and clinical trials, including under agreements with third parties, such as consultants, contractors and any contract manufacturing organizations, or CMOs, that we may engage, and in our manufacturing facility; · laboratory supplies and research materials; · facilities, depreciation and other expenses, which include direct and allocated expenses for rent and maintenance of facilities and insurance; and · payments made under third-party licensing agreements. We expense research and development costs as incurred. Advance payments that we make for goods or services to be received in the future for use in research and development activities are recorded as prepaid expenses. The prepaid amounts are expensed as the related goods are delivered or the services are performed. Our direct research, manufacturing and development expenses are tracked on a program-by-program basis for clinical candidates. These consist mostly of fees, reimbursed materials, testing and other costs paid to consultants, contractors, CMOs and CROs, as well as the cost of materials used at our manufacturing site. We do not allocate employee costs, costs associated with our discovery efforts, laboratory supplies and facilities expenses, including depreciation or other indirect costs, to specific product development programs because these costs are deployed across multiple programs and our platform technology and, as such, are not separately classified. Product candidates in later stages of clinical development generally have higher development costs than those in earlier stages of clinical development, due to the increased size and duration of later-stage clinical trials. We expect that our research and development expenses will increase substantially in connection with our planned preclinical and clinical development activities in the future. At this time, we cannot accurately estimate or know the nature, timing and costs of the efforts that will be necessary to complete the preclinical and clinical development of any of our product candidates. The successful development and commercialization of our product candidates is highly uncertain. This is due to the numerous risks and uncertainties associated with product development and commercialization, including the following: · the timing and progress of preclinical and clinical development activities; · the number and scope of preclinical and clinical programs we decide to pursue; · raising additional funds necessary to complete preclinical and clinical development of and commercialize our drug candidates; · the progress of the development efforts of parties with whom we may enter into collaboration arrangements; · our ability to maintain our current research and development programs and to establish new ones; · our ability to establish new licensing or collaboration arrangements; · the successful initiation and completion of clinical trials with safety, tolerability and efficacy profiles that are satisfactory to the U.S. Food and Drug Administration, or FDA, or any comparable foreign regulatory authority; · the receipt and related terms of regulatory approvals from applicable regulatory authorities; · the availability of specialty raw materials for use in production of our product candidates; · our ability to consistently manufacture our product candidates for use in clinical trials; · our ability to operate a manufacturing facility, or secure manufacturing supply through relationships with third parties; · our ability to obtain and maintain patents, trade secret protection and regulatory exclusivity, both in the United States and internationally; · our ability to protect our rights in our intellectual property portfolio; · the commercialization of our product candidates, if and when approved; · obtaining and maintaining third-party insurance coverage and adequate reimbursement; · the acceptance of our product candidates, if approved, by patients, the medical community and third-party payors; · competition with other products; and · a continued acceptable safety profile of our therapies following approval. A change in the outcome of any of these variables with respect to the development of any of our product candidates could significantly change the costs and timing associated with the development of that product candidate. We may never succeed in obtaining regulatory approval for any of our product candidates. General and Administrative Expenses General and administrative expenses include salaries and related costs, including stock-based compensation, for personnel in executive, finance and administrative functions. General and administrative expenses also include direct and allocated facility-related costs as well as professional fees for legal, patent, consulting, investor and public relations, accounting and audit services. We anticipate that our general and administrative expenses may increase in the future as we continue to build infrastructure to support the expansion of our research activities, development of our product candidates and any expanded compliance requirements. Other Income (Expense) Interest Income Interest income consists of interest earned on our invested cash balances. Interest Expense Interest expense consists of interest expense on outstanding borrowings under our loan and security agreements, as well as amortization of debt discount and debt issuance costs. Change in Fair Value of Preferred Stock Warrant Liability In connection with our 2015 loan and security agreement with Pacific Western Bank, we issued warrants to purchase Series A and Series B preferred stock. We classified these warrants as a liability on our consolidated balance sheet that we remeasured to fair value at each reporting date, and we recognized changes in the fair value of the warrant liability as a component of other income (expense) in our consolidated statements of operations and comprehensive loss. Upon the closing of our IPO in July 2018, the preferred stock warrants became exercisable for common stock instead of preferred stock and were concurrently exercised by the holders. As a result, the fair value of the warrants was reclassified to additional paid-in capital and we no longer have a warrant liability to remeasure. Other Income (Expense), Net Other income (expense), net consists of income earned under a sublease agreement and miscellaneous income and expense unrelated to our core operations. Income Taxes Since our inception, we have not recorded any income tax benefits for the net losses we have incurred in each year or for our research and development tax credits generated, as we believe, based upon the weight of available evidence, that it is more likely than not that all of our net operating loss, or NOL, carryforwards and tax credits will not be realized. As of December 31, 2019, we had U.S. federal and state net operating loss carryforwards of $222.9 million and $227.0 million, respectively, which may be available to offset future taxable income. The federal NOLs include $37.2 million, which expire at various dates through 2037, and $185.7 million, which carryforward indefinitely. The state NOLs expire at various dates through 2039. As of December 31, 2019, we also had U.S. federal and state research and development tax credit carryforwards of $9.5 million and $5.1 million, respectively, which may be available to offset future tax liabilities and begin to expire in 2034 and 2026, respectively. We have recorded a full valuation allowance against our net deferred tax assets at each balance sheet date. Results of Operations Comparison of the Years Ended December 31, 2019 and 2018 The following table summarizes our results of operations for the years ended December 31, 2019 and 2018: Research and Development Expenses Research and development expenses were $112.4 million for the year ended December 31, 2019, compared to $51.8 million for the year ended December 31, 2018. The increase in direct costs related to our rare disease program of $15.2 million was primarily due to costs incurred in connection with our Phase 1b clinical trial of RTX-134 in patients with phenylketonuria. Following the decision in March 2020 to deprioritize development of our rare disease programs, we expect these costs to decrease throughout the remainder of 2020 as the RTX-134 Phase 1b trial has been discontinued. The increase in direct costs of $8.4 million in our lead cancer programs, including RTX-240 and RTX-321, was related principally to preclinical and IND-enabling activities. The increases in personnel-related costs and stock-based compensation expense of $13.6 million and $5.2 million, respectively, were due to increased headcount in our research and development function. The increase in laboratory supplies and research materials of $5.9 million was due to increases in platform development, manufacturing process and scale-up and drug discovery activities. The increase in facility-related and other expenses of $9.3 million was mostly due to an increase in facilities costs resulting from the commencement of our lease of office and laboratory space in January and August 2019, as well as additional laboratory services to support increased headcount. General and Administrative Expenses General and administrative expenses for the year ended December 31, 2019 were $57.2 million, compared to $39.9 million for the year ended December 31, 2018. The increase in general and administrative expenses of $17.3 million was primarily due to an increase in stock-based compensation expense of $8.5 million, personnel related costs of $3.7 million and facility related and other costs of $3.1 million, all of which were due to increased headcount in our general and administrative function, including additions to the executive management team. The increase in facility-related and other expenses was mostly due to an increase in facilities costs resulting from the commencement of our lease of office and laboratory space in January and August 2019, as well as additional insurance costs resulting from operating as a public company. Professional and consultant fees increased by $1.9 million principally due to increased patent costs and increases in accounting, audit, legal and consulting fees incurred to operate as a public company. Interest Income Interest income was $8.0 million for the year ended December 31, 2019, compared to $5.1 million for the year ended December 31, 2018. Interest income increased as a result of higher invested balances due to cash proceeds received from our IPO in July 2018 and our 2018 Credit Facility (as defined below) in December 2018 and June 2019. Interest Expense Interest expense was $2.6 million for the year ended December 31, 2019, compared to $0.5 million for the year ended December 31, 2018. The increase in interest expense was principally due to higher outstanding borrowings in connection with our 2018 Credit Facility (as defined below). Change in Fair Value of Preferred Stock Warrant Liability The change in the fair value of our preferred stock warrant liability was due to its derecognition upon exercise, which was effective upon the closing of our IPO. Other Income (Expense), Net Other income (expense), net was $0.7 million for the year ended December 31, 2019, compared to less than $0.1 million for the year ended December 31, 2018. Other income (expense), net increased as a result of income earned from a sublease agreement that commenced February 2019. Comparison of the Years Ended December 31, 2018 and 2017 The following table summarizes our results of operations for the years ended December 31, 2018 and 2017: Research and Development Expenses Research and development expenses were $51.8 million for the year ended December 31, 2018, compared to $21.2 million for the year ended December 31, 2017. The increase in direct costs related to our RTX-134 program of $8.3 million was primarily due to contract manufacturing costs incurred and IND-enabling activities in preparation for our planned Phase 1b clinical trial of RTX-134 in patients with phenylketonuria. The increases in personnel-related costs and stock-based compensation expense of $8.7 million and $2.0 million, respectively, were due primarily to increased headcount in our research and development function. The increase in laboratory supplies and research materials of $4.2 million was primarily due to increases in platform development, manufacturing process and scale-up and drug discovery activities. The increase in facility-related and other expenses of $4.2 million was primarily due to an increase in facilities costs resulting from entering into two leases of office and laboratory space in July 2017 and May 2018, as well as additional laboratory services to support increased headcount. General and Administrative Expenses General and administrative expenses for the year ended December 31, 2018 were $39.9 million, compared to $22.0 million for the year ended December 31, 2017. The increase in general and administrative expenses of $17.9 million was primarily due to an increase in stock-based compensation expense of $7.6 million. The increase in stock-based compensation expense was primarily due to the recognition of compensation expense of $7.3 million for the year ended December 31, 2018 for stock-based awards granted to new employees during the years ended December 31, 2018 and 2017 as compared to $0.3 million of compensation expense recognized in the same period in 2017, as well as the recognition of compensation expense of $2.0 million for option awards with performance-based vesting conditions that were achieved during the year ended December 31, 2018, offset by a decrease of $2.0 million in compensation expense for stock-based awards granted to the chairman of our board of directors. Personnel-related costs increased by $4.5 million as a result of an increase in headcount in our general and administrative function as we prepared for our IPO and began to operate as a public company. Professional and consultant fees increased by $3.5 million primarily due to increased patent costs as we expanded our patent portfolio, consulting fees paid to the chairman of our board of directors for his services as a consultant and increases in accounting, public relations, investor relations, audit, legal, board fees and other consulting fees incurred as we began to operate as a public company. The increase in facility related and other expenses of $2.3 million was primarily due to an increase in facilities costs resulting from entering into two leases of office and laboratory space in July 2017 and May 2018, office costs to support increased headcount, as well as additional insurance costs resulting from operating as a public company. Interest Income Interest income was $5.1 million for the year ended December 31, 2018, compared to $0.6 million for the year ended December 31, 2017. Interest income increased primarily as a result of higher invested balances due to cash proceeds received from our Series C preferred stock financing in February 2018 and our IPO in July 2018. Interest Expense Interest expense was $0.5 million for the year ended December 31, 2018, compared to $0.3 million for the year ended December 31, 2017. The increase in interest expense was due to higher interest rates applicable to outstanding borrowings during the year ended December 31, 2018, as well as a loss of less than $0.1 million on the extinguishment of our 2015 loan and security agreement. Change in Fair Value of Preferred Stock Warrant Liability The change in the fair value of our preferred stock warrant liability was due to the increase in the value of our preferred stock prior to the warrant becoming a warrant for common stock upon the closing of our IPO. Other Income (Expense), Net Other income (expense), net was not significant during the years ended December 31, 2018 or 2017. Liquidity and Capital Resources Since our inception, we have incurred significant operating losses. We have not yet commercialized any of our product candidates and we do not expect to generate revenue from sales of any product candidates for several years, if at all. To date, we have funded our operations with proceeds from the sale of preferred stock and issuance of debt and, most recently, with proceeds from our IPO. As of December 31, 2019, we had cash, cash equivalents and investments of $283.3 million. In July 2018, we completed our IPO, pursuant to which we issued and sold 12,055,450 shares of common stock, inclusive of 1,572,450 shares pursuant to the full exercise of the underwriters’ option to purchase additional shares. We received proceeds of $254.3 million, after deducting underwriting discounts and commissions and other offering costs. In December 2018, we repaid all borrowings under our 2015 loan and security agreement and entered into a new loan and security agreement for an aggregate principal amount of $75.0 million, of which $50.0 million was outstanding as of December 31, 2019. Cash Flows The following table summarizes our sources and uses of cash for each of the periods presented: Operating Activities During the year ended December 31, 2019, operating activities used $110.4 million of cash, primarily resulting from our net loss of $163.5 million, partially offset by net non-cash charges of $42.6 million, primarily consisting of stock-based compensation expense. Changes in our operating assets and liabilities for the year ended December 31, 2019 provided cash of $10.4 million consisting primarily of a $5.5 million increase in accounts payable, accrued expenses and other current liabilities, a $5.0 million increase in operating lease, right-of-use asset, and a $2.7 million increase in prepaid expenses and other current assets, offset by a $2.7 million decrease in operating lease liabilities. During the year ended December 31, 2018, operating activities used $58.3 million of cash, primarily resulting from our net loss of $89.2 million, partially offset by net non-cash charges of $30.7 million, primarily consisting of stock-based compensation expense. Changes in our operating assets and liabilities for the year ended December 31, 2018 provided net cash of $0.1 million, which consisted primarily of a $9.2 million increase in accounts payable and accrued expenses and other current liabilities, offset by a $9.1 million increase in prepaid expenses and other current assets and other assets. During the year ended December 31, 2017, operating activities used $21.9 million of cash, primarily resulting from our net loss of $43.8 million, partially offset by net non-cash charges of $19.2 million, primarily consisting of stock-based compensation expense, and net cash provided by changes in our operating assets and liabilities of $2.7 million. Net cash provided by changes in our operating assets and liabilities for the year ended December 31, 2017 consisted primarily of a $3.4 million increase in accounts payable and accrued expenses and other current liabilities, partially offset by a $0.6 million increase in prepaid expenses and other current assets. Changes in accounts payable, accrued expenses and other current liabilities and prepaid expenses and other current assets in all periods presented were generally due to growth in our business, the advancement of our research programs and the timing of vendor invoicing and payments. Investing Activities During the year ended December 31, 2019, net cash used in investing activities was $132.6 million, consisting of purchases of investments of $319.1 million and purchases of property, plant and equipment of $40.7 million, offset by sales and maturities of investments of $227.2 million. Our purchases of property, plant and equipment primarily consisted of $29.8 million related to the renovation and customization of our manufacturing facility in Smithfield, Rhode Island, and $8.5 million for the purchase of laboratory equipment as we expanded our discovery and technical development activities. During the year ended December 31, 2018, net cash used in investing activities was $111.6 million, consisting of purchases of investments of $161.0 million and purchases of property, plant and equipment of $15.0 million, offset by sales and maturities of investments of $64.3 million. Our purchases of property, plant and equipment primarily consisted of $8.0 million for the acquisition of and subsequent design and demolition activities associated with our recently purchased manufacturing facility in Smithfield, Rhode Island and $4.4 million for the purchase of laboratory equipment as we expanded our discovery and manufacturing activities. During the years ended December 31, 2017, net cash used in investing activities was $2.3 million due to purchases of property and equipment related to equipment as we expanded our discovery and manufacturing activities. Financing Activities During the year ended December 31, 2019, net cash provided by financing activities of $27.3 million consisted of $25.0 million of proceeds received from borrowings under a loan and security agreement and $2.4 million proceeds received from the issuance of common stock upon exercise of stock options. During the year ended December 31, 2018, net cash provided by financing activities of $374.8 million consisted primarily of $257.9 million of proceeds from our IPO in July 2018, $101.0 million of proceeds from the issuance of preferred stock in February 2018, and $25.0 million of proceeds received from borrowings under a loan and security agreement entered in December 2018, net of financing costs paid in 2018. We used cash of $5.5 million to repay outstanding borrowings under our 2015 loan and security agreement. During the year ended December 31, 2017, net cash provided by financing activities was $121.7 million, consisting primarily of proceeds from the issuance of preferred stock of $120.1 million and borrowings of $1.5 million under our 2015 loan and security agreement. Loan and Security Agreements In November 2015, we entered into a loan and security agreement, as amended, or the 2015 Credit Facility, with Pacific Western Bank under which we borrowed an aggregate of $5.5 million. In December 2018, we repaid all borrowings under the 2015 Credit Facility and terminated it. The aggregate principal amount of the loan outstanding at the time of repayment was $5.5 million and we did not incur any penalties as a result of the repayment. We recognized a loss on the extinguishment of the 2015 Credit Facility of less than $0.1 million related to the unamortized debt discount at the time of repayment. The loss on extinguishment was recorded as additional interest expense. In December 2018, or the Closing Date, we entered into a loan and security agreement, or the Loan Agreement, with Solar Capital Ltd. as collateral agent for the lenders party thereto for an aggregate principal amount of $75.0 million, or the 2018 Credit Facility. The aggregate principal amount will be funded in three tranches of term loans of $25.0 million each. On the Closing Date, we made an initial borrowing of $25.0 million. In June 2019, we made a second borrowing of $25.0 million. The third tranche is available to us through June 30, 2020, subject to the satisfaction of certain financial covenants. Interest on the outstanding loan balance accrues at a rate of the one-month U.S. LIBOR rate plus 5.50%. Monthly principal payments will commence 36 months after the Closing Date and will be amortized over the following 24 months. The term loans are subject to a prepayment fee of 1.00% in the first year, 0.50% in the second year and 0.25% in the third year. In conjunction with 2018 Credit Facility, we incurred issuance costs of $0.8 million. The Loan Agreement contains financial covenants that require us to maintain either a certain minimum cash balance or a minimum market capitalization threshold. We were in compliance with all such covenants as of December 31, 2019. The Loan Agreement contains customary representations, warranties and covenants and also includes customary events of default, including payment defaults, breaches of covenants, change of control and a material adverse change default. Upon the occurrence of an event of default, a default interest rate of an additional 4.00% per annum may be applied to the outstanding loan balances, and the lenders may declare all outstanding obligations immediately due and payable. Borrowings under the Loan Agreement are collateralized by substantially all of our assets, other than its intellectual property. Common Stock Sales Agreement On August 1, 2019, we entered into a Distribution Agreement (the “Distribution Agreement”), with multiple sales agents, pursuant to which the Company may offer and sell to or through the agents, from time to time, shares of the Company's common stock, par value $0.001 per share, having an aggregate gross sales price of up to $100.0 million. Sales, if any, of the Company's shares of common stock will be made primarily in “at-the-market” offerings, as defined in Rule 415 under the Securities Act. The shares of common stock will be offered and sold pursuant to our registration statement on Form S-3 and a related prospectus supplement, both filed with the SEC on August 1, 2019. We intend to use substantially all of the net proceeds from any sale of shares of the Company's common stock for working capital and other general corporate purposes. There were no shares of the Company's common stock sold under the Distribution Agreement during 2019. Funding Requirements We expect our expenses to increase substantially in the future as we conduct the activities necessary to advance our product candidates through development. The timing and amount of our operating and capital expenditures will depend largely on: · the timing and progress of preclinical and clinical development activities; · the commencement, enrollment or results of the planned clinical trials of our product candidates or any future clinical trials we may conduct, or changes in the development status of our product candidates; · the timing and outcome of regulatory review of our product candidates; · our decision to initiate a clinical trial, not to initiate a clinical trial or to terminate an existing clinical trial; · changes in laws or regulations applicable to our product candidates, including but not limited to clinical trial requirements for approvals; · developments concerning our CMOs; · our ability to obtain materials to produce adequate product supply for any approved product or inability to do so at acceptable prices; · the costs associated with the operation of our multi-suite manufacturing facility and the costs and timing of any future renovation or expansion of the facility; · our ability to establish collaborations if needed; · the costs and timing of future commercialization activities, including product manufacturing, marketing, sales and distribution, for any of our product candidates for which we obtain marketing approval; · the legal patent costs involved in prosecuting patent applications and enforcing patent claims and other intellectual property claims; · additions or departures of key scientific or management personnel; · unanticipated serious safety concerns related to the use of our product candidates; and · the terms and timing of any collaboration, license or other arrangement, including the terms and timing of any milestone payments thereunder. We believe that our existing cash, cash equivalents and investments, will enable us to fund our operating expenses, capital expenditure requirements and debt service payments into 2022. We have based this estimate on assumptions that may prove to be wrong, and we could utilize our available capital resources sooner than we expect. Until such time, if ever, as we can generate substantial product revenue, we expect to finance our operations through a combination of equity offerings, debt financings, collaborations, strategic alliances and marketing, distribution or licensing arrangements. To the extent that we raise additional capital through the sale of equity or convertible debt securities, investors’ ownership interest will be diluted, and the terms of these securities may include liquidation or other preferences that adversely affect investors’ rights as a common stockholder. Debt financing and preferred equity financing, if available, may involve agreements that include covenants limiting or restricting our ability to take specific actions, such as incurring additional debt, making acquisitions or capital expenditures or declaring dividends. If we raise additional funds through collaborations, strategic alliances or marketing, distribution or licensing arrangements with third parties, we may have to relinquish valuable rights to our technologies, future revenue streams, research programs or drug candidates, or grant licenses on terms that may not be favorable to us. If we are unable to raise additional funds through equity or debt financings or other arrangements when needed, we may be required to delay, limit, reduce or terminate our research, product development or future commercialization efforts, or grant rights to develop and market drug candidates that we would otherwise prefer to develop and market ourselves. Contractual Obligations and Commitments The following table summarizes our contractual obligations as of December 31, 2019 and the effects that such obligations are expected to have on our liquidity and cash flows in future periods: (1)Amounts in table reflect payments due for our leases of office and laboratory space in Cambridge, Massachusetts under three operating lease agreements that expire in September 2021, January 2027 and August 2028 and our embedded lease resulting from an agreement with a contract manufacturing supplier that expires in December 2020. (2)Amounts in table reflect the contractually required principal and interest payments payable under the 2018 Credit Facility. For purposes of this table, the interest due under the 2018 Credit Facility was calculated using an assumed interest rate of 8.10% per annum, which was the interest rate in effect as of December 31, 2019. We enter into contracts in the normal course of business with CROs, CMOs and other third parties for preclinical research studies, assay development, clinical trials, manufacturing and testing services. These contracts do not contain minimum purchase commitments and are cancelable by us upon prior written notice. Payments due upon cancellation consist only of payments for services provided or expenses incurred, including noncancelable obligations of our service providers, up to the date of cancellation. These payments are not included in the table above as the amount and timing of such payments are not known. We have also entered into a license agreement with the Whitehead Institute for Biomedical Research (“WIBR”), as amended, under which we have been granted an exclusive, sublicensable, nontransferable license under certain patent families related to the development of our red cell therapeutics (the “WIBR License”). We are obligated to pay to WIBR low single-digit royalties based on annual net sales by us, our affiliates and our sublicensees of licensed products and licensed services that are covered by a valid claim of the licensed patent rights at the time and in the country of sale. Based on the progress the we make in the advancement of products covered by the licensed patent rights, we are required to make aggregate milestone payments of up to $1.6 million upon the achievement of specified preclinical, clinical and regulatory milestones. In addition, we are required to pay to WIBR a percentage of the non-royalty payments that it receives from sublicensees of the patent rights licensed by WIBR. This percentage varies from low single-digit to low double-digit percentages and will be based upon the clinical stage of the product that is the subject of the sublicense. Royalties shall be paid by us on a licensed product-by-licensed product and country-by-country basis, beginning on the first commercial sale of such licensed product in such country until expiration of the last valid patent claim covering such licensed product in such country. We have the right to terminate the WIBR License in its entirety, on a patent-by-patent or country-by-country basis, at will upon three months’ notice to WIBR. WIBR may terminate the agreement upon breach of contract or in the event of bankruptcy, liquidation, insolvency or cessation of business related to the license. For additional information, see “Business-Licenses.” Critical Accounting Policies and Significant Judgments and Estimates Our consolidated financial statements are prepared in accordance with generally accepted accounting principles in the United States, or GAAP. The preparation of our consolidated financial statements and related disclosures requires us to make estimates, assumptions and judgments that affect the reported amounts of assets, liabilities, revenue, costs and expenses, and related disclosures. We base our estimates on historical experience, known trends and events and various other factors that we believe are reasonable under the circumstances, the results of which form the basis for making judgments about the carrying values of assets and liabilities that are not readily apparent from other sources. We evaluate our estimates and assumptions on an ongoing basis. Our actual results may differ from these estimates under different assumptions or conditions. While our significant accounting policies are described in more detail in Note 2 to our consolidated financial statements, we believe that the following accounting policies are those most critical to the judgments and estimates used in the preparation of our financial statements. Accrued Research and Development Expenses As part of the process of preparing our consolidated financial statements, we are required to estimate our accrued research and development expenses. This process involves reviewing open contracts and purchase orders, communicating with our applicable personnel to identify services that have been performed on our behalf and estimating the level of service performed and the associated cost incurred for the service when we have not yet been invoiced or otherwise notified of actual costs. The majority of our service providers invoice us in arrears for services performed, on a pre-determined schedule or when contractual milestones are met; however, some require advance payments. We make estimates of our accrued expenses as of each balance sheet date in the consolidated financial statements based on facts and circumstances known to us at that time. We periodically confirm the accuracy of the estimates with the service providers and make adjustments if necessary. Examples of estimated accrued research and development expenses include fees paid to: · vendors in connection with preclinical and assay development activities; · CMOs in connection with process development and scale-up activities and the production and testing of preclinical and clinical trial materials; and · CROs in connection with clinical trials. We base the expense recorded related to contract research and manufacturing on our estimates of the services received and efforts expended pursuant to quotes and contracts with multiple CMOs and CROs that supply materials and conduct services. The financial terms of these agreements are subject to negotiation, vary from contract to contract and may result in uneven payment flows. There may be instances in which payments made to our vendors will exceed the level of services provided and result in a prepayment of the expense. In accruing service fees, we estimate the time period over which services will be performed and the level of effort to be expended in each period. If the actual timing of the performance of services or the level of effort varies from the estimate, we adjust the accrual or prepaid expense accordingly. Although we do not expect our estimates to be materially different from amounts actually incurred, our understanding of the status and timing of services performed relative to the actual status and timing of services performed may vary and may result in reporting amounts that are too high or too low in any particular period. To date, there have not been any material adjustments to our prior estimates of accrued research and development expenses. Stock-based Compensation We measure stock-based awards with service-based and performance-based vesting conditions granted to employees and directors and, commencing January 1, 2018, to non-employees based on their fair value on the date of the grant using the Black-Scholes option-pricing model for options or the difference between the purchase price per share of the award, if any, and the fair value of our common stock for restricted common stock awards. Compensation expense for those awards is recognized over the requisite service period, which is generally the vesting period of the respective award. We use the straight-line method to record the expense of awards with service-based vesting conditions. We use the graded-vesting method to record the expense of awards with both service-based and performance-based vesting conditions, commencing when achievement of the performance condition becomes probable. Prior to the adoption of ASU 2018-07, which was effective January 1, 2018, we measured the fair value of stock-based awards granted to non-employees on the date that the related service is complete, which was generally the vesting date of the award. Prior to the service completion date, compensation expense was recognized over the period during which services were rendered by such non-employees. At the end of each financial reporting period prior to the service completion date, the fair value of these awards was remeasured using the then-current fair value of our common stock and updated assumption inputs in the Black-Scholes option-pricing model for options or the difference between the purchase price per share of the award, if any, and the then-current fair value of our common stock for restricted common stock awards. In addition, for restricted stock awards under which restricted common stock was purchased by the holder with a promissory note treated as a nonrecourse note for accounting purposes, we measured the fair value of the award using the Black-Scholes option-pricing model. The Black-Scholes option-pricing model uses as inputs the fair value of our common stock and assumptions we make for the volatility of our common stock, the expected term of our common stock options, the risk-free interest rate for a period that approximates the expected term of our common stock options, and our expected dividend yield. We measure the fair value of stock-based awards with market-based vesting conditions on the date of grant using a Monte Carlo simulation model. When service-based vesting conditions also exist, we recognize stock-based compensation expense using the graded-vesting method over the longer of the derived service period from the market condition or the required service period. In accordance with accounting guidance for awards with market conditions, the stock-based compensation expense will be recognized over the appropriate period regardless of whether the award achieves the market condition and will only be adjusted to the extent the service condition is not met. When an award contains a market-based vesting condition and a performance-based vesting condition where both must be achieved to earn the award, we recognize stock-based compensation expense over the longer of the derived service period from the market condition or the period estimated for the performance-based vesting condition to be achieved. We begin recording stock based compensation expense for this type of award when the achievement of the performance-based vesting condition becomes probable regardless of whether the market condition has been achieved. Off-Balance Sheet Arrangements We did not have during the periods presented, and we do not currently have, any off-balance sheet arrangements, as defined in the rules and regulations of the SEC. Recently Issued Accounting Pronouncements A description of recently issued accounting pronouncements that may potentially impact our financial position, results of operations or cash flows are disclosed in Note 2 to our consolidated financial statements. Emerging Growth Company Status The Jumpstart Our Business Startups Act of 2012 permits an “emerging growth company” such as us to take advantage of an extended transition period to comply with new or revised accounting standards applicable to public companies until those standards would otherwise apply to private companies. We have elected not to “opt out” of such extended transition period, which means that when a standard is issued or revised and it has different application dates for public or private companies, we will adopt the new or revised standard at the time private companies adopt the new or revised standard and will do so until such time that we either (i) irrevocably elect to “opt out” of such extended transition period or (ii) no longer qualify as an emerging growth company. While we have not made such an irrevocable election, we have not delayed the adoption of any applicable accounting standards.

<s>[INST] Overview We are developing a new class of cellular medicines, Red Cell Therapeutics, or RCTs. Based on our vision that human red blood cells are the foundation of the next significant innovation in medicine, we have designed a proprietary platform to genetically engineer and culture RCTs that are selective, potent and readytouse cellular therapies. We believe that our RCTs will provide lifechanging or lifesaving benefits for patients with severe diseases across multiple therapeutic areas. We have generated hundreds of RCTs using our RED PLATFORM®, a highly versatile and proprietary cellular therapy platform. We are utilizing our universal engineering and manufacturing processes to advance a broad pipeline of RCT product candidates into clinical trials in cancer and autoimmune diseases. Common design and manufacturing elements of our RCTs should enable us to achieve significant advantages in product development. We are establishing end to end manufacturing capabilities and plan to develop commercial infrastructure to further establish Rubius Therapeutics as a leading, fully integrated cellular therapy company. During 2019, the IND for a Phase 1b clinical trial evaluating RTX134 for the treatment of phenylketonuria, or PKU, was allowed to proceed by the FDA and in January 2020, we dosed the first patient in the trial. In March 2020, we announced that we are discontinuing the Phase 1b clinical trial for RTX134 and deprioritizing our rare disease programs in order to primarily focus on our oncology and autoimmunity pipeline. Future capital investments and improvements in manufacturing efficiency, together with enhancements to the RED PLATFORM®, may enable us to revisit chronic, highdose rare diseases in the future. The IND for our second product candidate, RTX240 has been allowed to proceed by the FDA and we plan to submit an IND for RTX321 by the end of 2020. Since our inception, we have focused substantially all of our resources on building our proprietary RED PLATFORM, establishing and protecting our intellectual property portfolio, conducting research and development activities, developing our manufacturing process and manufacturing drug product material, organizing and staffing our company, business planning, raising capital and providing general and administrative support for these operations. We do not have any products approved for sale and have not generated any revenue from product sales. To date, we have funded our operations with proceeds from the sale of preferred stock and issuance of debt and with proceeds from our initial public offering, or IPO. On July 20, 2018, we completed our IPO pursuant to which we issued and sold 12,055,450 shares of common stock, inclusive of 1,572,450 shares pursuant to the full exercise of the underwriters’ option to purchase additional shares. We received proceeds of $254.3 million after deducting underwriting discounts and commissions and other offering costs. In August 2019, we entered into a Distribution Agreement with J.P. Morgan Securities LLC, Jefferies LLC and SVB Leerink LLC with respect to an atthemarket, or ATM, offering program under which we may offer and sell, from time to time at our sole discretion, shares of our common stock, having aggregate gross proceeds of up to $100.0 million. We have not yet sold any shares of our common stock under the ATM offering program. Since our inception, we have incurred significant operating losses. Our ability to generate any product revenue or product revenue sufficient to achieve profitability will depend on the successful development and eventual commercialization of one or more of our product candidates. We reported net losses of $163.5 million for the year ended December 31, 2019, $89.2 million for the year ended December 31, 2018 and $43.8 million for the year ended December 31, 2017. As of December 31, 2019, we had an accumulated deficit of $312.7 million. We expect to continue to incur significant expenses and increasing operating losses for at least the next several years. We expect that our expenses and capital requirements will increase substantially in connection with our on [/INST] Negative. </s>

ChaSerg Technology Acquisition Corp

2019-03-20

2018-12-31

Item 7. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS The following discussion should be read in conjunction with our Financial Statements and footnotes thereto contained in this report. Forward Looking Statements All statements other than statements of historical fact included in this Form 10-K including, without limitation, statements under “Management’s Discussion and Analysis of Financial Condition and Results of Operations” regarding our financial position, business strategy and the plans and objectives of management for future operations, are forward looking statements. When used in this Form 10-K, words such “may,” “should,” “could,” “would,” “expect,” “plan,” “anticipate,” “believe,” “estimate,” “continue,” or the negative of such terms or other similar expressions, as they relate to us or our management, identify forward looking statements. Factors that might cause or contribute to such a discrepancy include, but are not limited to, those described in our other Securities and Exchange Commission (“SEC”) filings. References to “we”, “us”, “our” or the “Company” are to ChaSerg Technology Acquisition Corp., except where the context requires otherwise. Such forward looking statements are based on the beliefs of management, as well as assumptions made by, and information currently available to, our management. No assurance can be given that results in any forward-looking statement will be achieved and actual results could be affected by one or more factors, which could cause them to differ materially. The cautionary statements made in this Annual Report on Form 10-K should be read as being applicable to all forward-looking statements whenever they appear in this Annual Report. For these statements, we claim the protection of the safe harbor for forward-looking statements contained in the Private Securities Litigation Reform Act. Actual results could differ materially from those contemplated by the forward looking statements as a result of certain factors detailed in our filings with the Securities and Exchange Commission. All subsequent written or oral forward looking statements attributable to us or persons acting on our behalf are qualified in their entirety by this paragraph. Overview We are a blank check company formed under the laws of the State of Delaware on May 21, 2018 for the purpose of effecting a merger, capital stock exchange, asset acquisition, stock purchase, reorganization or similar Business Combination with one or more target businesses. We intend to effectuate our Business Combination using cash from the proceeds of our Initial Public Offering and the sale of the Placement Units that occurred simultaneously with the completion of our Initial Public Offering, our capital stock, debt or a combination of cash, stock and debt. The issuance of additional shares in connection with an initial business combination to the owners of the target or other investors: ● may significantly dilute the equity interest of investors, which dilution would increase if the anti-dilution provisions in the Class B common stock resulted in the issuance of Class A common stock on a greater than one-to-one basis upon conversion of the Class B common stock; ● may subordinate the rights of holders of our common stock if preferred stock is issued with rights senior to those afforded our common stock; ● could cause a change in control if a substantial number of shares of our common stock is issued, which may affect, among other things, our ability to use our net operating loss carry forwards, if any, and could result in the resignation or removal of our present officers and directors; ● may have the effect of delaying or preventing a change of control of us by diluting the stock ownership or voting rights of a person seeking to obtain control of us; and ● may adversely affect prevailing market prices for our Class A common stock and/or warrants. Similarly, if we issue debt securities or otherwise incur significant debt to bank or other lenders or the owners of a target, it could result in: ● default and foreclosure on our assets if our operating revenues after an initial business combination are insufficient to repay our debt obligations; ● acceleration of our obligations to repay the indebtedness even if we make all principal and interest payments when due if we breach certain covenants that require the maintenance of certain financial ratios or reserves without a waiver or renegotiation of that covenant; ● our immediate payment of all principal and accrued interest, if any, if the debt security is payable on demand; ● our inability to obtain necessary additional financing if the debt security contains covenants restricting our ability to obtain such financing while the debt security is outstanding; ● our inability to pay dividends on our common stock; ● using a substantial portion of our cash flow to pay principal and interest on our debt, which will reduce the funds available for dividends on our common stock if declared, our ability to pay expenses, make capital expenditures and acquisitions, and fund other general corporate purposes; ● limitations on our flexibility in planning for and reacting to changes in our business and in the industry in which we operate; ● increased vulnerability to adverse changes in general economic, industry and competitive conditions and adverse changes in government regulation; ● limitations on our ability to borrow additional amounts for expenses, capital expenditures, acquisitions, debt service requirements, and execution of our strategy; and ● other purposes and other disadvantages compared to our competitors who have less debt. We expect to continue to incur significant costs in the pursuit of our acquisition plans. We cannot assure you that our plans to complete a Business Combination will be successful. Results of Operations We have neither engaged in any operations nor generated any revenues to date. Our only activities from inception to December 31, 2018 were organizational activities, those necessary to prepare for the Initial Public Offering, described below, and identifying a target company for a Business Combination. We do not expect to generate any operating revenues until after the completion of our Business Combination. We generate non-operating income in the form of interest income on marketable securities held in the Trust Account. We incur expenses as a result of being a public company (for legal, financial reporting, accounting and auditing compliance), as well as for due diligence expenses in connection with completing a Business Combination. For the period from May 21, 2018 (inception) through December 31, 2018, we had a net income of $615,364, which consists of interest income on marketable securities held in the Trust Account of $1,158,467, offset by operating costs of $325,726 and a provision for income taxes of $217,377. Liquidity and Capital Resources As of December 31, 2018, we had cash of $1,011,224. Until the consummation of the Initial Public Offering, the Company’s only source of liquidity was an initial purchase of common stock by the Sponsor and loans from our Sponsor. On October 10, 2018, we consummated the Initial Public Offering of 20,000,000 Units at a price of $10.00 per Unit, generating gross proceeds of $200,000,000. Simultaneously with the closing of the Initial Public Offering, we consummated the sale of 600,000 Placement Units to the Sponsor and the underwriters at a price of $10.00 per unit, generating gross proceeds of $6,000,000. On October 25, 2018, in connection with the underwriters’ election to partially exercise of their over-allotment option, we consummated the sale of an additional 2,000,000 Units and the sale of an additional 40,000 Placement Units, generating total gross proceeds of $20,400,000. Following the Initial Public Offering, the exercise of the over-allotment option and the sale of the Placement Units, a total of $220,000,000 was placed in the Trust Account and we had $1,354,817 of cash held outside of the Trust Account, after payment of costs related to the Initial Public Offering, and available for working capital purposes. We incurred $12,821,311 in transaction costs, including $4,400,000 of underwriting fees, $7,700,000 of deferred underwriting fees and $721,311 of other costs. We intend to use substantially all of the funds held in the Trust Account, including any amounts representing interest earned on the Trust Account (less deferred underwriting commissions) to complete our Business Combination. To the extent that our capital stock or debt is used, in whole or in part, as consideration to complete our Business Combination, the remaining proceeds held in the Trust Account will be used as working capital to finance the operations of the target business or businesses, make other acquisitions and pursue our growth strategies. We intend to use the funds held outside the Trust Account primarily to identify and evaluate target businesses, perform business due diligence on prospective target businesses, travel to and from the offices, plants or similar locations of prospective target businesses or their representatives or owners, review corporate documents and material agreements of prospective target businesses, and structure, negotiate and complete a Business Combination. In order to fund working capital deficiencies or finance transaction costs in connection with a Business Combination, our Sponsor or an affiliate of our Sponsor or certain of our officers and directors may, but are not obligated to, loan us funds as may be required. If we complete a Business Combination, we would repay such loaned amounts. In the event that a Business Combination does not close, we may use a portion of the working capital held outside the Trust Account to repay such loaned amounts but no proceeds from our Trust Account would be used for such repayment. Up to $1,500,000 of such loans may be convertible into units identical to the Placement Units, at a price of $10.00 per unit at the option of the lender. We do not believe we will need to raise additional funds in order to meet the expenditures required for operating our business. However, if our estimate of the costs of identifying a target business, undertaking in-depth due diligence and negotiating a Business Combination are less than the actual amount necessary to do so, we may have insufficient funds available to operate our business prior to our Business Combination. Moreover, we may need to obtain additional financing either to complete our Business Combination or because we become obligated to redeem a significant number of our public shares upon consummation of our Business Combination, in which case we may issue additional securities or incur debt in connection with such Business Combination. Subject to compliance with applicable securities laws, we would only complete such financing simultaneously with the completion of our Business Combination. If we are unable to complete our Business Combination because we do not have sufficient funds available to us, we will be forced to cease operations and liquidate the Trust Account. In addition, following our Business Combination, if cash on hand is insufficient, we may need to obtain additional financing in order to meet our obligations. Off-balance sheet financing arrangements We have no obligations, assets or liabilities, which would be considered off-balance sheet arrangements as of December 31, 2018. We do not participate in transactions that create relationships with unconsolidated entities or financial partnerships, often referred to as variable interest entities, which would have been established for the purpose of facilitating off-balance sheet arrangements. We have not entered into any off-balance sheet financing arrangements, established any special purpose entities, guaranteed any debt or commitments of other entities, or purchased any non-financial assets. Contractual obligations We do not have any long-term debt, capital lease obligations, operating lease obligations or long-term liabilities, other than an agreement to pay an affiliate of the Sponsor a monthly fee of $15,000 for office space, utilities and secretarial and administrative support to the Company. We began incurring these fees on October 10, 2018 and will continue to incur these fees monthly until the earlier of the completion of the Business Combination and the Company’s liquidation. Critical Accounting Policies The preparation of financial statements and related disclosures in conformity with accounting principles generally accepted in the United States of America requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities, disclosure of contingent assets and liabilities at the date of the financial statements, and income and expenses during the periods reported. Actual results could materially differ from those estimates. We have not identified any critical accounting policies. Recent accounting pronouncements In August 2018, the SEC adopted the final rule under SEC Release No. 33-10532, “Disclosure Update and Simplification,” amending certain disclosure requirements that were redundant, duplicative, overlapping, outdated or superseded. In addition, the amendments expanded the disclosure requirements on the analysis of stockholders’ equity for interim financial statements. Under the amendments, an analysis of changes in each caption of stockholders’ equity presented in the balance sheet must be provided in a note or separate statement. The analysis should present a reconciliation of the beginning balance to the ending balance of each period for which a statement of comprehensive income is required to be filed. This final rule is effective on November 5, 2018. We anticipate our first presentation of the revised disclosures on the changes in stockholders’ equity will be included in our Form 10-Q for the quarter ended March 31, 2019. Management does not believe that any other recently issued, but not yet effective, accounting standards, if currently adopted, would have a material effect on our financial statements.

<s>[INST] Forward Looking Statements All statements other than statements of historical fact included in this Form 10K including, without limitation, statements under “Management’s Discussion and Analysis of Financial Condition and Results of Operations” regarding our financial position, business strategy and the plans and objectives of management for future operations, are forward looking statements. When used in this Form 10K, words such “may,” “should,” “could,” “would,” “expect,” “plan,” “anticipate,” “believe,” “estimate,” “continue,” or the negative of such terms or other similar expressions, as they relate to us or our management, identify forward looking statements. Factors that might cause or contribute to such a discrepancy include, but are not limited to, those described in our other Securities and Exchange Commission (“SEC”) filings. References to “we”, “us”, “our” or the “Company” are to ChaSerg Technology Acquisition Corp., except where the context requires otherwise. Such forward looking statements are based on the beliefs of management, as well as assumptions made by, and information currently available to, our management. No assurance can be given that results in any forwardlooking statement will be achieved and actual results could be affected by one or more factors, which could cause them to differ materially. The cautionary statements made in this Annual Report on Form 10K should be read as being applicable to all forwardlooking statements whenever they appear in this Annual Report. For these statements, we claim the protection of the safe harbor for forwardlooking statements contained in the Private Securities Litigation Reform Act. Actual results could differ materially from those contemplated by the forward looking statements as a result of certain factors detailed in our filings with the Securities and Exchange Commission. All subsequent written or oral forward looking statements attributable to us or persons acting on our behalf are qualified in their entirety by this paragraph. Overview We are a blank check company formed under the laws of the State of Delaware on May 21, 2018 for the purpose of effecting a merger, capital stock exchange, asset acquisition, stock purchase, reorganization or similar Business Combination with one or more target businesses. We intend to effectuate our Business Combination using cash from the proceeds of our Initial Public Offering and the sale of the Placement Units that occurred simultaneously with the completion of our Initial Public Offering, our capital stock, debt or a combination of cash, stock and debt. The issuance of additional shares in connection with an initial business combination to the owners of the target or other investors: may significantly dilute the equity interest of investors, which dilution would increase if the antidilution provisions in the Class B common stock resulted in the issuance of Class A common stock on a greater than onetoone basis upon conversion of the Class B common stock; may subordinate the rights of holders of our common stock if preferred stock is issued with rights senior to those afforded our common stock; could cause a change in control if a substantial number of shares of our common stock is issued, which may affect, among other things, our ability to use our net operating loss carry forwards, if any, and could result in the resignation or removal of our present officers and directors; may have the effect of delaying or preventing a change of control of us by diluting the stock ownership or voting rights of a person seeking to obtain control of us; and may adversely affect prevailing market prices for our Class A common stock and/or warrants. Similarly, if we issue debt securities or otherwise incur significant debt to bank or other lenders or the owners of a target, it could result in: default and foreclosure on our assets if our operating revenues after an initial business combination are insufficient to repay our debt obligations; acceleration of our obligations to repay the indebtedness even if we make all principal and interest payments when due if we breach certain covenants that require the maintenance of certain financial ratios or reserves without a waiver or renegotiation of that covenant; our immediate payment of all principal and accrued interest, if any, if the debt security is payable on demand; our inability to obtain necessary additional financing if the debt security contains covenants restricting our ability to obtain such financing while the debt security is outstanding; our inability to pay dividends on our common stock; using a substantial portion of our c [/INST] Negative. </s>

ChaSerg Technology Acquisition Corp

2020-03-04

2019-12-31

Item 7. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS The following discussion should be read in conjunction with our Financial Statements and footnotes thereto contained in this report. Forward Looking Statements All statements other than statements of historical fact included in this Form 10-K including, without limitation, statements under “Management’s Discussion and Analysis of Financial Condition and Results of Operations” regarding our financial position, business strategy and the plans and objectives of management for future operations, are forward looking statements. When used in this Form 10-K, words such “may,” “should,” “could,” “would,” “expect,” “plan,” “anticipate,” “believe,” “estimate,” “continue,” or the negative of such terms or other similar expressions, as they relate to us or our management, identify forward looking statements. Factors that might cause or contribute to such a discrepancy include, but are not limited to, those described in our other Securities and Exchange Commission (“SEC”) filings. References to “we”, “us”, “our” or the “Company” are to ChaSerg Technology Acquisition Corp., except where the context requires otherwise. Such forward looking statements are based on the beliefs of management, as well as assumptions made by, and information currently available to, our management. No assurance can be given that results in any forward-looking statement will be achieved and actual results could be affected by one or more factors, which could cause them to differ materially. The cautionary statements made in this Annual Report on Form 10-K should be read as being applicable to all forward-looking statements whenever they appear in this report. For these statements, we claim the protection of the safe harbor for forward-looking statements contained in the Private Securities Litigation Reform Act. Actual results could differ materially from those contemplated by the forward looking statements as a result of certain factors detailed in our filings with the SEC. All subsequent written or oral forward looking statements attributable to us or persons acting on our behalf are qualified in their entirety by this paragraph. Overview We are a blank check company formed under the laws of the State of Delaware on May 21, 2018 for the purpose of effecting a merger, capital stock exchange, asset acquisition, stock purchase, reorganization or similar business combination with one or more target businesses. We intend to effectuate our business combination using cash from the proceeds of our Initial Public Offering and the sale of the Placement Units that occurred simultaneously with the completion of our Initial Public Offering, our capital stock, debt or a combination of cash, stock and debt. The issuance of additional shares in connection with an initial business combination to the owners of the target or other investors: ● may significantly dilute the equity interest of investors, which dilution would increase if the anti-dilution provisions in the Class B common stock resulted in the issuance of Class A common stock on a greater than one-to-one basis upon conversion of the Class B common stock; ● may subordinate the rights of holders of our common stock if preferred stock is issued with rights senior to those afforded our common stock; ● could cause a change in control if a substantial number of shares of our common stock is issued, which may affect, among other things, our ability to use our net operating loss carry forwards, if any, and could result in the resignation or removal of our present officers and directors; ● may have the effect of delaying or preventing a change of control of us by diluting the stock ownership or voting rights of a person seeking to obtain control of us; and ● may adversely affect prevailing market prices for our Class A common stock and/or warrants. Similarly, if we issue debt securities or otherwise incur significant debt to bank or other lenders or the owners of a target, it could result in: ● a decrease in the prevailing market prices for our common stock and/or warrants; ● default and foreclosure on our assets if our operating revenues after an initial business combination are insufficient to repay our debt obligations; ● acceleration of our obligations to repay the indebtedness even if we make all principal and interest payments when due if we breach certain covenants that require the maintenance of certain financial ratios or reserves without a waiver or renegotiation of that covenant; ● our immediate payment of all principal and accrued interest, if any, if the debt security is payable on demand; ● our inability to obtain necessary additional financing if the debt security contains covenants restricting our ability to obtain such financing while the debt security is outstanding; ● our inability to pay dividends on our common stock; ● using a substantial portion of our cash flow to pay principal and interest on our debt, which will reduce the funds available for dividends on our common stock if declared, our ability to pay expenses, make capital expenditures and acquisitions, and fund other general corporate purposes; ● limitations on our flexibility in planning for and reacting to changes in our business and in the industry in which we operate; ● increased vulnerability to adverse changes in general economic, industry and competitive conditions and adverse changes in government regulation; ● limitations on our ability to borrow additional amounts for expenses, capital expenditures, acquisitions, debt service requirements, and execution of our strategy; and ● other purposes and other disadvantages compared to our competitors who have less debt. We have incurred and continue to incur significant costs in the pursuit of our business combination with Grid Dynamics or any other business combination. We cannot assure you that our plans to complete our Business Combination will be successful. Agreement for Business Combination On November 13, 2019, we entered into the Merger Agreement to effect a business combination by and among (i) our company (ii) Merger Sub 1 (iii) Merger Sub 2 (iv) Grid Dynamics and (v) ASL, solely in its capacity as representative of the stockholders of Grid Dynamics immediately prior to the consummation of the business combination. Grid Dynamics is an emerging leader in driving enterprise-level digital transformation in Fortune 1000 companies. Since its inception in 2006 in Menlo Park, California, as a grid and cloud consultancy firm, Grid Dynamics has been on the forefront of digital transformation, working on big ideas like cloud computing, NOSQL, DevOps, microservices, big data and AI and quickly established itself as a provider of choice for technology and digital enterprise companies. Upon the consummation of the transactions contemplated by the Merger Agreement, (i) Grid Dynamics will become our wholly-owned subsidiary; and (ii) we will change our name to “Grid Dynamics Holding, Inc.” and (iii) the selling security holders (other than the selling security holders who have properly demanded appraisal rights in accordance with the California law, in connection with the transactions described in the Merger Agreement) will be entitled to receive the merger consideration set forth in the Merger Agreement. Consummation of the transactions contemplated by the Merger Agreement is subject to customary conditions representations, warranties and covenants in the Merger Agreement, including, among others, covenants with respect to the conduct of the business of our company and Grid Dynamics during the period between execution of the Merger Agreement and the consummation of the Business Combination. The Merger Agreement and related agreements are further described in the Form 8-K filed by the Company on November 13, 2019. For additional information regarding Grid Dynamics, the Merger Agreement and the Business Combination, see the Definitive Proxy Statement on Schedule 14A filed by the Company on February 10, 2020. The Business Combination will be accounted for as a reverse recapitalization with no goodwill or other intangible assets recorded, in accordance with GAAP. Under this method of accounting, we will be treated as the “acquired” company for financial reporting purposes. Accordingly, for accounting purposes, the Business Combination will be treated as the equivalent of Grid Dynamics issuing stock for our net assets, accompanied by a recapitalization. Our net assets will be stated at historical cost, with no goodwill or other intangible assets recorded. Operations prior to the Business Combination will be those of Grid Dynamics. On February 27, 2020, we amended our underwriting agreement with Cantor pursuant to which Cantor agreed to forfeit 75% of the aggregate $7,700,000 deferred fee, or $5,775,000, that would otherwise be payable to them upon the consummation of a Business Combination. The forfeiture of the deferred fee will only apply in the event that we consummate the Business Combination with Grid Dynamics. On February 27, 2020, we entered into a capital markets advisory agreement (the “Capital Market Advisory Agreement”) with Cantor pursuant to which we engaged Cantor to act as a capital markets advisor in connection with our proposed Business Combination with Grid Dynamics. We have agreed to pay Cantor a cash fee of $4,525,000, of which we may reduce the fee by up to $455,000, solely to the extent such amount is paid to Northland Securities Inc. and Benchmark Investments Inc. The fee is payable to Cantor upon the consummation of the Business Combination with Grid Dynamics. Results of Operations We have neither engaged in any operations nor generated any revenues to date. Our only activities from inception to December 31, 2019 were organizational activities, those necessary to prepare for the Initial Public Offering, described below, and identifying a target company for a Business Combination. We do not expect to generate any operating revenues until after the completion of our Business Combination. We generate non-operating income in the form of interest income on marketable securities held in the Trust Account. We incur expenses as a result of being a public company (for legal, financial reporting, accounting and auditing compliance), as well as for due diligence expenses in connection with completing a Business Combination. For the year ended December 31, 2019, we had a net loss of $3,321,949, which consists of operating costs of $7,143,705 and a provision for income taxes of $843,156, offset by interest income on marketable securities held in the Trust Account of $4,664,912. For the period from May 21, 2018 (inception) through December 31, 2018, we had net income of $615,364, which consists of interest income on marketable securities held in the Trust Account of $1,158,467, offset by operating costs of $325,726 and a provision for income taxes of $217,377. Liquidity and Capital Resources As of December 31, 2019, we had cash of $141,583 held outside of the Trust Account. Until the consummation of the Initial Public Offering, the Company’s only source of liquidity was an initial purchase of Class B common stock by the Sponsor and loans from our Sponsor. On October 10, 2018, we consummated the Initial Public Offering of 20,000,000 Units at a price of $10.00 per Unit, generating gross proceeds of $200,000,000. Simultaneously with the closing of the Initial Public Offering, we consummated the sale of 600,000 Placement Units to the Sponsor and the underwriters at a price of $10.00 per unit, generating gross proceeds of $6,000,000. On October 25, 2018, in connection with the underwriters’ election to partially exercise of their over-allotment option, we consummated the sale of an additional 2,000,000 Units and the sale of an additional 40,000 Placement Units, generating total gross proceeds of $20,400,000. Following the Initial Public Offering, the exercise of the over-allotment option and the sale of the Placement Units, a total of $220,000,000 was placed in the Trust Account. We incurred $12,821,311 in transaction costs, including $4,400,000 of underwriting fees, $7,700,000 of deferred underwriting fees and $721,311 of other costs. We intend to use substantially all of the funds held in the Trust Account, including any amounts representing interest earned on the Trust Account (less deferred underwriting commissions) to complete our Business Combination. To the extent that our capital stock or debt is used, in whole or in part, as consideration to complete our Business Combination, the remaining proceeds held in the Trust Account will be used as working capital to finance the operations of the target business or businesses, make other acquisitions and pursue our growth strategies. We intend to use the funds held outside the Trust Account primarily to identify and evaluate target businesses, perform business due diligence on prospective target businesses, travel to and from the offices, plants or similar locations of prospective target businesses or their representatives or owners, review corporate documents and material agreements of prospective target businesses, and structure, negotiate and complete a Business Combination. In order to fund working capital deficiencies or finance transaction costs in connection with a Business Combination, our Sponsor or an affiliate of our Sponsor or certain of our officers and directors may, but are not obligated to, loan us funds as may be required. If we complete a Business Combination, we would repay such loaned amounts. In the event that a Business Combination does not close, we may use a portion of the working capital held outside the Trust Account to repay such loaned amounts but no proceeds from our Trust Account would be used for such repayment. Up to $1,500,000 of such loans may be convertible into units identical to the Placement Units, at a price of $10.00 per unit at the option of the lender. Liquidity and Going Concern As of December 31, 2019, we had a cash balance of approximately $142,000 and a working capital deficit of approximately $5,419,000. In addition, we had $224,016,036 in the Trust Account, which includes interest income of approximately $4,016,000 from our investments in the Trust Account which is available to us to pay our tax obligations. We intend to use substantially all of the funds held in the Trust Account, including any amounts representing interest earned on the Trust Account (less taxes payable and deferred underwriting commissions) to complete our initial Business Combination. To the extent necessary, the Sponsor or an affiliate of the Sponsor, or certain of our officers and directors may, but are not obligated to, loan us funds as may be required, up to $1,500,000. Such loans may be convertible into units of the post Business Combination entity at a price of $10.00 per unit. The units would be identical to the Placement Units (see Note 5). If our estimates of the costs of identifying a target business, undertaking in-depth due diligence and negotiating a Business Combination are less than the actual amount necessary to do so, we may have insufficient funds available to operate our business prior to a Business Combination. Moreover, we may need to obtain additional financing either to complete a Business Combination or because we become obligated to redeem a significant number of our public shares upon completion of a Business Combination, in which case we may issue additional securities or incur debt in connection with such Business Combination. In connection with our assessment of going concern considerations in accordance with Financial Accounting Standard Board’s Accounting Standards Update (“ASU”) 2014-15, “Disclosures of Uncertainties about an Entity’s Ability to Continue as a Going Concern,” management has determined that the working capital deficit and mandatory liquidation and subsequent dissolution raises substantial doubt about our ability to continue as a going concern. Off-balance sheet financing arrangements We have no obligations, assets or liabilities, which would be considered off-balance sheet arrangements as of December 31, 2019. We do not participate in transactions that create relationships with unconsolidated entities or financial partnerships, often referred to as variable interest entities, which would have been established for the purpose of facilitating off-balance sheet arrangements. We have not entered into any off-balance sheet financing arrangements, established any special purpose entities, guaranteed any debt or commitments of other entities, or purchased any non-financial assets. Contractual obligations We do not have any long-term debt, capital lease obligations, operating lease obligations or long-term liabilities, other than an agreement to pay an affiliate of the Sponsor a monthly fee of $15,000 for office space, utilities and secretarial and administrative support. We began incurring these fees on October 10, 2018 and will continue to incur these fees monthly until the earlier of the completion of the Business Combination and our liquidation. We have entered into engagement letters or agreements with various consultants, advisors, professionals and others in connection with an initial business combination. The services under these engagement letters and agreements are material in amount and in some instances include contingent or success fees. A substantial portion of these costs, including contingent or success fees and ongoing accrued transactions costs (but not deferred underwriting compensation) will be charged to operations in the quarter that an initial business combination is consummated. In most instances, these engagement letters and agreements specifically provide that such counterparties waive their rights to seek repayment from the funds in the Trust Account. In addition, we have an agreement to pay the underwriters a deferred fee of $0.35 per Unit, or $7,700,000 in the aggregate. The deferred fee will become payable to the underwriters from the amounts held in the Trust Account solely in the event that we complete a Business Combination, subject to the terms of the underwriting agreement. Critical Accounting Policies The preparation of financial statements and related disclosures in conformity with accounting principles generally accepted in the United States of America requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities, disclosure of contingent assets and liabilities at the date of the financial statements, and income and expenses during the periods reported. Actual results could materially differ from those estimates. We have not identified any critical accounting policies. Recent accounting pronouncements Management does not believe that any other recently issued, but not yet effective, accounting standards, if currently adopted, would have a material effect on our financial statements.

<s>[INST] Forward Looking Statements All statements other than statements of historical fact included in this Form 10K including, without limitation, statements under “Management’s Discussion and Analysis of Financial Condition and Results of Operations” regarding our financial position, business strategy and the plans and objectives of management for future operations, are forward looking statements. When used in this Form 10K, words such “may,” “should,” “could,” “would,” “expect,” “plan,” “anticipate,” “believe,” “estimate,” “continue,” or the negative of such terms or other similar expressions, as they relate to us or our management, identify forward looking statements. Factors that might cause or contribute to such a discrepancy include, but are not limited to, those described in our other Securities and Exchange Commission (“SEC”) filings. References to “we”, “us”, “our” or the “Company” are to ChaSerg Technology Acquisition Corp., except where the context requires otherwise. Such forward looking statements are based on the beliefs of management, as well as assumptions made by, and information currently available to, our management. No assurance can be given that results in any forwardlooking statement will be achieved and actual results could be affected by one or more factors, which could cause them to differ materially. The cautionary statements made in this Annual Report on Form 10K should be read as being applicable to all forwardlooking statements whenever they appear in this report. For these statements, we claim the protection of the safe harbor for forwardlooking statements contained in the Private Securities Litigation Reform Act. Actual results could differ materially from those contemplated by the forward looking statements as a result of certain factors detailed in our filings with the SEC. All subsequent written or oral forward looking statements attributable to us or persons acting on our behalf are qualified in their entirety by this paragraph. Overview We are a blank check company formed under the laws of the State of Delaware on May 21, 2018 for the purpose of effecting a merger, capital stock exchange, asset acquisition, stock purchase, reorganization or similar business combination with one or more target businesses. We intend to effectuate our business combination using cash from the proceeds of our Initial Public Offering and the sale of the Placement Units that occurred simultaneously with the completion of our Initial Public Offering, our capital stock, debt or a combination of cash, stock and debt. The issuance of additional shares in connection with an initial business combination to the owners of the target or other investors: may significantly dilute the equity interest of investors, which dilution would increase if the antidilution provisions in the Class B common stock resulted in the issuance of Class A common stock on a greater than onetoone basis upon conversion of the Class B common stock; may subordinate the rights of holders of our common stock if preferred stock is issued with rights senior to those afforded our common stock; could cause a change in control if a substantial number of shares of our common stock is issued, which may affect, among other things, our ability to use our net operating loss carry forwards, if any, and could result in the resignation or removal of our present officers and directors; may have the effect of delaying or preventing a change of control of us by diluting the stock ownership or voting rights of a person seeking to obtain control of us; and may adversely affect prevailing market prices for our Class A common stock and/or warrants. Similarly, if we issue debt securities or otherwise incur significant debt to bank or other lenders or the owners of a target, it could result in: a decrease in the prevailing market prices for our common stock and/or warrants; default and foreclosure on our assets if our operating revenues after an initial business combination are insufficient to repay our debt obligations; acceleration of our obligations to repay the indebtedness even if we make all principal and interest payments when due if we breach certain covenants that require the maintenance of certain financial ratios or reserves without a waiver or renegotiation of that covenant; our immediate payment of all principal and accrued interest, if any, if the debt security is payable on demand; our inability to obtain necessary additional financing if the debt security contains covenants restricting our ability to obtain such financing while the debt security is outstanding; our inability to pay dividends on our [/INST] Negative. </s>

Y-mAbs Therapeutics, Inc.

2019-03-22

2018-12-31

ITEM 7. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS. You should read the following discussion and analysis of our financial condition and results of operations together with our accompanying financial statements and related notes thereto included elsewhere in this Annual Report on Form 10-K. Some of the information contained in this discussion and analysis or set forth elsewhere in this Annual Report on Form 10-K, including information with respect to our plans and strategy for our business and related financing, includes forward-looking statements that involve risks and uncertainties. As a result of many factors, including those factors set forth in the “Risk Factors” section of this Annual Report on Form 10-K, our actual results could differ materially from the results described in or implied by the forward-looking statements contained in the following discussion and analysis. For convenience of presentation some of the numbers have been rounded in the text below. Overview We are a late-stage clinical biopharmaceutical company focused on the development and commercialization of novel, antibody-based therapeutic products for the treatment of cancer. We have a broad and advanced product pipeline, including two pivotal-stage product candidates-naxitamab and omburtamab-which target tumors that express GD2 and B7-H3, respectively. We are developing naxitamab for the treatment of pediatric patients with R/R high-risk NB, and radiolabeled omburtamab for the treatment of pediatric patients with CNS/LM, from NB. NB is a rare and almost exclusively pediatric cancer that develops in the sympathetic nervous system and CNS/LM is a rare and usually fatal complication of NB in which the disease spreads to the membranes, or meninges, surrounding the brain and spinal cord in the CNS. We expect to submit a BLA for each of our two lead product candidates in 2019, with a goal of receiving approval by the FDA in 2020. We plan to commercialize both of our lead product candidates in the United States as soon as possible after obtaining FDA approval, if such approval occurs. Additionally, we have two omburtamab follow-on product candidates in pre-clinical development, omburtamab-DTPA and huB7-H3, a humanized version of omburtamab, each targeting indications with large adult patient populations. In addition, we have initiated a Phase I trial with our huGD2 BsAb product candidate for the treatment of refractory GD2 positive adult and pediatric solid tumours, thereby addressing large patient populations. We are also advancing a pipeline of novel BsAbs through late pre-clinical development, including our huCD33-BsAb product candidate for the treatment of hematological cancers expressing CD33, a transmembrane receptor expressed on cells of myeloid lineage. We believe our BsAbs have the potential to result in improved tumor-binding, longer serum half-life and significantly greater T-cell mediated killing of tumor cells without the need for continuous infusion. Our mission is to become the world leader in developing better and safer antibody-based pediatric oncology products addressing clear unmet medical needs and, as such, have a transformational impact on the lives of patients. We intend to advance and expand our product pipeline into certain adult cancer indications either independently or in collaboration with potential partners. Since our inception on April 30, 2015, we have devoted substantially all of our resources to organizing and staffing our company, business planning, identifying potential product candidates, conducting pre-clinical studies of our product candidates and clinical trials of our lead product candidates, raising capital, and acquiring and developing our technology platform among other matters. We do not have any products approved for sale and have not generated any revenues from product sales. To date, we have financed our operations primarily through private placements of our securities and the proceeds of our initial public offering. On September 25, 2018, we completed the initial public offering, or IPO, of our common stock pursuant to which we issued and sold 6,900,000 shares at a price of $16.00 per share which included the exercise in full of the underwriters’ option to purchase additional shares for gross proceeds of approximately $110.4 million, before deducting underwriting discounts and commissions and estimated offering expenses. We have received aggregate gross proceeds of $230.0 million through December 31, 2018 from the sale and issuance of our common stock. As of December 31, 2018, we had an accumulated deficit of $84.8 million. Our net losses were $43.3 million for the year ended December 31, 2018 and $19.2 million for the year ended December 31, 2017. We have incurred significant net operating losses in every year since our inception and expect to continue to incur increasing net operating losses and significant expenses for the foreseeable future. Our net losses may fluctuate significantly from quarter to quarter and year to year. We anticipate that our expenses will increase significantly as we: · continue to advance our lead product candidates through pivotal stage development towards registration; · continue to advance our other product candidates through pre-clinical and clinical development; · continue to identify additional research programs and additional product candidates, as well as additional indications for existing product candidates; · initiate pre-clinical studies and clinical trials for any additional product candidates we identify; · develop, maintain, expand and protect our intellectual property portfolio; · hire additional research, sales force, commercialization, clinical and scientific personnel; and · incur additional costs associated with operating as a public company, including expanding our operational, finance and management teams. We believe that our cash on hand will be sufficient to fund our operations through the fourth quarter of 2020. We do not expect to generate revenues from product sales unless and until we successfully complete development and obtain regulatory approval for a product candidate, which is subject to significant uncertainty and may never occur. Although no assurance can be given, our goal is to complete the development of our lead product candidates, naxitamab for the treatment of pediatric R/R high-risk NB, and omburtamab for the treatment of CNS/LM from NB, by the end of 2019. Additionally, we currently use CROs and CMOs to carry out our pre-clinical and clinical development activities and we do not yet have a sales organization. Moreover, pursuant to the MSK License, we have obtained exclusive rights to MSK’s rights in our current product candidates. Under the MSK License, we have committed to funding scientific research and conducting certain clinical trial activities at MSK through 2020. As these product candidates progress through clinical development, regulatory approval and commercialization, certain milestone payments will come due either as a result of the milestones having been met or the passage of time even if the milestones have not been met. Also, we will owe MSK customary royalties on commercial sales of our approved products, including a fixed minimum royalty starting in 2020 whether or not product sales are ever achieved. In addition, we have committed to obtain certain personnel and laboratory services at MSK under our MDSA, and two separate CFSAs. Also under our MCTA with MSK, we will provide drug product and funding for certain clinical trials at MSK. These MSK agreements are important to our business. For a more detailed discussion of the terms and conditions of these agreements, see the section herein entitled “Business-Intellectual Property-MSK Agreements.” If we obtain regulatory approval for our product candidates, we expect to incur significant commercialization expenses related to product sales, marketing, manufacturing and distribution. Accordingly, we may continue to fund our operations through public or private equity or debt financings or other sources, including strategic collaborations. We may, however, be unable to raise additional funds or enter into such other arrangements when needed on favorable terms or at all. Our failure to raise capital or enter into such other arrangements as and when needed would have a negative impact on our financial condition and our ability to develop our current product candidates, or any additional product candidates, if developed. Because of the numerous risks and uncertainties associated with the development of our existing product candidates and any future product candidates, our platform and technology and because the extent to which we may enter into collaborations with third parties for development of any of our product candidates is unknown, we are unable to estimate the amounts of increased capital outlays and operating expenses associated with completing the research and development of our product candidates. If we raise additional funds through collaborations, strategic alliances, or licensing arrangements with third parties, we may have to relinquish valuable rights to our technologies, future revenue streams, research programs, product candidates or grant licenses on terms that may not be favorable to us and could have a negative impact on our financial condition. Components of Our Results of Operations Revenue To date, we have not generated any revenue from product sales and do not expect to do so in the near future. We expect that we will experience increasing losses as we continue our development of, and seek regulatory approvals for, our product candidates and begin to commercialize any approved products. Our ability to generate revenue for each product candidate for which we receive regulatory approval, if any, will depend on numerous factors, including reimbursement coverage, competition, commercial manufacturing capability and market acceptance of such approved products. Operating Expenses Research and Development Expenses Research and development expenses consist of expenses incurred in connection with the discovery and development of our product candidates. We expense research and development costs as incurred. These expenses include: · sponsored research, laboratory facility services, clinical trial and data service at MSK under the SRA, the two CFSAs, the MCTA, and the MDSA, with MSK; · expenses incurred under agreements with CROs, as well as investigative sites and consultants that conduct our non-clinical studies and pre-clinical and clinical trials; · expenses incurred under agreement with CMOs, including manufacturing scale-up expenses and the cost of acquiring and manufacturing pre-clinical and clinical trial materials, including manufacturing validation batches; · upfront and milestone and other non-revenue related payments due under our third-party licensing agreements; · employee-related expenses, which include salaries, benefits, travel and stock-based compensation; · expenses relating to regulatory activities, including filing fees paid to regulatory agencies; · outsourced professional scientific development services; and · allocated expenses for utilities and other facility-related costs, including rent, insurance, supplies and maintenance expenses, and other operating costs. The successful development and regulatory approval of our product candidates is highly uncertain. At this time, we cannot reasonably estimate or know the nature, timing and costs of the efforts that will be necessary to complete the remainder of the development of naxitamab and omburtamab or any future product candidates we may develop. This uncertainty is due to the numerous risks and uncertainties associated with the duration and cost of clinical trials, which vary significantly over the life of a project as a result of many factors, including: · the number of clinical sites included in the trials; · the availability and length of time required to enroll a sufficient number of suitable patients in our clinical trials; · the actual probability of success for our product candidates, including the safety and efficacy, early clinical data, competition, manufacturing capability and commercial viability; · significant and changing government regulation and regulatory guidance; · the performance of our existing and any future collaborators; · the number of doses patients receive; · the duration of patient follow-up; · the results of our clinical trials and pre-clinical studies; · the establishment of commercial manufacturing capabilities; · adequate ongoing availability of raw materials and drug substance for clinical development and any commercial sales; · the timing of our BLA submissions and their acceptance; · the receipt of marketing approvals, including a safety, tolerability and efficacy profile that is satisfactory to the FDA or any non-U.S. regulatory authority; · the expense of filing, prosecuting, defending and enforcing any patent claims and other intellectual property rights; and · the commercialization of approved products. Our expenditures are subject to additional uncertainties, including the terms and timing of regulatory approvals. We may never succeed in achieving regulatory approval for naxitamab, omburtamab or any other product candidates we may develop. A change in the outcome of any of these variables with respect to the development of a product candidate could mean a significant change in the costs and timing associated with the development of that product candidate. For example, if the FDA or another regulatory authority were to require us to conduct clinical trials beyond those that we anticipate will be required for the completion of clinical development of a product candidate, or if we experience significant delays in our clinical trials due to patient enrollment or other reasons, we would be required to expend significant additional financial resources and time on the completion of clinical development. Research and development activities are central to our business model. Product candidates in later stages of clinical development, like naxitamab and omburtamab, generally have higher development costs than those in earlier stages of clinical development, primarily due to the increased size and duration of later-stage clinical trials. We expect our research and development expenses to increase significantly over the next several years as we increase personnel costs, including stock-based compensation, conduct clinical trials and potentially prepare regulatory filings for naxitamab and omburtamab. General and Administrative Expenses General and administrative expenses consist primarily of employee related expenses, including salaries, bonus, benefits, and stock-based compensation expenses for personnel in executive, finance and administrative functions. Other significant costs include facility costs not otherwise included in research and development expenses, legal fees relating to corporate matters, and fees for patent, accounting, tax, and consulting services. We anticipate that our general and administrative expenses will increase in the future to support continued research and development activities, potential commercialization of our product candidates and increased costs associated with operating as a public company, including expenses related to services associated with maintaining compliance with exchange listing and the SEC requirements, director and officer insurance costs and investor and public relations costs. These increases will likely include increased costs related to the hiring of additional personnel and fees to outside consultants, lawyers and accountants, among other expenses. Additionally, if and when we believe a regulatory approval of a product candidate appears likely, we anticipate an increase in payroll and other employee-related expenses as a result of our preparation for commercial operations, especially as it relates to the sales and marketing of that product candidate. Critical Accounting Policies and Significant Judgments and Estimates Our management’s discussion and analysis of our financial condition and results of operations is based on our financial statements, which we have prepared in accordance with U.S. generally accepted accounting principles, or GAAP. We believe that several accounting policies are significant to understanding our historical and future performance. We refer to these policies as critical because these specific areas generally require us to make judgments and estimates about matters that are uncertain at the time we make the estimate, and different estimates-which also would have been reasonable-could have been used. On an ongoing basis, we evaluate our estimates and judgments, including those described in greater detail below. We base our estimates on historical experience and other market-specific or other relevant assumptions that we believe to be reasonable under the circumstances, the results of which form the basis for making judgments about the carrying value of assets and liabilities that are not readily apparent from other sources. Actual results may differ from these estimates under different assumptions or conditions. While our significant accounting policies are described in more detail in the notes to our financial statements appearing elsewhere in this Annual Report on Form 10-K, we believe the following accounting policies to be most critical to the judgments and estimates used in the preparation of our financial statements. Use of Estimates The preparation of financial statements in conformity with GAAP requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities, the disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of expenses during the reporting period. Significant estimates and assumptions reflected in these financial statements include, but are not limited to, the accrual for research and development expenses, the accrual of milestone and royalty payments, the valuation of shares of common stock and stock options. Estimates are periodically reviewed in light of changes in circumstances, facts and experience. Changes in estimates are recorded in the period in which they become known. Actual results could differ from those estimates. Research and Development Expenses Research and development costs are charged to operations when incurred and are included in operating expenses. Research and development costs consist principally of compensation cost for our employees and consultants that perform our research activities, the fees paid to maintain our licenses, the payments to third parties for manufacturing and clinical research organizations and additional product development, and consumables and other materials used in research and development. We record accruals for estimated ongoing research costs. When evaluating the adequacy of the accrued liabilities, we analyze progress of the studies or clinical trials, including the phase or completion of events, invoices received and contracted costs. Actual results could differ from our estimates. We are obligated to make certain milestone and royalty payments in accordance with the contractual terms of the MSK License based upon the resolution of certain contingencies. Certain of these milestone payments are due and payable with the passage of time whether or not the milestones have actually been met. We record the milestone and royalty payment when the achievement of the milestone (including the passage of time) or payment of the milestone or royalty is probable and the amount of the payment is reasonably estimable. Income Taxes We account for income taxes under the asset and liability approach for the financial accounting and reporting of income taxes. Deferred tax assets and liabilities are recognized for the estimated future tax consequences attributable to net operating loss carry forwards and temporary differences between the financial statement carrying amounts of existing assets and liabilities and their respective tax bases. These assets and liabilities are measured using enacted tax rates expected to apply to taxable income in the years in which the temporary differences are expected to reverse. A valuation allowance is established when management determines that it is more likely than not that some portion or all of the deferred tax assets will not be realized. We prepare and file tax returns based on its interpretation of tax laws and regulations. In the normal course of business, our tax returns are subject to examination by various taxing authorities. Such examinations may result in future tax and interest assessments by these taxing authorities. In determining our tax provision for financial reporting purposes, we establish a reserve for uncertain tax positions unless such positions are determined to be more likely than not of being sustained upon examination based on their technical merits. We consider many factors when evaluating and estimating our tax positions and tax benefits, which may require periodic adjustments and which may not accurately anticipate actual outcomes. Accordingly, we will report a liability for unrecognized tax benefits resulting from any uncertain tax positions taken or expected to be taken on a tax return. Our policy is to recognize, when applicable, interest and penalties on uncertain tax positions as part of income tax expense. Stock-Based Compensation We measure stock options granted to employees and directors based on the fair value on the date of the grant and recognize compensation expense of those awards, over the requisite service period, which is the vesting period of the respective award. Forfeitures are accounted for as they occur. We issue stock options to employees and directors with only service-based vesting conditions and record the expense for these awards using the straight-line method over the requisite service period. For share-based awards granted to non-employees, compensation expense is recognized over the period during which services are rendered by such non-employees until completed. At the end of each financial reporting period prior to completion of the service, the fair value of these awards is remeasured using the then-current fair value of our shares of common stock and updated assumption inputs in the Black-Scholes option-pricing model. The fair value of each stock option grant is estimated on the date of grant using the Black-Scholes option pricing model. Historically, we have been a private company and lack company-specific historical and implied volatility information for our shares. Therefore, we estimate our expected share price volatility based on the historical volatility of a group of publicly-traded peer companies and we expect to continue to do so until such time as we have adequate historical data regarding the volatility of our own traded share price. The expected term of our stock options has been determined utilizing the “simplified” method for awards as we have limited historical data to support the expected term assumption. The expected term of stock options granted to non-employees is equal to the contractual term of the option award. The risk-free interest rate is determined by reference to the U.S. Treasury yield curve in effect at the time of grant of the award for time periods approximately equal to the expected term of the award. The expected dividend yield is based on the fact that we have never paid cash dividends on shares of our common stock and do not expect to pay any cash dividends in the foreseeable future. Determination of the Fair Value of Common Stock Prior to our IPO, the estimated fair value of our common stock was determined by our board of directors as of the date of each award grant, with input from management, considering our then most recently completed or ongoing private placement activities and then most recently available third-party valuation of our common stock. Third-party valuations were performed in accordance with the guidance outlined in the American Institute of Certified Public Accountants’ Accounting and Valuation Guide, Valuation of Privately-Held-Company Equity Securities issued as Compensation. This process resulted in estimated fair value of our common stock of $0.20 per share as of June 6, 2015; $4.38 per share as of May 20, 2016, October 21, 2016 and August 22, 2016; $8.50 per share as of December 14, 2016; $9.35 per share as of September 13, 2017 and December 5, 2017; $11.16 per share as of April 24, 2018; and $13.11 as of July 10, 2018. In addition to considering the results of such recently completed or ongoing private placements, our board of directors considered various objective and subjective factors to determine the fair value of our common stock as of each grant date including: · the progress of our research and development programs, including the status of pre-clinical studies and clinical trials for our product candidates; · our stage of development and commercialization and our business strategy; · material risks related to our business; · external market conditions affecting the biotechnology industry, and trends within the biotechnology industry; · our financial position, including cash on hand, and our historical and forecasted performance and operating results; · the lack of an active public market for our common stock; · the likelihood of achieving a liquidity event, such as an initial public offering or a sale of our company in light of prevailing market conditions; and · an analysis of initial public offerings and the market performance of similar companies in the biopharmaceutical industry. The assumptions underlying these valuations represented management’s best estimates, which involved inherent uncertainties and the application of management judgment. As a result, if factors or expected outcomes changed and we used significantly different assumptions or estimates at the time, our stock-based compensation expense could be materially different. Since the closing of our IPO, our board of directors has determined the per share fair value of our common stock based on the closing price of our common stock as reported by the NASDAQ Global Select Market on the date of grant. Stock Options Granted All options to purchase shares of our common stock are granted with an exercise price per share equal to or greater than the estimated fair value per share of our common stock on the date of grant, based on the information known to us on the date of grant. The following table sets forth by grant date the number of shares of common stock subject to options granted from 2016 to 2018, the per share exercise price of the options, the fair value per share of common stock on each grant date, and the per share estimated fair value of the options: We expect the amount of share-based compensation expense recognized for stock options to increase for future awards in future periods due to the potential increase in both the value of our common stock and the size of our company in terms of headcount. Fair Value of Stock Options The fair value of each stock option grant is estimated on the date of grant using the Black-Scholes option pricing model. The assumptions that the Company used to determine the fair value of the stock options granted to employees and directors were as follows, presented on a weighted average basis: The assumptions that the Company used to determine the fair value of the stock options granted to non-employees were as follows, presented on a weighted average basis: · Risk-free interest rate: The risk-free interest rate assumption is based on the U.S. Treasury instruments whose terms were consistent with the expected option term of our stock options. · Expected Dividend Yield: The expected dividend yield assumption is based on the fact that we have never paid cash dividends and have no present intention to pay cash dividends. Consequently, we used an expected dividend of zero. · Expected Volatility: The expected stock price volatility is estimated by taking the average historic price volatility of industry peers and adjusting for differences in our life cycle and financing leverage. Our industry peers consist of several public companies in the biopharmaceutical industry. · Expected Term: We determine the average expected life of stock options based on the simplified method in accordance with SEC Staff Accounting Bulletin Nos. 107 and 110. We expect to continue to use the simplified method until we have sufficient historical exercise data to provide a reasonable basis upon which to estimate expected term. Results of Operations Comparison of the Years Ended December 31, 2018 and 2017 The following table summarizes our results of operations for the years ended December 31, 2018 and 2017: Research and Development Expenses We do not record our research and development expenses on a program-by-program or on a product-by-product basis as they primarily relate to personnel, research, manufacturing, license fees, non-cash expense in connection with equity issuances to strategic partner and consumable costs, which are simultaneously deployed across multiple projects under development. These costs are included in the table below. Research and development expenses increased by $20.0 million, from $14.3 million for the year ended December 31, 2017, to $34.3 million for the year ended December 31, 2018. This was primarily due to a $7.5 million increase in manufacturing services and a $4.6 million increase in outsourced services and supplies, primarily obtained from MSK and CROs for our lead product candidates, naxitamab and omburtamab. Other clinical trial costs increased by $2.8 million for the year ended December 31, 2018. Employee-related costs including salary, benefits and non-cash stock-based compensation for personnel related to our research activities, increased by $3.2 million for the year ended December 31, 2018. Professional and consulting fees increased by $0.6 million for the year ended December 31, 2018. General and Administrative Expenses General and administrative expenses increased by $4.0 million from $5.0 million for the year ended December 31, 2017 to $9.0 million for the year ended December 31, 2018. The increase in general and administrative expenses was primarily attributable to a $1.8 million increase in employee-related costs, including salary, benefits and non-cash stock-based compensation for personnel related to our business activities. In addition, leasehold expenses increased by $0.4 million and fees for auditors, legal advice and other consultancy services increased by $0.7 million for the year ended December 31, 2018. Interest and Other Income (Expense) Other Income for the year ended December 31, 2017 were $83,000 as compared to Other Expenses of ($44,000) for the year ended December 31, 2018. Our interest income has not been significant due to low interest earned on cash balances. Liquidity and Capital Resources Overview Since our inception we have incurred significant net operating losses and expect to continue to incur increasing net operating losses and significant expenses for the foreseeable future. Our net losses may fluctuate significantly from quarter to quarter and year to year. We do not currently have any approved products and have never generated any revenue from product sales. We have financed our operations through December 31, 2018 primarily through gross proceeds of $230.0 million from the sale of our common stock. As of December 31, 2018, we had cash and cash equivalents of $147.8 million. We will need additional capital to continue funding our operations, which we may obtain from additional equity or debt financings, collaborations, licensing arrangements, or other sources. Cash Flows The following table provides information regarding our cash flows for the years ended December 31, 2018 and December 31, 2017: Net Cash Used in Operating Activities The use of cash in all periods resulted primarily from our net losses adjusted for non-cash charges and changes in components of working capital. Net cash used in operating activities was $41.2 million during the year ended December 31, 2018, as compared to $15.9 million during the year ended December 31, 2017. The $25.3 million increase in net cash used in operations was primarily due to an increase in our net loss of $24.1 million for the year ended December 31, 2018. This increase was primarily due to an increase in our operating expenses in connection with the development of our lead product candidates, naxitamab and omburtamab, and the expansion of our other business activities. Non-cash expenses included stock-based compensation to employees and non-employees, which increased by $1.4 million. Adjustment of working capital reflects changes in other current assets, accrued expenses, accounts payable, and other non-current liabilities of $2.7 million for the year ended December 31, 2017, as compared to $(0.1) million the year ended December 31, 2018. Net Cash Used in Investing Activities Net cash used in investing activities was $0.2 million for the year ended December 31, 2018, as compared to no investment activities for the year ended December 31, 2017. The $0.2 million increase in net cash used in investing activities relates to investment in furniture for our new office facilities. Net Cash Provided by Financing Activities Net cash provided by financing activities was $98.8 million during the year ended December 31, 2018, as compared to $89.6 million during the year ended December 31, 2017. The cash provided by financing activities was attributable to net proceeds of $99.8 million related to the issuance of common stock in the Company’s IPO in the year ended December 31, 2018, which exceed the $89.8 million net proceeds related to the issuance of common stock in a private placement in the year ended December 31, 2017. Funding Requirements We expect our expenses to increase in connection with our ongoing activities, particularly as we complete clinical development of our lead product candidates, naxitamab and omburtamab, and potentially initiate our planned BLA submissions for both product candidates. In addition, we plan to advance the development of other pipeline programs, initiate new research and pre-clinical development efforts and seek marketing approval for any additional product candidates that we successfully develop. If we obtain marketing approval for any of our product candidates, we expect to incur commercialization expenses, which may be significant, related to establishing sales, marketing, manufacturing capabilities, distribution and other commercial infrastructure to commercialize such products. Furthermore, we expect to incur additional costs associated with operating as a public company. Accordingly, we might need to obtain substantial additional funding in connection with our continuing operations. If we are unable to raise capital when needed or on attractive terms, we would be forced to delay, reduce or eliminate our research and development programs and/or future commercialization efforts. We believe that our existing cash and cash equivalents as of December 31, 2018, will enable us to fund our operating expenses and capital expenditure requirements through the fourth quarter of 2020. We have based our projections of operating capital requirements on assumptions that may prove to be incorrect and we may use all of our available capital resources sooner than we expect. Because of the numerous risks and uncertainties associated with the development and commercialization of naxitamab and omburtamab, and the research, development and commercialization of other potential product candidates, we are unable to estimate the exact amount of our operating capital requirements. Our future capital requirements will depend on many factors, including: · the scope, progress, timing, costs and results of clinical trials for developing our lead product candidates, naxitamab and omburtamab, and conducting pre-clinical studies and clinical trials for our other product candidates; · research and pre-clinical development efforts for any future product candidates that we may develop; · our ability to enter into and the terms and timing of any collaborations, licensing agreements or other arrangements; · the achievement of milestones or occurrence of other developments that trigger payments under any collaboration or other agreements; · the number of future product candidates that we pursue and their development requirements; · the outcome, timing and costs of seeking regulatory approvals; · the costs of commercialization activities for any of our product candidates that receive marketing approval to the extent such costs are not the responsibility of any future collaborators, including the costs and timing of establishing product sales, marketing, distribution and manufacturing capabilities; · subject to receipt of marketing approval, revenue, if any, received from commercial sales of our current and future product candidates; · proceeds received, if any, from monetization of any future PRVs; · our headcount growth and associated costs as we expand our research and development and establish a commercial infrastructure; · the costs of preparing, filing and prosecuting patent applications, maintaining and protecting our intellectual property rights and defending against intellectual property related claims; and · the costs of operating as a public company. Identifying potential product candidates and conducting pre-clinical studies and clinical trials is a time-consuming, expensive and uncertain process that takes many years to complete, and we may never generate the necessary data or results required to obtain marketing approval and achieve product sales. In addition, our product candidates, if approved, may not achieve commercial success. Accordingly, we will need to continue to rely on additional financing to achieve our business objectives. Adequate additional financing may not be available to us on acceptable terms, or at all. Until such time, if ever, as we can generate substantial product revenues, we expect to finance our cash needs through a combination of equity offerings, debt financings, collaborations, strategic alliances and licensing arrangements. To the extent that we raise additional capital through the sale of equity or convertible debt securities, your ownership interest in our company may be materially diluted, and the terms of these securities may include liquidation or other preferences that adversely affect your rights as a common stockholder. Debt financing, if available, may involve agreements that include covenants limiting or restricting our ability to take specific actions, such as incurring additional debt, making capital expenditures or declaring dividends. If we raise funds through additional collaborations, strategic alliances or licensing arrangements with third parties, we may have to relinquish valuable rights to our technologies, future revenue streams, research programs or product candidates or to grant licenses on terms that may not be favorable to us. If we are unable to raise additional funds through equity or debt financings when needed, we may be required to delay, limit, reduce or terminate our product development or future commercialization efforts or grant rights to develop and market product candidates that we would otherwise prefer to develop and market ourselves. Off-Balance Sheet Arrangements We did not have during the periods presented, and we do not currently have, any off-balance sheet arrangements, as defined under the applicable regulations of the SEC. Contractual Obligations and Commitments Contractual obligations as of December 31, 2018 are related to payments of operating leases for our corporate headquarters in New York, New York and our office space in Hørsholm, Denmark. Our obligations and commitments are disclosed in the contractual obligations table below: We enter into contracts in the normal course of business with CROs, CMOs, clinical sites and other third parties for clinical trials, pre-clinical research studies and testing, professional consultants for expert advice and other vendors for clinical supply, manufacturing and other services. These contracts are not considered contractual obligations, as they provide for termination upon prior notice, and, therefore, are cancelable contracts and do not include any minimum purchase commitments. Payments due upon cancellation consist only of payments for services provided or expenses incurred, including non-cancellable obligations of our service providers, up to the date of cancellation. These payments are not included in the table of contractual obligations and commitments above. As further described below, under various licensing and related agreements with third parties, we have agreed to make milestone and royalty payments to third parties. We have not included the contingent payment of certain milestones in the table above, which timing cannot be determined because they are not date certain. In addition, we have other contingent payment obligations, such as such as royalties or other third party milestones, which are not included in the table above as the amount, timing and likelihood of such payments are not known. We have entered into two license agreements and certain other agreements with MSK. The license agreements are further described below as the MSK License and the MSK CD33 License. Under the MSK License and MSK CD33 License we are obligated to (i) make certain payments to MSK, which become due based upon the achievement of the related milestone activities or the passage of time in the event such milestone activities are not achieved, as well as certain sales-related milestones, (ii) pay mid to high single-digit royalties to MSK, on a product-by-product and country-by-country basis, of a mid-to-high single-digit royalties based on net sales of products licensed under the applicable agreement and (iii) pay to MSK a percentage of any sublicense fees received by us. Under the MSK License, we are also obligated to pay annual minimum royalties of $80,000 over the royalty term, starting in 2020. Under the MSK CD33 License, we are obligated to pay annual minimum royalties of $40,000 over the royalty term beginning in 2027, increasing to $60,000 once a patent within the licensed rights is issued. These amounts are non-refundable but are creditable against royalty payments otherwise due under the respective agreements. Total expensed minimum royalty payments in 2016 under the MSK License were $1,200,000, upon determination that the payment of such minimum royalties was probable and the amount was estimable in 2016. We are also obligated to pay MSK certain clinical, regulatory and sales-based milestone payments under the MSK License and MSK CD33 License. Certain of the clinical and regulatory milestone payments become due at the earlier of completion of the related milestone activity or the date indicated in the MSK License. Total clinical, regulatory and sales based milestones potentially due under the MSK License are $2,450,000, $9,000,000 and $20,000,000, respectively. In addition, under the MSK CD33 License, we are obligated to make potential payments of $550,000, $500,000 and $7,500,000 for clinical, regulatory and sales based milestones, respectively. We record milestones in the period in which the contingent liability is probable and the amount is reasonably estimable. Research and development is inherently uncertain and, should such research and development fail, the MSK License and MSK CD33 License are cancelable at our option. We have also considered the development risk and each party’s termination rights under the two license agreements when considering whether any contingent payments, certain of which also contain time-based payment requirements, were probable. In addition, to the extent we enter into sublicense arrangements, we are obligated to pay to MSK a percentage of certain payments that we receive from sublicensees of the rights licensed to us by MSK, which percentage will be based upon the achievement of certain clinical milestones. To date, we have not entered into any sublicenses related to the MSK License or the MSK CD33 License. Our failure to meet certain conditions under such arrangements could cause the related license to such licensed product to be canceled and could result in termination of the entire respective arrangement with MSK. In addition, we may terminate the MSK License or the MSK CD33 License with prior written notice to MSK. Total milestones expensed in 2017 under the MSK License were $150,000, all of which related to clinical milestones, which become due either based upon the passage of time or achievement of the related milestone activities. Total milestones expensed in 2017 under the MSK CD33 License was $550,000, all of which related to clinical milestones, which become due either based upon the passage of time or achievement of the related milestone activities. No milestones were expensed in 2018 under the MSK License and the MSK CD33 License. On June 27, 2018, we entered into the Sublicense Agreement, or the MabVax Sublicense, with MabVax Therapeutics Holdings, Inc., or MabVax, pursuant to which MabVax granted us all of the exclusive rights granted to MabVax under its license agreement with MSK, or the MabVax-MSK License, for a bi-valent ganglioside based vaccine intended to treat NB, or the NB vaccine. MSK originally developed the NB vaccine and licensed to MabVax as part of a portfolio of anti-cancer vaccines. Under the terms of the MabVax Sublicense, we paid MabVax an upfront payment of $700,000, and, as we have decided to move forward with the development of the vaccine, we have agreed to make an additional payment of $600,000 on the first anniversary of the MabVax Sublicense. We will also be responsible for any potential downstream payment obligations to MSK related to the NB vaccine that were specified in the MabVax-MSK license agreement. This includes the obligation to pay development milestones totaling $1,400,000 and mid single-digit royalty payments to MSK. In addition, if we obtain FDA approval for the NB vaccine, then we are obligated to file with the FDA for a PRV. If the PRV is granted and subsequently sold, MabVax will receive a percentage of the proceeds from the sale thereof. The MabVax Sublicense will terminate upon the termination or expiration of the MabVax-MSK License. Total milestones expensed in 2018 under the MabVax License were $1,300,000, all of which relate to the upfront payment and payment for the first anniversary of the MabVax License. Recent Accounting Pronouncements Refer to Note 3, “Summary of Significant Accounting Policies,” in the accompanying notes to the consolidated financial statements for a discussion of recent accounting pronouncements. Internal Controls and Procedures We will be required, pursuant to Section 404(a) of the Sarbanes-Oxley Act, or Section 404, to furnish a report by management on, among other things, the effectiveness of our internal control over financial reporting for the year following our first annual report required to be filed with the SEC. This assessment will need to include disclosure of any material weaknesses identified by management over our internal control over financial reporting. However, our independent registered public accounting firm will not be required to report on the effectiveness of our internal control over financial reporting pursuant to Section 404(b) until the later of the year following our first annual report required to be filed with the SEC, or the date we are no longer an “emerging growth company” if we take advantage of the exemptions contained in the JOBS Act. Internal control over financial reporting is a process designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements in accordance with GAAP. Prior to our initial public offering, we were a private company and we are currently planning a process for reviewing, documenting and testing our internal control over financial reporting. Certain material weaknesses have been identified in our internal control over financial reporting. See the section herein entitled “Risk Factors-It has been determined that we have material weaknesses in our internal control over financial reporting. If our remediation of these material weaknesses is not effective, or if we experience additional material weaknesses or otherwise fail to maintain an effective system of internal controls in the future, we may not be able to accurately or timely report our financial condition or results of operations, which may adversely affect investor confidence in us and, as a result, the value of our common stock. In addition, because of our status as an emerging growth company, our independent registered public accounting firm is not required to provide an attestation report as to our internal control over financial reporting for the foreseeable future.” If we fail to maintain an effective system of disclosure controls and internal control over financial reporting, our ability to produce timely and accurate financial statements or comply with applicable regulations could be impaired. If we are unable to remediate these identified material weaknesses, or if we experience additional material weaknesses in the future or otherwise fail to maintain an effective system of internal controls, we may not be able to accurately or timely report our financial condition or results of operations, or comply with the accounting and reporting requirements applicable to public companies, which may adversely affect investor confidence in us and, as a result, the value of our common stock. We have not performed an evaluation of our internal control over financial reporting, as required by Section 404 of the Sarbanes-Oxley Act, nor have we engaged an independent registered public accounting firm to perform an audit of our internal control over financial reporting as of any balance sheet date or for any period reported in our financial statements. Presently, we are not an accelerated filer, as such term is defined by Rule 12b-2 of the Exchange Act, and therefore, our management is not presently required to perform an annual assessment of the effectiveness of our internal control over financial reporting. This requirement will first apply to our second Annual Report on Form 10-K. Our independent public registered accounting firm will first be required to attest to the effectiveness of our internal control over financial reporting for our Annual Report on Form 10-K for the first year we are no longer an “emerging growth company.” We are in the very early stages of the costly and challenging process of compiling the system and processing documentation necessary to perform the evaluation needed to comply with Section 404. We may not be able to complete our evaluation, testing or any required remediation in a timely fashion. During the evaluation and testing process, if we identify one or more material weaknesses in our internal control over financial reporting, we will be unable to assert that our internal controls are designed and operating effectively, which could result in a loss of investor confidence in the accuracy and completeness of our financial reports. This could cause the price of our common stock to decline, and we may be subject to investigation or sanctions by the SEC. Emerging Growth Company Status; The JOBS Act The JOBS Act permits an “emerging growth company” such as us to take advantage of an extended transition period to comply with new or revised accounting standards applicable to public companies until those standards would otherwise apply to private companies. We have irrevocably elected to “opt out” of this provision and, as a result, we will comply with new or revised accounting standards when they are required to be adopted by public companies that are not emerging growth companies. For so long as we are an emerging growth company and qualify as a smaller reporting company we expect that: · we will present only two years of audited financial statements, in addition to any required unaudited financial statements, with correspondingly reduced Management’s Discussion and Analysis of Financial Condition and Results of Operations disclosure as long as we continue to qualify as a smaller reporting company; · we will avail ourselves of the exemption from the requirement to comply with any requirement that may be adopted by the Public Company Accounting Oversight Board regarding a supplement to the auditor’s report providing additional information about the audit and the financial statements; · we will avail ourselves of the exemption from the requirement to obtain an attestation and report from our auditors on the assessment of our internal control over financial reporting pursuant to the Sarbanes-Oxley Act; and · we will provide less extensive disclosure about our executive compensation arrangements. We will remain an emerging growth company for up to five years, although we will cease to be an “emerging growth company” upon the earliest of: (i) the last day of the fiscal year following the fifth anniversary of our initial public offering, (ii) the last day of the first fiscal year in which our annual gross revenues are $1.07 billion or more, which amount is periodically updated, (iii) the date on which we have, during the previous rolling three-year period, issued more than $1.0 billion in non-convertible debt securities or (iv) the date on which we are deemed to be a “large accelerated filer” as defined in the Exchange Act.

<s>[INST] Overview We are a latestage clinical biopharmaceutical company focused on the development and commercialization of novel, antibodybased therapeutic products for the treatment of cancer. We have a broad and advanced product pipeline, including two pivotalstage product candidatesnaxitamab and omburtamabwhich target tumors that express GD2 and B7H3, respectively. We are developing naxitamab for the treatment of pediatric patients with R/R highrisk NB, and radiolabeled omburtamab for the treatment of pediatric patients with CNS/LM, from NB. NB is a rare and almost exclusively pediatric cancer that develops in the sympathetic nervous system and CNS/LM is a rare and usually fatal complication of NB in which the disease spreads to the membranes, or meninges, surrounding the brain and spinal cord in the CNS. We expect to submit a BLA for each of our two lead product candidates in 2019, with a goal of receiving approval by the FDA in 2020. We plan to commercialize both of our lead product candidates in the United States as soon as possible after obtaining FDA approval, if such approval occurs. Additionally, we have two omburtamab followon product candidates in preclinical development, omburtamabDTPA and huB7H3, a humanized version of omburtamab, each targeting indications with large adult patient populations. In addition, we have initiated a Phase I trial with our huGD2 BsAb product candidate for the treatment of refractory GD2 positive adult and pediatric solid tumours, thereby addressing large patient populations. We are also advancing a pipeline of novel BsAbs through late preclinical development, including our huCD33BsAb product candidate for the treatment of hematological cancers expressing CD33, a transmembrane receptor expressed on cells of myeloid lineage. We believe our BsAbs have the potential to result in improved tumorbinding, longer serum halflife and significantly greater Tcell mediated killing of tumor cells without the need for continuous infusion. Our mission is to become the world leader in developing better and safer antibodybased pediatric oncology products addressing clear unmet medical needs and, as such, have a transformational impact on the lives of patients. We intend to advance and expand our product pipeline into certain adult cancer indications either independently or in collaboration with potential partners. Since our inception on April 30, 2015, we have devoted substantially all of our resources to organizing and staffing our company, business planning, identifying potential product candidates, conducting preclinical studies of our product candidates and clinical trials of our lead product candidates, raising capital, and acquiring and developing our technology platform among other matters. We do not have any products approved for sale and have not generated any revenues from product sales. To date, we have financed our operations primarily through private placements of our securities and the proceeds of our initial public offering. On September 25, 2018, we completed the initial public offering, or IPO, of our common stock pursuant to which we issued and sold 6,900,000 shares at a price of $16.00 per share which included the exercise in full of the underwriters’ option to purchase additional shares for gross proceeds of approximately $110.4 million, before deducting underwriting discounts and commissions and estimated offering expenses. We have received aggregate gross proceeds of $230.0 million through December 31, 2018 from the sale and issuance of our common stock. As of December 31, 2018, we had an accumulated deficit of $84.8 million. Our net losses were $43.3 million for the year ended December 31, 2018 and $19.2 million for the year ended December 31, 2017. We have incurred significant net operating losses in every year since our inception and expect to continue to incur increasing net operating losses and significant expenses for the foreseeable future. Our net losses may fluctuate significantly from quarter to quarter and year to year. We anticipate that our expenses will increase significantly as we: · continue to advance our lead product candidates through pivotal stage development [/INST] Negative. </s>

Y-mAbs Therapeutics, Inc.

2020-03-12

2019-12-31

ITEM 7. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS. You should read the following discussion and analysis of our financial condition and results of operations together with our accompanying financial statements and related notes thereto included elsewhere in this Annual Report on Form 10-K. Some of the information contained in this discussion and analysis or set forth elsewhere in this Annual Report on Form 10-K, including information with respect to our plans and strategy for our business and related financing, includes forward-looking statements that involve risks and uncertainties. As a result of many factors, including those factors set forth in the “Risk Factors” section of this Annual Report on Form 10-K, our actual results could differ materially from the results described in or implied by the forward-looking statements contained in the following discussion and analysis. For convenience of presentation some of the numbers have been rounded in the text below. Overview We are a late-stage clinical biopharmaceutical company focused on the development and commercialization of novel, antibody-based therapeutic products for the treatment of cancer. We have a broad and advanced product pipeline, including two pivotal-stage product candidates-naxitamab and omburtamab-which target tumors that express GD2 and B7-H3, respectively. We are developing naxitamab for the treatment of pediatric patients with R/R high-risk NB, and radiolabeled omburtamab for the treatment of pediatric patients with CNS/LM, from NB. NB is a rare and almost exclusively pediatric cancer that develops in the sympathetic nervous system and CNS/LM is a rare and usually fatal complication of NB in which the disease spreads to the membranes, or meninges, surrounding the brain and spinal cord in the CNS. In November 2019, we submitted the initial portion of our BLA for naxitamab to the FDA under the FDA’s rolling review process with a goal of receiving approval by the FDA in 2020. We also expect to submit a BLA for omburtamab via a rolling submission in May 2020 with the goal of receiving approval by the FDA in 2020. We plan to commercialize both of our lead product candidates in the United States as soon as possible after obtaining FDA approval, if such approval occurs. Additionally, we have two omburtamab follow-on product candidates in pre-clinical development, 177Lu-omburtamab and huB7-H3, a humanized version of omburtamab, each targeting indications with large adult patient populations. In addition, we have initiated a Phase 1 trial with our huGD2 BsAb product candidate for the treatment of refractory GD2 positive adult and pediatric solid tumors, thereby addressing large patient populations. We are also advancing a pipeline of novel BsAbs through late pre-clinical development, including our huCD33-BsAb product candidate for the treatment of hematological cancers expressing CD33, a transmembrane receptor expressed on cells of myeloid lineage. We believe our BsAbs have the potential to result in improved tumor-binding, longer serum half-life and significantly greater T-cell mediated killing of tumor cells without the need for continuous infusion. Our GD2-GD3 Vaccine for the treatment of high-risk NB patients in remission is being tested in a Phase 2 trial. Our mission is to become the world leader in developing better and safer antibody-based pediatric oncology products addressing clear unmet medical needs and, as such, have a transformational impact on the lives of patients. We intend to advance and expand our product pipeline into certain adult cancer indications either independently or in collaboration with potential partners. Since our inception on April 30, 2015, we have devoted substantially all of our resources to organizing and staffing our company, business planning, identifying potential product candidates, conducting pre-clinical studies of our product candidates and clinical trials of our lead product candidates, raising capital, and acquiring and developing our technology platform among other matters. We do not have any products approved for sale and have not generated any revenues from product sales. To date, we have financed our operations primarily through private placements of our securities, proceeds of our initial public offering and proceeds from our secondary public offering. Most recently, on November 1, 2019, we completed our secondary public offering of 5,134,750 shares of our common stock, at a price of $28.00 per share, which includes the exercise in full of the underwriters’ option to purchase 669,750 additional shares of common stock. The aggregate gross proceeds to us, before deducting underwriting discounts and commissions and estimated offering expenses payable by us, were approximately $143.8 million. We have received aggregate gross proceeds of $373.8 million through December 31, 2019 from the sale and issuance of our common stock. As of December 31, 2019, we had an accumulated deficit of $165.9 million. Our net losses were $81.0 million for the year ended December 31, 2019 and $43.3 million for the year ended December 31, 2018. We have incurred significant net operating losses in every year since our inception and expect to continue to incur increasing net operating losses and significant expenses for the foreseeable future. Our net losses may fluctuate significantly from quarter to quarter and year to year. We anticipate that our expenses will increase significantly as we: · continue to advance our lead product candidates through pivotal stage development towards registration; · continue to advance our other product candidates through pre-clinical and clinical development; · continue to identify additional research programs and additional product candidates, as well as additional indications for existing product candidates; · initiate pre-clinical studies and clinical trials for any additional product candidates we identify; · develop, maintain, expand and protect our intellectual property portfolio; · hire additional research, sales force, commercialization, clinical and scientific personnel; and · incur additional costs associated with operating as a public company, including expanding our operational, finance and management teams. We believe that our cash on hand will be sufficient to fund our operations through the fourth quarter of 2022. We do not expect to generate revenues from product sales unless and until we successfully complete development and obtain regulatory approval for a product candidate, which is subject to significant uncertainty and may never occur. Although no assurance can be given, our goal is to complete the submission of our BLA for our lead product candidate, naxitamab for the treatment of pediatric R/R high-risk NB, by the end of the first quarter 2020 and our BLA for our second lead product candidate omburtamab for the treatment of CNS/LM from NB in May 2020. We currently use CROs and CMOs to carry out our pre-clinical and clinical development activities. Pursuant to the MSK License, we have obtained exclusive rights to MSK’s rights in our current antibody product candidates. Under the MSK License, we have committed to funding scientific research through 2020 at MSK as well as conducting certain clinical trial activities at MSK. As these product candidates progress through clinical development, regulatory approval and commercialization, certain milestone payments will come due either as a result of the milestones having been met or the passage of time even if the milestones have not been met. Also, we will owe MSK customary royalties on commercial sales of our approved products, including a fixed minimum royalty starting in 2020 whether or not product sales are ever achieved. In addition, we have committed to obtain certain personnel and laboratory services at MSK under our MDSA, and two separate CFSAs. Also under our MCTA with MSK, we will provide drug product and funding for certain clinical trials at MSK. These MSK agreements are important to our business. For a more detailed discussion of the terms and conditions of these agreements, see the section herein entitled “Business-Intellectual Property-MSK Agreements.” If we obtain regulatory approval for our product candidates, we expect to incur significant commercialization expenses related to product sales, marketing, manufacturing and distribution. Accordingly, we may continue to fund our operations through public or private equity or debt financings or other sources, including strategic collaborations. We may, however, be unable to raise additional funds or enter into such other arrangements when needed on favorable terms or at all. Our failure to raise capital or enter into such other arrangements as and when needed would have a negative impact on our financial condition and our ability to develop our current product candidates, or any additional product candidates, if developed. Because of the numerous risks and uncertainties associated with the development of our existing product candidates and any future product candidates, our platform and technology and because the extent to which we may enter into collaborations with third parties for development of any of our product candidates is unknown, we are unable to estimate the amounts of increased capital outlays and operating expenses associated with completing the research and development of our product candidates. If we raise additional funds through collaborations, strategic alliances, or licensing arrangements with third parties, we may have to relinquish valuable rights to our technologies, future revenue streams, research programs, product candidates or grant licenses on terms that may not be favorable to us and could have a negative impact on our financial condition. Components of Our Results of Operations Revenue To date, we have not generated any revenue from product sales and do not expect to do so until the end of 2020. We expect that we will experience increasing losses as we continue our development of, and seek regulatory approvals for, our product candidates and begin to commercialize any approved products. Our ability to generate revenue for each product candidate for which we receive regulatory approval, if any, will depend on numerous factors, including reimbursement coverage, competition, commercial manufacturing capability and market acceptance of such approved products. Operating Expenses Research and Development Expenses Research and development expenses consist of expenses incurred in connection with the discovery and development of our product candidates. We expense research and development costs as incurred. These expenses include: · sponsored research, laboratory facility services, clinical trial and data service at MSK under the SRA, the two CFSAs, the MCTA, and the MDSA, with MSK; · expenses incurred under agreements with CROs, as well as investigative sites and consultants that conduct our non-clinical studies and pre-clinical and clinical trials; · expenses incurred under agreement with CMOs, including manufacturing scale-up expenses and the cost of acquiring and manufacturing pre-clinical and clinical trial materials, including manufacturing validation batches; · upfront, milestone and other non-revenue related payments due under our third-party licensing agreements; · employee-related expenses, which include salaries, benefits, travel and stock-based compensation; · expenses related to regulatory activities, including filing fees paid to regulatory agencies; · outsourced professional scientific development services; and · allocated expenses for utilities and other facility-related costs, including rent, insurance, supplies and maintenance expenses, and other operating costs. The successful development and regulatory approval of our product candidates is highly uncertain. At this time, we cannot reasonably estimate or know the nature, timing and costs of the efforts that will be necessary to complete the remainder of the development of naxitamab and omburtamab or any future product candidates we may develop. This uncertainty is due to the numerous risks and uncertainties associated with the duration and cost of clinical trials, which vary significantly over the life of a project as a result of many factors, including: · the number of clinical sites included in the trials; · the availability and length of time required to enroll a sufficient number of suitable patients in our clinical trials; · the actual probability of success for our product candidates, including the safety and efficacy, early clinical data, competition, manufacturing capability and commercial viability; · significant and changing government regulation and regulatory guidance; · the performance of our existing and any future collaborators; · the number of doses patients receive; · the duration of patient follow-up; · the results of our clinical trials and pre-clinical studies; · the establishment of commercial manufacturing capabilities; · adequate ongoing availability of raw materials and drug substance for clinical development and any commercial sales; · the timing of our BLA submissions and their acceptance; · the receipt of marketing approvals, including a safety, tolerability and efficacy profile that is satisfactory to the FDA or any non-U.S. regulatory authority; · any requirement by the FDA or any non-US regulatory authority to conduct post market surveillance or safety studies; · the expense of filing, prosecuting, defending and enforcing any patent claims and other intellectual property rights; and · the commercialization of approved products. Our expenditures are subject to additional uncertainties, including the terms and timing of regulatory approvals. We may never succeed in achieving regulatory approval for naxitamab, omburtamab or any other product candidates we may develop. A change in the outcome of any of these variables with respect to the development of a product candidate could mean a significant change in the costs and timing associated with the development of that product candidate. For example, if the FDA or another regulatory authority were to require us to conduct clinical trials beyond those that we anticipate will be required for the completion of clinical development of a product candidate, or if we experience significant delays in our clinical trials due to patient enrollment or other reasons, we would be required to expend significant additional financial resources and time on the completion of clinical development. Research and development activities are central to our business model. Product candidates in later stages of clinical development, like naxitamab and omburtamab, generally have higher development costs than those in earlier stages of clinical development, primarily due to the increased size and duration of later-stage clinical trials. We expect our research and development expenses to increase significantly over the next several years as we increase personnel costs, including stock-based compensation, conduct clinical trials and potentially prepare regulatory filings for naxitamab and omburtamab. General and Administrative Expenses General and administrative expenses consist primarily of employee related expenses, including salaries, bonus, benefits, and stock-based compensation expenses for personnel in executive, finance and administrative functions. Other significant costs include facility costs not otherwise included in research and development expenses, legal fees relating to corporate matters, and fees for patent, accounting, tax, and consulting services. We anticipate that our general and administrative expenses will increase in the future to support continued research and development activities, potential commercialization of our product candidates and increased costs associated with operating as a public company, including expenses related to services associated with maintaining compliance with exchange listing and the SEC requirements, director and officer insurance costs and investor and public relations costs. These increases will likely include increased costs related to the hiring of additional personnel and fees to outside consultants, lawyers and accountants, among other expenses. Additionally, if and when we believe a regulatory approval of a product candidate appears likely, we anticipate an increase in payroll and other employee-related expenses as a result of our preparation for commercial operations, especially as it relates to the sales and marketing of that product candidate. Critical Accounting Policies and Significant Judgments and Estimates Our management’s discussion and analysis of our financial condition and results of operations is based on our financial statements, which we have prepared in accordance with U.S. generally accepted accounting principles, or GAAP. We believe that several accounting policies are significant to understanding our historical and future performance. We refer to these policies as critical because these specific areas generally require us to make judgments and estimates about matters that are uncertain at the time we make the estimate, and different estimates-which also would have been reasonable-could have been used. On an ongoing basis, we evaluate our estimates and judgments, including those described in greater detail below. We base our estimates on historical experience and other market-specific or other relevant assumptions that we believe to be reasonable under the circumstances, the results of which form the basis for making judgments about the carrying value of assets and liabilities that are not readily apparent from other sources. Actual results may differ from these estimates under different assumptions or conditions. While our significant accounting policies are described in more detail in the notes to our financial statements appearing elsewhere in this Annual Report on Form 10-K, we believe the following accounting policies to be most critical to the judgments and estimates used in the preparation of our financial statements. Use of Estimates The preparation of financial statements in conformity with GAAP requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities, the disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of expenses during the reporting period. Significant estimates and assumptions reflected in these financial statements include, but are not limited to, the accrual for research and development expenses, the accrual of milestone and royalty payments, the valuation of shares of common stock prior to becoming a public company and stock options. Estimates are periodically reviewed in light of changes in circumstances, facts and experience. Changes in estimates are recorded in the period in which they become known. Actual results could differ from those estimates. Research and Development Expenses Research and development costs are charged to operations when incurred and are included in operating expenses. Research and development costs consist principally of compensation cost for our employees and consultants that perform our research activities, the fees paid to maintain our licenses, the payments to third parties for manufacturing and clinical research organizations and additional product development, and consumables and other materials used in research and development. We record accruals for estimated ongoing research costs. When evaluating the adequacy of the accrued liabilities, we analyze progress of the studies or clinical trials, including the phase or completion of events, invoices received and contracted costs. Actual results could differ from our estimates. We are obligated to make certain milestone and royalty payments in accordance with the contractual terms of the MSK License based upon the resolution of certain contingencies. Certain of these milestone payments are due and payable with the passage of time whether or not the milestones have actually been met. We record the milestone and royalty payment when the achievement of the milestone (including the passage of time) or payment of the milestone or royalty is probable and the amount of the payment is reasonably estimable. Fair Value Measurements Certain assets and liabilities are carried at fair value under GAAP. Fair value is defined as the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date (i.e. an exit price). The accounting guidance includes a fair value hierarchy that prioritizes the inputs to valuation techniques used to measure fair value. The three levels of the fair value hierarchy are as follows: • Level 1 - Unadjusted quoted prices for identical assets or liabilities in active markets; • Level 2 - Inputs other than quoted prices in active markets for identical assets and liabilities that are observable either directly or indirectly for substantially the full term of the asset or liability; and • Level 3 - Unobservable inputs for the asset or liability, which include management's own assumption about the assumptions market participants would use in pricing the asset or liability, including assumptions about risk. The Company’s cash equivalents are carried at fair value, determined according to the fair value hierarchy described above. Income Taxes We account for income taxes under the asset and liability approach for the financial accounting and reporting of income taxes. Deferred tax assets and liabilities are recognized for the estimated future tax consequences attributable to net operating loss carry forwards and temporary differences between the financial statement carrying amounts of existing assets and liabilities and their respective tax bases. These assets and liabilities are measured using enacted tax rates expected to apply to taxable income in the years in which the temporary differences are expected to reverse. We maintain a full valuation allowance on our deferred tax assets based on cumulative historical and expected losses. If we commercialize our products and achieve profitability, we will consider the continued need for such valuation allowance. We prepare and file tax returns based on its interpretation of tax laws and regulations. In the normal course of business, our tax returns are subject to examination by various taxing authorities. Such examinations may result in future tax and interest assessments by these taxing authorities. In determining our tax provision for financial reporting purposes, we establish a reserve for uncertain tax positions unless such positions are determined to be more likely than not of being sustained upon examination based on their technical merits. We consider many factors when evaluating and estimating our tax positions and tax benefits, which may require periodic adjustments and which may not accurately anticipate actual outcomes. Accordingly, we will report a liability for unrecognized tax benefits resulting from any uncertain tax positions taken or expected to be taken on a tax return. Our policy is to recognize, when applicable, interest and penalties on uncertain tax positions as part of income tax expense. Stock-Based Compensation We measure stock options granted to employees and directors based on the fair value on the date of the grant and recognize compensation expense of those awards, over the requisite service period, which is the vesting period of the respective award. Forfeitures are accounted for as they occur. We issue stock options to employees and directors with only service-based vesting conditions and record the expense for these awards using the straight-line method over the requisite service period. For share-based awards granted to non-employees, compensation expense is recognized over the period during which services are rendered by such non-employees until completed. At the end of each financial reporting period prior to completion of the service, the fair value of these awards is remeasured using the then-current fair value of our shares of common stock and updated assumption inputs in the Black-Scholes option-pricing model. The fair value of each stock option grant is estimated on the date of grant using the Black-Scholes option pricing model. Historically, we have been a private company and lack company-specific historical and implied volatility information for our shares. Therefore, we estimate our expected share price volatility based on the historical volatility of a group of publicly-traded peer companies and we expect to continue to do so until such time as we have adequate historical data regarding the volatility of our own traded share price. The expected term of our stock options has been determined utilizing the “simplified” method for awards as we have limited historical data to support the expected term assumption. The expected term of stock options granted to non-employees is equal to the contractual term of the option award. The risk-free interest rate is determined by reference to the U.S. Treasury yield curve in effect at the time of grant of the award for time periods approximately equal to the expected term of the award. The expected dividend yield is based on the fact that we have never paid cash dividends on shares of our common stock and do not expect to pay any cash dividends in the foreseeable future. Determination of the Fair Value of Common Stock Prior to our IPO, the estimated fair value of our common stock was determined by our board of directors as of the date of each award grant, with input from management, considering our then most recently completed or ongoing private placement activities and then most recently available third-party valuation of our common stock. Third-party valuations were performed in accordance with the guidance outlined in the American Institute of Certified Public Accountants’ Accounting and Valuation Guide, Valuation of Privately-Held-Company Equity Securities issued as Compensation. This process resulted in estimated fair value of our common stock of $0.20 per share as of June 6, 2015; $4.38 per share as of May 20, 2016, October 21, 2016 and August 22, 2016; $8.50 per share as of December 14, 2016; $9.35 per share as of September 13, 2017 and December 5, 2017; $11.16 per share as of April 24, 2018; and $13.11 as of July 10, 2018. Prior to our Initial Public Offering, or IPO, in September 2018, in addition to considering the results of such recently completed or ongoing private placements, our board of directors considered various objective and subjective factors to determine the fair value of our common stock as of each grant date including: · the progress of our research and development programs, including the status of pre-clinical studies and clinical trials for our product candidates; · our stage of development and commercialization and our business strategy; · material risks related to our business; · external market conditions affecting the biotechnology industry, and trends within the biotechnology industry; · our financial position, including cash on hand, and our historical and forecasted performance and operating results; · the lack of an active public market for our common stock; · the likelihood of achieving a liquidity event, such as an initial public offering or a sale of our company in light of prevailing market conditions; and · an analysis of initial public offerings and the market performance of similar companies in the biopharmaceutical industry. The assumptions underlying these valuations represented management’s best estimates, which involved inherent uncertainties and the application of management judgment. As a result, if factors or expected outcomes changed and we used significantly different assumptions or estimates at the time, our stock-based compensation expense could be materially different. Since the closing of our IPO, our board of directors has determined the per share fair value of our common stock based on the closing price of our common stock as reported by the NASDAQ Global Select Market on the date of grant such as $21.97 as of December 11, 2018; $22.33 as of March 5, 2019; $21.45 as of June 12, 2019; $25.01 as of October 3, 2019; and $33.74 as of December 10, 2019. Stock Options Granted All options to purchase shares of our common stock are granted with an exercise price per share equal to or greater than the estimated fair value per share of our common stock on the date of grant, based on the information known to us on the date of grant. The following table sets forth by grant date the number of shares of common stock subject to options granted from 2016 to 2019, the per share exercise price of the options, the fair value per share of common stock on each grant date, and the per share estimated fair value of the options: We expect the amount of share-based compensation expense recognized for stock options to increase in future periods due to the potential increase in the value of our common stock, additional grants to employees in the future and a growing headcount. Fair Value of Stock Options The fair value of each stock option grant is estimated on the date of grant using the Black-Scholes option pricing model. The assumptions that the Company used to determine the fair value of the stock options granted to employees and directors were as follows, presented on a weighted average basis: · Risk-free interest rate: The risk-free interest rate assumption is based on the U.S. Treasury instruments whose terms were consistent with the expected option term of our stock options. · Expected Dividend Yield: The expected dividend yield assumption is based on the fact that we have never paid cash dividends and have no present intention to pay cash dividends. Consequently, we used an expected dividend of zero. · Expected Volatility: The expected stock price volatility is estimated by taking the average historic price volatility of industry peers and adjusting for differences in our life cycle and financing leverage. Our industry peers consist of several public companies in the biopharmaceutical industry. · Expected Term: We determine the average expected life of stock options based on the simplified method in accordance with SEC Staff Accounting Bulletin Nos. 107 and 110. We expect to continue to use the simplified method until we have sufficient historical exercise data to provide a reasonable basis upon which to estimate expected term. Results of Operations Comparison of the Years Ended December 31, 2019 and 2018 The following table summarizes our results of operations for the years ended December 31, 2019 and 2018: Research and Development Expenses We do not record our research and development expenses on a program-by-program or on a product-by-product basis as they primarily relate to personnel, research, manufacturing, license fees, non-cash expense in connection with equity issuances to strategic partners and consumable costs, which are simultaneously deployed across multiple projects under development. These costs are included in the table below. Research and development expenses increased by $29.2 million, from $34.3 million for the year ended December 31, 2018, to $63.5 million for the year ended December 31, 2019. This was primarily due to a $17.1 million increase in manufacturing services and a $5.4 million increase in outsourced services and supplies, primarily obtained from MSK and CROs for our lead product candidates, naxitamab and omburtamab. Other clinical trial costs increased by $2.5 million for the year ended December 31, 2019. Employee-related costs including salary, benefits and non-cash stock-based compensation for personnel related to our research activities, increased by $3.3 million for the year ended December 31, 2019. Professional and consulting fees increased by $0.6 million for the year ended December 31, 2019. General and Administrative Expenses General and administrative expenses increased by $10.5 million from $9.0 million for the year ended December 31, 2018 to $19.5 million for the year ended December 31, 2019. The increase in general and administrative expenses was primarily attributable to a $5.1 million increase in employee-related costs, including salary, benefits and non-cash stock-based compensation for personnel related to our business activities. Compared with 2018, insurance expenses increased by $1.4 million and commercial expenses increased by $2.8 million in 2019. Commercial expense is for building up the sales and marketing infrastructure for the potential launch of naxitamab and omburtamab. Interest and Other Income (Expense) Other Income for the year ended December 31, 2019 increased by $2.0 million from Other Expenses of ($44,000) for the year ended December 31, 2018. Our interest income increased by $2.0 million due to higher average cash balances as a result of our IPO and our secondary public offering. Liquidity and Capital Resources Overview Since our inception we have incurred significant net operating losses and expect to continue to incur increasing net operating losses and significant expenses for the foreseeable future. Our net losses may fluctuate significantly from quarter to quarter and year to year. We do not currently have any approved products and have never generated any revenue from product sales. We have financed our operations through December 31, 2019 primarily through gross proceeds from the sale of our common stock of $230.0 million in the years 2015 through 2018 and an additional $143.8 million from the sale of our common stock in 2019. As of December 31, 2019, we had cash and cash equivalents of $207.1 million. We will need additional capital to continue funding our operations, which we may obtain from additional equity or debt financings, collaborations, licensing arrangements, or other sources. Cash Flows The following table provides information regarding our cash flows for the years ended December 31, 2019 and December 31, 2018: Net Cash Used in Operating Activities The use of cash in all periods resulted primarily from our net losses adjusted for non-cash charges and changes in components of working capital. Net cash used in operating activities was $73.5 million during the year ended December 31, 2019, as compared to $41.2 million during the year ended December 31, 2018. The $32.3 million increase in net cash used in operations was primarily due to an increase in our net loss for the year ended December 31, 2019 of $37.8 million, compared to the year ended December 31, 2018. This increase was primarily due to an increase in our operating expenses in connection with the development of our lead product candidates, naxitamab and omburtamab, and the expansion of our other business activities. Non-cash expenses included stock-based compensation to employees and non-employees, which increased by $2.7 million. Adjustments of working capital reflect an increase of $2.7 million for the year ended December 31, 2019 compared to the year ended December 31, 2018. Net Cash Used in Investing Activities Net cash used in investing activities was $2.0 million for the year ended December 31, 2019, as compared to $0.2 million for the year ended December 31, 2018. The $1.8 million increase in net cash used in investing activities relates to investment in furniture and equipment for our offices and lab facilities. Net Cash Provided by Financing Activities Net cash provided by financing activities was $134.7 million during the year ended December 31, 2019, as compared to $98.8 million during the year ended December 31, 2018. The cash provided by financing activities was attributable to net proceeds of $134.7 million related to the issuance of common stock in the Company’s secondary public offering in the year ended December 31, 2019, which exceed the $98.8 million net proceeds related to the issuance of common stock in the Company’s IPO in the year ended December 31, 2018. Funding Requirements We expect our expenses to increase in connection with our ongoing activities, particularly as we complete clinical development of our lead product candidates, naxitamab and omburtamab, and initiate and advance our BLA submissions for both product candidates. In addition, we plan to advance the development of other pipeline programs, initiate new research and pre-clinical development efforts and seek marketing approval for any additional product candidates that we successfully develop. If we obtain approval for any of our product candidates, we expect to incur commercialization expenses, which may be significant, related to establishing sales, marketing, manufacturing capabilities, distribution and other commercial infrastructure to commercialize such products. Furthermore, we expect to incur additional costs associated with operating as a public company. Accordingly, we might need to obtain substantial additional funding in connection with our continuing operations. If we are unable to raise capital when needed or on attractive terms, we would be forced to delay, reduce or eliminate our research and development programs and/or future commercialization efforts. We believe that our existing cash and cash equivalents as of December 31, 2019, will enable us to fund our operating expenses and capital expenditure requirements through the fourth quarter of 2022. We have based our projections of operating capital requirements on assumptions that may prove to be incorrect and we may use all of our available capital resources sooner than we expect. Because of the numerous risks and uncertainties associated with the development and commercialization of naxitamab and omburtamab, and the research, development and commercialization of other potential product candidates, we are unable to estimate the exact amount of our operating capital requirements. Our future capital requirements will depend on many factors, including: · the scope, progress, timing, costs and results of clinical trials for developing our lead product candidates, naxitamab and omburtamab, and conducting pre-clinical studies and clinical trials for our other product candidates; · research and pre-clinical development efforts for any future product candidates that we may develop; · our ability to enter into and the terms and timing of any collaborations, licensing agreements or other arrangements; · the achievement of milestones or occurrence of other developments that trigger payments under any collaboration or other agreements; · the number of future product candidates that we pursue and their development requirements; · the outcome, timing and costs of seeking regulatory approvals; · the costs of commercialization activities for any of our product candidates that receive marketing approval to the extent such costs are not the responsibility of any future collaborators, including the costs and timing of establishing product sales, marketing, distribution and manufacturing capabilities; · the amount and timing of future revenue, if any, received from commercial sales of our current and future product candidates upon any marketing approvals; · proceeds received, if any, from monetization of any future PRVs; · our headcount growth and associated costs as we expand our research and development and establish a commercial infrastructure; · the costs of preparing, filing and prosecuting patent applications, maintaining and protecting our intellectual property rights and defending against intellectual property related claims; and · the costs of operating as a public company. Identifying potential product candidates and conducting pre-clinical studies and clinical trials is a time-consuming, expensive and uncertain process that takes many years to complete, and we may never generate the necessary data or results required to obtain marketing approval and achieve product sales. In addition, our product candidates, if approved, may not achieve commercial success. Accordingly, we will need to continue to rely on additional financing to achieve our business objectives. Adequate additional financing may not be available to us on acceptable terms, or at all. Until such time, if ever, as we can generate substantial product revenues, we expect to finance our cash needs through a combination of equity offerings, debt financings, collaborations, strategic alliances and licensing arrangements. To the extent that we raise additional capital through the sale of equity or convertible debt securities, your ownership interest in our company may be materially diluted, and the terms of these securities may include liquidation or other preferences that adversely affect your rights as a common stockholder. Debt financing, if available, may involve agreements that include covenants limiting or restricting our ability to take specific actions, such as incurring additional debt, making capital expenditures or declaring dividends. If we raise funds through additional collaborations, strategic alliances or licensing arrangements with third parties, we may have to relinquish valuable rights to our technologies, future revenue streams, research programs or product candidates or to grant licenses on terms that may not be favorable to us. If we are unable to raise additional funds through equity or debt financings when needed, we may be required to delay, limit, reduce or terminate our product development or future commercialization efforts or grant rights to develop and market product candidates that we would otherwise prefer to develop and market ourselves. Off-Balance Sheet Arrangements We did not have during the periods presented, and we do not currently have, any off-balance sheet arrangements, as defined under the applicable regulations of the SEC. Contractual Obligations and Commitments Contractual obligations as of December 31, 2019 are related to payments of operating leases for our corporate headquarters in New York, New York, a laboratory space located in Nutley, New Jersey, and our office space in Hørsholm, Denmark. Our obligations and commitments are disclosed in the contractual obligations table below: We enter into contracts in the normal course of business with CROs, CMOs, clinical sites and other third parties for clinical trials, pre-clinical research studies and testing, professional consultants for expert advice and other vendors for clinical supply, manufacturing and other services. These contracts are not considered contractual obligations, as they provide for termination upon prior notice, and, therefore, are cancelable contracts and do not include any minimum purchase commitments. Payments due upon cancellation consist only of payments for services provided or expenses incurred, including non-cancellable obligations of our service providers, up to the date of cancellation. These payments are not included in the table of contractual obligations and commitments above. As further described below, under various licensing and related agreements with third parties, we have agreed to make milestone and royalty payments to third parties. We have not included the contingent payment of certain milestones in the table above, where timing is uncertain. In addition, we have other contingent payment obligations, such as royalties or other third party milestones, which are not included in the table above as the amount, timing and likelihood of such payments are not known. We have entered into two license agreements and certain other agreements with MSK. The license agreements are further described below as the MSK License and the MSK CD33 License. Additionally, through the SAAA we have established a direct license with MSK relating to the GD2-GD3 Vaccine. Under the MSK License and MSK CD33 License we are obligated to (i) make certain payments to MSK, which become due based upon the achievement of the related milestone activities or the passage of time in the event such milestone activities are not achieved, as well as certain sales-related milestones, (ii) pay mid-to-high single-digit royalties to MSK, on a product-by-product and country-by-country basis, of a mid-to-high single-digit royalties based on net sales of products licensed under the applicable agreement and (iii) pay to MSK a percentage of any sublicense fees received by us. Under the MSK License, we are also obligated to pay annual minimum royalties of $80,000 over the royalty term, starting in 2020. Under the MSK CD33 License, we are obligated to pay annual minimum royalties of $40,000 over the royalty term beginning in 2027, increasing to $60,000 once a patent within the licensed rights is issued. These amounts are non-refundable but are creditable against royalty payments otherwise due under the respective agreements. Total expensed minimum royalty payments in 2016 under the MSK License were $1,200,000, upon determination that the payment of such minimum royalties was probable and the amount was estimable in 2016. We are also obligated to pay MSK certain clinical, regulatory and sales-based milestone payments under the MSK License and MSK CD33 License. Certain of the clinical and regulatory milestone payments become due at the earlier of completion of the related milestone activity or the date indicated in the MSK License. Total clinical, regulatory and sales based milestones potentially due under the MSK License are $2,450,000, $9,000,000 and $20,000,000, respectively. In addition, under the MSK CD33 License, we are obligated to make potential payments of $550,000, $500,000 and $7,500,000 for clinical, regulatory and sales based milestones, respectively. We record milestones in the period in which the contingent liability is probable and the amount is reasonably estimable. Research and development is inherently uncertain and, should such research and development fail, the MSK License and MSK CD33 License are cancelable at our option. We have also considered the development risk and each party’s termination rights under the two license agreements when considering whether any contingent payments, certain of which also contain time-based payment requirements, were probable. In addition, to the extent we enter into sublicense arrangements, we are obligated to pay to MSK a percentage of certain payments that we receive from sublicensees of the rights licensed to us by MSK, which percentage will be based upon the achievement of certain clinical milestones. To date, we have not entered into any sublicenses related to the MSK License or the MSK CD33 License. Our failure to meet certain conditions under such arrangements could cause the related license to such licensed product to be canceled and could result in termination of the entire respective arrangement with MSK. In addition, we may terminate the MSK License or the MSK CD33 License with prior written notice to MSK. Total milestones expensed in 2019 under the MSK License were $75,000, all of which related to clinical milestones, which become due either based upon the passage of time or achievement of the related milestone activities. No milestones were expensed in 2019 under the MSK CD33 License. No milestones were expensed in 2018 under the MSK License and the MSK CD33 License. On December 2, 2019, we entered into the Settlement and Assumption and Assignment, or SAAA, of MSK License and Y-mAbs Sublicense Agreement, or the MabVax/Y-mAbs Sublicense, between us and Mabvax dated June 27, 2018, with MabVax Therapeutics Holdings, Inc. and MabVax Therapeutics, Inc., or together, MabVax, and MSK, which became effective on December 13, 2019. Pursuant to the Mabvax/Y-mAbs Sublicense, MabVax sublicensed to us certain patent rights and know-how for development and commercialization of products for the prevention or treatment of NB by means of administering a bi-valent ganglioside vaccine granted to MabVax, pursuant to an exclusive license agreement dated June 20, 2008 between MabVax and MSK, as amended, or the MabVax/MSK License Agreement. On March 21, 2019, MabVax filed a voluntary petition for relief under Chapter 11 of the Bankruptcy Code. The essence of the transaction created by the SAAA was for us, in light of the Chapter 11 bankruptcy proceedings affecting MabVax, to preserve the MabVax/MSK License Agreement and the rights granted to us under the MabVax/Y-mAbs Sublicense and for us to create a direct relationship with MSK with respect to the rights covered under the MabVax/Y-mAbs Sublicense. Pursuant to the SAAA, MabVax agreed to assume the MabVax/Y-mAbs Sublicense and the MabVax/Y-mAbs License Agreement pursuant to Section 365 of the Bankruptcy Code and concurrently to assign both of these agreements to MSK. MabVax has also agreed to pay MSK a certain amount to cure all of its existing defaults under the MabVax/MSK License Agreement. We remain responsible for any potential downstream payment obligations to MSK related to the GD2-GD3 Vaccine that were specified in the MabVax/MSK License Agreement. This includes the obligation to pay development milestones totaling $1,400,000 and mid-single digit royalty payments to MSK. In addition, if we obtain FDA approval for the GD2-GD3 Vaccine, then we are obligated to file with the FDA for a Priority Review Voucher, or PRV. The SAAA stipulates that, if we are granted a PRV from the FDA covering a licensed product under the MabVax/Y-mAbs Sublicense and the PRV is subsequently sold, we will pay directly to MabVax and to MSK, respectively, a percentage of the proceeds from the sale thereof in order that MabVax and MSK each receive the same amount therefrom as envisaged under the MabVax/MSK License Agreement. The MabVax/MSK License Agreement will expire with effect for us, on a country by country basis, on the later of the expiration of (i) 10 years from the first commercial sale of the licensed product in such country or (ii) the last to expire valid claim covering such licensed product rights at the time of and in the country of sale. Recent Accounting Pronouncements Refer to Note 3, “Summary of Significant Accounting Policies,” in the accompanying notes to the consolidated financial statements for a discussion of recent accounting pronouncements. Internal Controls and Procedures We are required, pursuant to Section 404(a) of the Sarbanes Oxley Act, to furnish a report by management on, among other things, the effectiveness of our internal control over financial reporting. This assessment includes disclosure of any material weaknesses identified by management over our internal control over financial reporting. However, our independent registered public accounting firm will not be required to report on the effectiveness of our internal control over financial reporting pursuant to Section 404(b) of the Sarbanes-Oxley Act until the later of the year following our first annual report required to be filed with the SEC, or the date we are no longer an “emerging growth company” if we take advantage of the exemptions contained in the JOBS Act. Internal control over financial reporting is a process designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements in accordance with GAAP. Prior to our initial public offering, we were a private company and we are currently finalizing a process for reviewing, documenting and testing our internal control over financial reporting. Certain material weaknesses have been identified in our internal control over financial reporting. See the section herein entitled “Risk Factors”-We have determined that we have material weaknesses in our internal control over financial reporting. If our remediation of these material weaknesses is not effective, or if we experience additional material weaknesses or otherwise fail to maintain an effective system of internal controls in the future, we may not be able to accurately or timely report our financial condition or results of operations, which may adversely affect investor confidence in us and, as a result, the value of our common stock. In addition, because of our status as an emerging growth company, our independent registered public accounting firm is not required to provide an attestation report as to our internal control over financial reporting for the foreseeable future.” If we fail to maintain an effective system of disclosure controls and internal control over financial reporting, our ability to produce timely and accurate financial statements or comply with applicable regulations could be impaired. If we are unable to remediate these identified material weaknesses, or if we experience additional material weaknesses in the future or otherwise fail to maintain an effective system of internal controls, we may not be able to accurately or timely report our financial condition or results of operations, or comply with the accounting and reporting requirements applicable to public companies, which may adversely affect investor confidence in us and, as a result, the value of our common stock. We have completed an evaluation of our internal control over financial reporting, as required by Section 404. We have not engaged an independent registered public accounting firm to perform an audit of our internal control over financial reporting as of any balance sheet date or for any period reported in our financial statements. Our independent public registered accounting firm will first be required to attest to the effectiveness of our internal control over financial reporting for our Annual Report on Form 10 K for the first year we are no longer an “emerging growth company.” We are in the very early stages of the costly and challenging process of compiling the system and processing documentation necessary to complete the remediation needed to comply with Section 404. We may not be able to complete our evaluation, testing or any required remediation in a timely fashion. During the evaluation and testing process, if we identify one or more material weaknesses in our internal control over financial reporting, we will be unable to assert that our internal controls are designed and operating effectively, which could result in a loss of investor confidence in the accuracy and completeness of our financial reports. This could cause the price of our common stock to decline, and we may be subject to investigation or sanctions by the SEC. Emerging Growth Company Status; The JOBS Act The JOBS Act permits an “emerging growth company” such as us to take advantage of an extended transition period to comply with new or revised accounting standards applicable to public companies until those standards would otherwise apply to private companies. We have irrevocably elected to “opt out” of this provision and, as a result, we will comply with new or revised accounting standards when they are required to be adopted by public companies that are not emerging growth companies. For so long as we are an emerging growth company and qualify as a smaller reporting company we expect that: · we will present only two years of audited financial statements, in addition to any required unaudited financial statements, with correspondingly reduced Management’s Discussion and Analysis of Financial Condition and Results of Operations disclosure as long as we continue to qualify as a smaller reporting company; · we will avail ourselves of the exemption from the requirement to comply with any requirement that may be adopted by the Public Company Accounting Oversight Board regarding a supplement to the auditor’s report providing additional information about the audit and the financial statements; · we will avail ourselves of the exemption from the requirement to obtain an attestation and report from our auditors on the assessment of our internal control over financial reporting pursuant to the Sarbanes-Oxley Act; and · we will provide less extensive disclosure about our executive compensation arrangements. We will remain an emerging growth company for up to five years, although we will cease to be an “emerging growth company” upon the earliest of: (i) the last day of the fiscal year following the fifth anniversary of our initial public offering, (ii) the last day of the first fiscal year in which our annual gross revenues are $1.07 billion or more, which amount is periodically updated, (iii) the date on which we have, during the previous rolling three-year period, issued more than $1.0 billion in non-convertible debt securities or (iv) the date on which we are deemed to be a “large accelerated filer” as defined in the Exchange Act.

<s>[INST] Overview We are a latestage clinical biopharmaceutical company focused on the development and commercialization of novel, antibodybased therapeutic products for the treatment of cancer. We have a broad and advanced product pipeline, including two pivotalstage product candidatesnaxitamab and omburtamabwhich target tumors that express GD2 and B7H3, respectively. We are developing naxitamab for the treatment of pediatric patients with R/R highrisk NB, and radiolabeled omburtamab for the treatment of pediatric patients with CNS/LM, from NB. NB is a rare and almost exclusively pediatric cancer that develops in the sympathetic nervous system and CNS/LM is a rare and usually fatal complication of NB in which the disease spreads to the membranes, or meninges, surrounding the brain and spinal cord in the CNS. In November 2019, we submitted the initial portion of our BLA for naxitamab to the FDA under the FDA’s rolling review process with a goal of receiving approval by the FDA in 2020. We also expect to submit a BLA for omburtamab via a rolling submission in May 2020 with the goal of receiving approval by the FDA in 2020. We plan to commercialize both of our lead product candidates in the United States as soon as possible after obtaining FDA approval, if such approval occurs. Additionally, we have two omburtamab followon product candidates in preclinical development, 177Luomburtamab and huB7H3, a humanized version of omburtamab, each targeting indications with large adult patient populations. In addition, we have initiated a Phase 1 trial with our huGD2 BsAb product candidate for the treatment of refractory GD2 positive adult and pediatric solid tumors, thereby addressing large patient populations. We are also advancing a pipeline of novel BsAbs through late preclinical development, including our huCD33BsAb product candidate for the treatment of hematological cancers expressing CD33, a transmembrane receptor expressed on cells of myeloid lineage. We believe our BsAbs have the potential to result in improved tumorbinding, longer serum halflife and significantly greater Tcell mediated killing of tumor cells without the need for continuous infusion. Our GD2GD3 Vaccine for the treatment of highrisk NB patients in remission is being tested in a Phase 2 trial. Our mission is to become the world leader in developing better and safer antibodybased pediatric oncology products addressing clear unmet medical needs and, as such, have a transformational impact on the lives of patients. We intend to advance and expand our product pipeline into certain adult cancer indications either independently or in collaboration with potential partners. Since our inception on April 30, 2015, we have devoted substantially all of our resources to organizing and staffing our company, business planning, identifying potential product candidates, conducting preclinical studies of our product candidates and clinical trials of our lead product candidates, raising capital, and acquiring and developing our technology platform among other matters. We do not have any products approved for sale and have not generated any revenues from product sales. To date, we have financed our operations primarily through private placements of our securities, proceeds of our initial public offering and proceeds from our secondary public offering. Most recently, on November 1, 2019, we completed our secondary public offering of 5,134,750 shares of our common stock, at a price of $28.00 per share, which includes the exercise in full of the underwriters’ option to purchase 669,750 additional shares of common stock. The aggregate gross proceeds to us, before deducting underwriting discounts and commissions and estimated offering expenses payable by us, were approximately $143.8 million. We have received aggregate gross proceeds of $373.8 million through December 31, 2019 from the sale and issuance of our common stock. As of December 31, 2019, we had an accumulated deficit of $165.9 million. Our net losses were $81.0 million for the year ended December 3 [/INST] Negative. </s>

Origin Bancorp, Inc.

2019-02-28

2018-12-31

Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations The following discussion and analysis presents our financial condition and results of operations on a consolidated basis. However, we conduct all of our material business operations through our wholly owned bank subsidiary, Origin Bank, and the discussion and analysis that follows primarily relates to activities conducted at the Bank level. The following discussion and analysis should be read in conjunction with our consolidated financial statements and related notes contained in Item 8 of this report. To the extent that this discussion describes prior performance, the descriptions relate only to the periods listed, which may not be indicative of our future financial outcomes. In addition to historical information, this discussion contains forward-looking statements that involve risks, uncertainties and assumptions that could cause results to differ materially from management's expectations. Factors that could cause such differences are discussed in the sections titled "Cautionary Note Regarding Forward-Looking Statements" and "Item 1A. Risk Factors." We assume no obligation to update any of these forward-looking statements. Critical Accounting Estimates Our consolidated financial statements are prepared in accordance with United States generally accepted accounting principles ("GAAP") and with general practices within the financial services industry. Application of these principles requires management to make estimates and assumptions that affect the amounts reported in the financial statements and accompanying notes. We base our estimates on historical experience and on various other assumptions that we believe to be reasonable under current circumstances. These assumptions form the basis for our judgments about the carrying values of assets and liabilities that are not readily available from independent, objective sources. We evaluate our estimates on an ongoing basis. Use of alternative assumptions may have resulted in significantly different estimates. Actual results may differ from these estimates. Please refer to Note 1 - Significant Accounting Policies to our consolidated financial statements contained in Item 8 of this report for a full discussion of our accounting policies, including estimates. We have identified the following accounting estimates that, due to the difficult, subjective or complex judgments and assumptions inherent in those estimates and the potential sensitivity of the financial statements to those judgments and assumptions, are critical to an understanding of our financial condition and results of operations. We believe that the judgments, estimates and assumptions used in the preparation of the financial statements are appropriate. Allowance for Loan Losses. Our allowance for loan losses is established as losses are estimated to have occurred through a provision for loan losses charged to earnings. Subsequent recoveries, if any, are credited to the allowance. The allowance for loan losses is evaluated on a regular basis by management and is based upon management's periodic review of the collectability of the loans in light of historical experience, the nature and volume of the loan portfolio, adverse situations that may affect the borrower's ability to repay, estimated value of any underlying collateral, and prevailing economic conditions. This evaluation is inherently subjective as it requires estimates that are susceptible to significant revision as more information becomes available. Loans are charged against the allowance for loan losses when management believes the loss is confirmed. Mortgage Servicing Rights. We recognize as assets the rights to service mortgage loans based on the estimated fair value of the Mortgage Servicing Right ("MSR") when loans are sold and the associated servicing rights are retained. We elected to account for the MSR at fair value. The fair value of the MSR is determined using a valuation model administered by a third party that calculates the present value of estimated future net servicing income. The model incorporates assumptions that market participants use in estimating future net servicing income, including estimates of prepayment speeds, discount rate, default rates, cost to service (including delinquency and foreclosure costs), escrow account earnings, contractual servicing fee income and other ancillary income such as late fees. Management reviews all significant assumptions quarterly. Mortgage loan prepayment speeds, a key assumption in the model, is the annual rate at which borrowers are forecasted to repay their mortgage loan principal. The discount rate used to determine the present value of estimated future net servicing income, another key assumption in the model, is an estimate of the rate of return investors in the market would require for an asset with similar risk. Both assumptions can, and generally will, change as market conditions and interest rates change. An increase in either the prepayment speed or discount rate assumption will result in a decrease in the fair value of the MSR, while a decrease in either assumption will result in an increase in the fair value of the MSR. In recent years, there have been significant market-driven fluctuations in loan prepayment speeds and discount rates. These fluctuations can be rapid and may continue to be significant. Therefore, estimating prepayment speed and/or discount rates within ranges that market participants would use in determining the fair value of the MSR requires significant management judgment. General We are a financial holding company headquartered in Ruston, Louisiana. Through our wholly owned bank subsidiary, Origin Bank, we provide a broad range of financial services to small and medium-sized businesses, municipalities, high net worth individuals and retail clients through 41 banking centers in Louisiana, Texas and Mississippi. As a financial holding company operating through one segment, we generate the majority of our revenue from interest earned on loans and investments, service charges and fees on deposit accounts. We incur interest expense on deposits and other borrowed funds and noninterest expense, such as salaries and employee benefits and occupancy expenses. We analyze our ability to maximize income generated from interest earning assets and expense of our liabilities through our net interest margin. Net interest margin is a ratio calculated as net interest income divided by average interest-earning assets. Net interest income is the difference between interest income on interest-earning assets, such as loans, securities and interest-bearing cash, and interest expense on interest-bearing liabilities, such as deposits and borrowings. Changes in market interest rates and the interest rates we earn on interest-earning assets or pay on interest-bearing liabilities, as well as in the volume and types of interest-earning assets, interest-bearing and noninterest-bearing liabilities and stockholders' equity, are usually the largest drivers of periodic changes in net interest spread, net interest margin and net interest income. Fluctuations in market interest rates are driven by many factors, including governmental monetary policies, inflation, deflation, macroeconomic developments, changes in unemployment, the money supply, political and international conditions and conditions in domestic and foreign financial markets. Periodic changes in the volume and types of loans in our loan portfolio are affected by, among other factors, economic and competitive conditions, as well as developments affecting the real estate, technology, financial services, insurance, transportation and manufacturing sectors within our target markets. Comparison of Results of Operations for the Years Ended December 31, 2018, 2017 and 2016 Net Interest Income Year ended December 31, 2018, compared to year ended December 31, 2017 Net interest income for the year ended December 31, 2018, was $153.5 million, an increase of $23.1 million over the year ended December 31, 2017. The increase was driven by higher yields and higher average outstanding balances in our loan portfolio. The yield earned on our loans held for investment was 4.96% for the year ended December 31, 2018, compared to 4.38% for the year ended December 31, 2017. Average loans held for investment totaled $3.40 billion for the year ended December 31, 2018, compared to $3.13 billion for the year ended December 31, 2017. Increases in the yield earned on loans held for investment provided approximately $19.5 million of the increase in interest income, while average loans held for investment provided approximately $11.6 million of the increase. Commercial and industrial and commercial real estate loans contributed a total of $20.0 million of the increase. These increases were partially offset by an increase in the cost of funding primarily driven by increases in market interest rates. The average cost of our interest-bearing liabilities increased during the year ended December 31, 2018, compared to 2017, primarily due to higher average savings and interest-bearing transaction account rates. The average rate paid on interest-bearing deposits was 1.10% for the year ended December 31, 2018, an increase of 36 basis points from 0.74% for the year ended December 31, 2017. Year ended December 31, 2017, compared to year ended December 31, 2016 Net interest income for the year ended December 31, 2017, was $130.3 million, a $9.6 million, or 8.0%, increase from $120.7 million for the year ended December 31, 2016. The increase was primarily the result of increased yields earned, and to a lesser extent, increases in the average balances in our loan portfolio. The average yield on our loan portfolio for the year ended December 31, 2017, was 4.37%, a 27 basis point increase from 4.10% for the year ended December 31, 2016. The increase in yield earned on our loan portfolio was attributed to a mix of fewer nonperforming loans which resulted in higher interest earned and increases in the interest rate environment during 2017, but was partially offset by increased rates for our interest-bearing liabilities. During 2016, credit deterioration in our energy lending portfolio resulted in a downward impact of 15 basis points to the total yield on our loan portfolio. During 2017, our energy lending portfolio resulted in a downward impact of three basis points to the total yield on our loan portfolio. In 2017, we executed on our strategy to manage the reduction in our energy loan portfolio through the sale of certain remaining energy loans. We had no energy loans held for sale at December 31, 2017, and we do not expect significant losses on energy loan sales in the future. The average cost of our interest-bearing liabilities for the year ended December 31, 2017, was 0.82%, an increase of 14 basis points from 0.68% for the year ended December 31, 2016. The increase in the cost of interest-bearing liabilities was primarily attributed to rises in the interest rate environment, which increase our costs to retain and attract deposits. For the year ended December 31, 2017, our net interest margin increased by 14 basis points to 3.42% from 3.28% for the year ended December 31, 2016. The following table presents average balance sheet information, interest income, interest expense and the corresponding average yields earned and rates paid for the years ended December 31, 2018, 2017 and 2016. ____________________________ (1) Nonaccrual loans are included in their respective loan category for the purpose of calculating the yield earned. All average balances are daily average balances. (2) Yields earned and rates paid are calculated at the portfolio level using the actual number of days in the year, except for our securities, consumer real estate and held for sale loan portfolios, which are calculated using 360 days in a year. Yields earned are calculated net of deferred fees and costs. (3) Includes Government National Mortgage Association ("GNMA") repurchase average balances of $30.1 million, $26.1 million and $15.3 million for the years ended December 31, 2018, 2017 and 2016, respectively. The GNMA repurchase asset and liability are recorded as equal offsetting amounts in the consolidated balance sheets, with the asset included in loans held for sale and the liability included in FHLB advances and other borrowings. For more information on the GNMA repurchase option, see Note 8 - Mortgage Banking in the notes to our consolidated financial statements. (4) Net interest spread is the average yield on interest-earning assets minus the average rate on interest-bearing liabilities. (5) In order to present pre-tax income and resulting yields on tax-exempt investments comparable to those on taxable investments, a tax-equivalent adjustment has been computed. This adjustment also includes income tax credits received on Qualified School Construction Bonds. Income from tax-exempt investments and tax credits were computed using a Federal income tax rate of 21% for the year ended December 31, 2018, and 35% for the years ended December 31, 2017 and 2016. The tax-equivalent net interest margin would have been 3.49% and 3.35% for the years ended December 31, 2017 and 2016, respectively, if we had been subject to the 21% Federal income tax rate enacted for 2018, in the Tax Cuts and Jobs Act. Rate/Volume Analysis The following tables present the dollar amount of changes in interest income and interest expense for major components of interest-earning assets and interest-bearing liabilities. It distinguishes between the changes related to outstanding balances and those due to changes in interest rates. The change in interest attributable to rate changes has been determined by applying the change in rate between periods to average balances outstanding in the earlier period. The change in interest due to volume has been determined by applying the rate from the earlier period to the change in average balances outstanding between periods. For purposes of this table, changes attributable to both rate and volume that cannot be segregated have been allocated to rate. Provision for Credit Losses The provision for credit losses, which includes both the provision for loan losses and provision for off-balance sheet commitments, is based on management's assessment of the adequacy of both our allowance for loan losses and our reserve for off-balance sheet lending commitments. Factors impacting the provision include inherent risk characteristics in our loan portfolio, the level of nonperforming loans and net charge-offs, both current and historic, local economic and credit conditions, the direction of the change in collateral values, and the funding probability on unfunded lending commitments. The provision for credit losses is charged against earnings in order to maintain our allowance for loan losses, which reflects management's best estimate of probable losses inherent in our loan portfolio at the balance sheet date, and our reserve for off-balance sheet lending commitments, which reflects management's best estimate of probable losses inherent in our legally binding lending-related commitments. Year ended December 31, 2018, compared to year ended December 31, 2017 We recorded provision expense of $1.0 million for the year ended December 31, 2018, a $7.3 million decrease from provision expense of $8.3 million for the year ended December 31, 2017. The decrease in provision expense was due to improvement in the overall credit quality of our loan portfolio, including reductions in specific reserves on certain collateral-dependent impaired loans during 2018. Our allowance for loan losses was 0.90% of total loans held for investment at December 31, 2018, compared to 1.14% at December 31, 2017. Specific reserves on impaired loans totaled $366,000 at December 31, 2018, compared to $4.8 million at December 31, 2017. General reserves totaled $33.8 million, or 0.89% of total loans held for investment at December 31, 2018, compared to $32.3 million, or 1.00% at December 31, 2017. Year ended December 31, 2017, compared to year ended December 31, 2016 The provision for credit losses for the year ended December 31, 2017, was $8.3 million, a decrease of $21.7 million, or 72.3%, from $30.1 million for the year ended December 31, 2016. The decrease in provision expense was driven by significant provision expense recorded in 2016 on our energy lending portfolio. Of the 2016 provision expense, $31.7 million was attributable to deterioration in our energy loan portfolio due to the decline in the price of oil and resulting downturn in the energy sector, partially offset by a net recovery in the remainder of our loan portfolio. Net charge-offs for the twelve months ended December 31, 2017, were $21.7 million compared to $21.9 million for same period in 2016, while net charge-offs for the energy portfolio were $14.6 million and $22.7 million for the same periods, respectively. Our energy portfolio totaled $54.3 million at December 31, 2017, compared to $151.0 million at December 31, 2016. Noninterest Income Our primary sources of recurring noninterest income are service charges on deposit accounts, mortgage banking revenue, insurance commission and fee income, and other fee income. The table below presents the various components of and changes in our noninterest income for the periods indicated. Year ended December 31, 2018, compared to year ended December 31, 2017 Noninterest income for the year ended December 31, 2018, increased by $12.1 million, or 41.3%, to $41.2 million, compared to $29.2 million for the year ended December 31, 2017. The increase in noninterest income during the year ended December 31, 2018, was largely driven by $12.7 million in losses incurred on non-mortgage loans held for sale in 2017, with no comparable expense incurred during 2018. Other contributing factors were increases in other income and insurance commission and fee income of $3.4 million and $2.5 million, respectively. The most significant driver of the increase in other noninterest income for the year ended December 31, 2018, compared to 2017, was a positive valuation adjustment of $2.0 million on a common stock investment due to a recent accounting standard change. For more information on this accounting standard update, please refer to Note 1 - Significant Accounting Policies in the notes to the consolidated financial statements. The increase in insurance commission and fee income was primarily driven by the RCF acquisition in July 2018, which significantly expanded the Company's insurance presence in the North Louisiana market. Partially offsetting the net increase in noninterest income was a $6.2 million decrease in mortgage banking revenue. This decrease was primarily due to a 67.2% decline in the volume of mortgage loans sold, resulting in a $5.0 million decrease in gains on the sale of mortgage loans. The reduction in volume was primarily driven by the closing of a loan production office outside of our core geographic footprint that accounted for a significant portion of mortgage production, as we shifted our focus to retail originations within our core geographic banking footprint. Also contributing to the decrease in volume on mortgage loans sold was a broader downturn in the mortgage industry. As part of this strategy, we also reduced the amount of third party originations in our mortgage pipeline during 2018 compared to 2017. Year ended December 31, 2017, compared to year ended December 31, 2016 Noninterest income was $29.2 million, representing a decrease of $12.7 million, or 30.3%, compared to the year ended December 31, 2016. The decrease in noninterest income during the year ended December 31, 2017, was primarily driven by $12.7 million in losses incurred on non-mortgage loans held for sale in 2017, with no comparable expense incurred during 2016. In addition, other income decreased by $2.5 million, or 38.6%, to $4.1 million for the year ended December 31, 2017, compared to $6.6 million for the year ended December 31, 2016. The decrease was primarily a result of a decrease in limited partnership income of $2.3 million. During the year ended December 31, 2016, we recognized a gain of $1.9 million as a result of the sale of certain assets held in one of our limited partnership investments. Excluding this gain, we recorded income from our limited partnerships of $893,000 for the year ended December 31, 2016, compared to income of $444,000 for the year ended December 31, 2017. The investment partnerships are Small Business Investment Companies, and our investments in these partnerships provide us credit toward our requirements under the Community Reinvestment Act. Partially offsetting the net decrease in noninterest income during the year ended December 31, 2017, compared to 2016, was a $1.6 million increase in gains on sale and disposal of other assets. This was driven by the sale of a bank-owned tract of vacant land in 2017 for a gain of $1.5 million, with no corresponding sale during 2016. Noninterest Expense The following table presents the significant components of noninterest expense for the periods indicated: Year ended December 31, 2018, compared to year ended December 31, 2017 Noninterest expense increased by $562,000, or 0.4%, in 2018 to $131.2 million, primarily due to increases in salaries and employee benefits, advertising and marketing expenses and other noninterest expense. Salaries and employee benefits increased by $9.6 million, or 13.6%, for the year ended December 31, 2018, compared to 2017. The increase was driven by increases in the cost of salaries and incentive compensation. The increase in salary expense was driven by the addition of our Houston lift-out team, consummation of the RCF acquisition and additional headcount to support our recent growth. The increase in incentive compensation was driven by the overall improvement in the Company's performance during 2018 compared to 2017, which resulted in performance targets, such as return on assets, individual loan volume and credit quality goals, being met by more employees. The $1.4 million, or 46.3%, increase in advertising and marketing expense for the year ended December 31, 2018, compared to 2017, was due to a Company-wide expense management strategy that temporarily scaled back marketing expenditures in 2017. In March 2018, marketing efforts were resumed with the launch of a new advertising campaign. Other noninterest expense increased by $1.0 million, or 23.7%, during the year ended December 31, 2018, compared to 2017. The most significant driver was intangible asset amortization expense, which increased by $352,000 due to the RCF acquisition in 2018. These increases were partially offset by decreases of $10.0 million, $1.5 million and $1.4 million in litigation settlement expenses, professional services and loan related expenses, respectively. During the year ended December 31, 2017, we entered into a Settlement and Release Agreement with respect to litigation with the ResCap Liquidating Trust ("ResCap"), as successor to Residential Funding Company, LLC f/k/a Residential Funding Corporation. Under the agreement, we paid $10.0 million to fully resolve all claims under the lawsuit and to avoid the further costs, disruption and distraction of defending the ResCap litigation. We recorded a charge to non-interest expense in our consolidated statement of income in 2017 to recognize this settlement. There were no such charges recorded during the year ended December 31, 2018. During the year ended December 31, 2017, we incurred approximately $883,000 in consulting fees related to the marketing and sale of certain energy loans as part of our strategic initiative to reduce our exposure to nonperforming energy loans, and incurred approximately $613,000 in legal fees that were associated with the resolution of the ResCap litigation. Neither of these expenses were incurred during the year ended December 31, 2018. The largest driver of the decrease in loan related expenses was a $544,000 decrease in loan related legal fees. During 2017, the Company incurred legal costs in conjunction with the marketing and sale of energy loans which were not incurred during 2018. The remaining decreases in loan related expenses were not individually significant and generally resulted from a lower volume of mortgage loans sold during 2018 compared to 2017. Year ended December 31, 2017, compared to year ended December 31, 2016 Noninterest expense for the year ended December 31, 2017, increased by $14.0 million, or 12.0% to $130.7 million, compared to $116.7 million for the year ended December 31, 2016. The increase was primarily due to increases in litigation settlement expense and salaries and employee benefit expense. As discussed above, during the year ended December 31, 2017, we entered into a Settlement and Release Agreement with respect to litigation with ResCap. Under the agreement, we paid $10.0 million to fully resolve all claims under the lawsuit. Salaries and employee benefit expense increased $7.3 million, or 11.4%, during the year ended December 31, 2017, compared to 2016. The amount of salary expenses deferred as loan origination costs in 2017 declined by $3.0 million compared to 2016 due to updating our estimates of costs to originate loans, as well as a change in the mix of loans originated in 2017 compared to 2016. Salary expense also increased by $1.7 million during the year ended December 31, 2017, compared to the same period in 2016, primarily as a result of increases in headcount and annual raises. Incentive compensation expense increased by $1.2 million during the year ended December 31, 2017, compared to 2016, primarily as a result of improvements in financial performance in relation to established metrics. These increases were partially offset by decreases in occupancy and equipment and other noninterest expense. Occupancy and equipment expense decreased by $1.2 million or 7.1% for the year ended December 31, 2017, compared to 2016, primarily as a result of a decrease in depreciation expense relating to leasehold improvements and furniture, fixtures and equipment as several significant items became fully depreciated during the third and fourth quarter of 2016, resulting in lower depreciation expense in 2017. Other noninterest expense decreased by $1.5 million, or 25.8%, during the year ended December 31, 2017, compared to 2016. The majority of the decrease was due to lower amortization expense on our deposit-based and relationship-based intangible assets during 2017 as two significant deposit-based intangibles became fully amortized during the fourth quarter of 2016. Amortization expense for the year ended December 31, 2017, was $518,000 compared to $1.5 million in 2016. Income Tax Expense For the year ended December 31, 2018, we recognized income tax expense of $10.8 million, compared to $5.8 million and $2.9 million for the years ended December 31, 2017 and 2016, respectively. Our effective tax rate for the year ended December 31, 2018, was 17.4% compared to 28.4% and 18.5% for the years ended December 31, 2017 and 2016, respectively. The decrease in our effective tax rate for the year ended December 31, 2018 was primarily the result of the Tax Cuts and Jobs Act ("Tax Act"), which was enacted on December 22, 2017. The Tax Act lowered the Federal corporate income tax rate to 21% from 35% for tax years beginning in 2018. The Tax Act also required a revaluation of the Company's net deferred tax asset ("DTA") to account for the future impact of lower corporate income tax rates and other provisions of the legislation. The revaluation of the Company's DTA balance resulted in a $282,000 adjustment from accumulated other comprehensive income to retained earnings. Our effective income tax rates have differed from the applicable U.S. statutory rates of 21% at December 31, 2018, and 35% for both December 31, 2017 and 2016, due to the effect of tax-exempt income from securities, low income housing and qualified school construction bond tax credits, tax-exempt income from life insurance policies and income tax effects associated with stock-based compensation. Because of these items, we expect our effective income tax rate to continue to remain below the applicable U.S. statutory rate. These tax-exempt items can have a larger than proportional effect on the effective income tax rate as net income decreases. Comparison of Financial Condition at December 31, 2018, and December 31, 2017 General Total assets increased by $667.6 million, or 16.1%, to $4.82 billion at December 31, 2018, from $4.15 billion at December 31, 2017. The increase was primarily attributable to increases in loans held for investment and securities available for sale of $548.1 million and $171.1 million, respectively, and was partially offset by a decrease of $70.5 million in cash and cash equivalents. Loan Portfolio Our loan portfolio is our largest category of interest-earning assets and interest income earned on our loan portfolio is our primary source of income. At December 31, 2018, 71.5% of the loan portfolio held for investment was comprised of commercial and industrial loans, mortgage warehouse lines of credit and commercial real estate loans, which were primarily originated within our market areas of North Louisiana, Texas and Mississippi. The following table presents the ending balance of our loan portfolio held for investment by purpose category at the dates indicated. At December 31, 2018, total loans held for investment were $3.79 billion, an increase of $548.1 million, or 16.9%, compared to $3.24 billion at December 31, 2017. The increase was driven by organic growth in all markets and led by increases in commercial and industrial and commercial real estate loans. In 2018, as a complement to our organic growth strategy, several lift-out teams were on-boarded in our Houston market and seasoned lending professionals and relationship managers were recruited in our Dallas and Shreveport markets. Our Houston lift-out team was responsible for $130.3 million in loan growth during 2018. Loan Portfolio Maturity Analysis The table below presents the maturity distribution of our loans held for investment at December 31, 2018. The table also presents the portion of our loans that have fixed interest rates, rather than interest rates that fluctuate over the life of the loans based on changes in the interest rate environment. Nonperforming Assets Nonperforming assets consist of nonperforming loans and property acquired through foreclosures or repossession. Our nonperforming loans are comprised of nonaccrual loans and accruing loans that are contractually 90 days or more past due. Loans are considered past due when principal and interest payments have not been received at the date such payments are contractually due. We discontinue accruing interest on loans when we determine the borrower's financial condition is such that collection of interest and principal payments in accordance with the terms of the loan are not reasonably assured. Loans may be placed on nonaccrual status even if the contractual payments are not past due if information becomes available that causes substantial doubt about the borrower's ability to meet the contractual obligations of the loan. All interest accrued but not collected for loans that are placed on nonaccrual status is reversed against interest income. Interest income is subsequently recognized only to the extent cash payments are received in excess of principal outstanding. Loans are returned to accrual status when all principal and interest amounts contractually due are brought current and future payments are reasonably assured. If a loan is determined by management to be uncollectible, regardless of size, the portion of the loan determined to be uncollectible is then charged to the allowance for loan losses. We manage the quality of our lending portfolio in part through a disciplined underwriting policy and through continual monitoring of loan performance and borrowers' financial condition. There can be no assurance, however, that our loan portfolio will not become subject to losses due to declines in economic conditions or deterioration in the financial condition of our borrowers. The following schedule shows our nonperforming loans and nonperforming assets at the dates indicated: At December 31, 2018, total nonperforming loans increased by $8.8 million, or 37.0%, over December 31, 2017, primarily due to downgrades associated with three commercial lending relationships, the largest of which was a $6.3 million commercial real estate loan secured by a health care facility that was reclassified to nonaccrual status due to the facility experiencing lower than expected occupancy rates. The increase in other real estate owned was caused by the closure and reclassification, from premises and equipment to other real estate owned, of one of our branch locations valued at $2.8 million, and subsequently listing the property for sale. Despite the increase in total nonperforming loans, we continue to see improvement in our overall credit profile as disclosed in Note 4 - Loans within our consolidated financial statements, driven by downward trends in impaired and past due loans. Potential Problem Loans From a credit risk standpoint, we classify loans in one of five categories: pass, special mention, substandard, doubtful or loss. The classifications of loans reflect a judgment about the risks of default and loss associated with the loan. We review the ratings on loans and adjust them to reflect the degree of risk and loss that is felt to be inherent in each loan. The methodology is structured so that reserve allocations are increased in accordance with deterioration in credit quality (and a corresponding increase in risk and loss) or decreased in accordance with improvement in credit quality (and a corresponding decrease in risk and loss). Loans rated special mention reflect borrowers who exhibit credit weaknesses or downward trends deserving close attention. If left uncorrected, these potential weaknesses may result in deterioration of the repayment prospects for the asset or in the bank's credit position at some future date. While potentially weak, no loss of principal or interest is envisioned and these borrowers currently do not pose sufficient risk to warrant adverse classification. Loans rated substandard are those borrowers with deteriorating trends and well-defined weaknesses that jeopardize the orderly liquidation of debt. A substandard loan is inadequately protected by the current sound worth and paying capacity of the obligor or by the collateral pledged, if any. Normal repayment from the borrower might be in jeopardy, although no loss of principal is envisioned. Loans rated as doubtful have the weaknesses of substandard assets with the additional characteristic that the weaknesses make collection or liquidation in full questionable and there is a high probability of loss based on currently existing facts, conditions and values. Loans classified as loss are charged-off and we have no expectation of the recovery of any payments in respect to loans rated as loss. Information regarding the internal risk ratings of our loans at December 31, 2018, is included in Note 4 - Loans in the notes to our consolidated financial statements contained in Item 8 of this report. Allowance for Loan Losses We maintain an allowance for loan losses that represents management's estimate of loan losses inherent within the portfolio of loans held for investment at the respective balance sheet date. The allowance for loan losses is maintained at a level which management believes is adequate to absorb all existing probable losses on loans in the loan portfolio. The amount of the allowance for loan losses should not be interpreted as an indication that charge-offs in future periods will necessarily occur in those amounts, or at all. In determining the allowance for loan losses, we estimate losses on specific loans, or groups of loans, where the probable loss can be identified and reasonably determined. The balance of the allowance for loan losses is based on internally assigned risk classifications of loans, historical loan loss rates, changes in the nature of the loan portfolio, overall portfolio quality, industry concentrations, delinquency trends, current economic factors and the estimated impact of current economic conditions on certain historical loan loss rates. The amount of the allowance is affected by loan charge-offs, which decrease the allowance, recoveries on loans previously charged off, which increase the allowance, as well as the provision for loan losses charged to income, which increases the allowance. We allocate the allowance for loan losses either to specific allocations, or general allocations for each major loan category. In determining the provision for loan losses, management monitors fluctuations in the allowance resulting from actual charge-offs and recoveries and to periodically review the size and composition of the loan portfolio in light of current and anticipated economic conditions. If actual losses exceed the amount of allowance for loan losses, it could materially and adversely affect our earnings. As a general rule, when it becomes evident that the full principal and accrued interest of a loan may not be collected, or at 90 days past due, we will reflect that loan as nonperforming. It will remain nonperforming until it performs in a manner that it is reasonable to expect that we will collect principal and accrued interest in full. When the amount or likelihood of a loss on a loan has been confirmed, a charge-off should be taken in the period it is determined. We establish general allocations for each major loan category and credit quality. The general allocation is based, in part, on historical charge-off experience and the expected loss given default, derived from our internal risk rating process. Other adjustments may be made to the allowance for pools of loans after an assessment of internal or external influences on credit quality that are not fully reflected in the historical loss or risk rating data. We give consideration to trends, changes in loan mix, delinquencies, prior losses and other related information. In connection with the review of our loan portfolio, we consider risk elements attributable to particular loan types or categories in assessing the quality of individual loans. Some of the risk elements we consider include: • for commercial real estate loans, the debt service coverage ratio, operating results of the owner in the case of owner occupied properties, the loan to value ratio, the age and condition of the collateral and the volatility of income, property value and future operating results typical of properties of that type; • for construction, land and land development loans, the perceived feasibility of the project including the ability to sell developed lots or improvements constructed for resale or the ability to lease property constructed for lease, the quality and nature of contracts for presale or prelease, if any, experience and ability of the developer and loan to value ratio; • for residential mortgage loans, the borrower's ability to repay the loan, including a consideration of the debt to income ratio and employment and income stability, the loan-to-value ratio, and the age, condition and marketability of the collateral; and • for commercial and industrial loans, the debt service coverage ratio (income from the business in excess of operating expenses compared to loan repayment requirements), the operating results of the commercial, industrial or professional enterprise, the borrower's business, professional and financial ability and expertise, the specific risks and volatility of income and operating results typical for businesses in that category and the value, nature and marketability of collateral. The following table presents the allowance for loan loss by loan category: ____________________________ (1) Represents the ratio of each loan type to total loans held for investment. Our allowance for loan losses decreased by $2.9 million, or 7.8%, to $34.2 million at December 31, 2018, from $37.1 million at December 31, 2017. The ratio of allowance for loan losses to total loans held for investment at December 31, 2018, and December 31, 2017, was 0.90% and 1.14%, respectively. The decrease in the total allowance for loan losses was driven primarily by a $4.4 million decrease in specific reserves that was partially offset by a $1.5 million increase in general reserves due to significant growth in our loan portfolio. Our specific reserve was $366,000, or 0.01% of total loans held for investment at December 31, 2018, compared to $4.8 million, or 0.15% of total loans held for investment at December 31, 2017. Our general reserve totaled $33.8 million and $32.3 million at December 31, 2018, and 2017, respectively. The following table presents an analysis of the allowance for loan losses and other related data as of the periods indicated. Securities Our securities portfolio is the second largest component of earning assets and provides a significant source of revenue. We use the securities portfolio to provide a source of liquidity, provide an appropriate return on funds invested, manage interest rate risk and meet collateral as well as regulatory capital requirements. We manage the securities portfolio to optimize returns while maintaining an appropriate level of risk. Securities within the portfolio are classified as either held-to-maturity, available-for-sale or at fair value through income, based on the intent and objective of the investment and the ability to hold to maturity. Unrealized gains and losses arising in the available for sale portfolio as a result of changes in the fair value of the securities are reported on an after-tax basis as a component of accumulated other comprehensive income in stockholders' equity while securities classified as held to maturity are carried at amortized cost. For further discussion of the valuation components and classification of investment securities, see Note 1 - Significant Accounting Policies in the consolidated financial statements contained in Item 8 of this report. Our securities portfolio totaled $606.2 million at December 31, 2018, representing an increase of $169.4 million, or 38.8%, from $436.8 million at December 31, 2017. During the quarter ended September 30, 2018, we borrowed $250.0 million from the Federal Home Loan Bank of Dallas ("FHLB") to fund loan growth and manage short-term liquidity. However, the portion not utilized to repay higher rate advances was re-deployed into higher yielding interest earning assets such as loans, investment securities and interest bearing cash accounts. For additional information regarding our securities portfolio, please see Note 3 - Securities in the consolidated financial statements contained in Item 8 of this report. The following table sets forth the composition of our securities portfolio at the dates indicated. The following table presents the fair value of securities available for sale and amortized cost of securities held to maturity and their corresponding yields at December 31, 2018. The securities are grouped by contractual maturity and use amortized cost for all yield calculations. Mortgage backed securities and collateralized mortgage obligations, which do not have contractual payments due at a single maturity date, are shown at the date the last underlying mortgage matures. The contractual maturity of mortgage-backed securities and collateralized mortgage obligations is not a reliable indicator of their expected life because borrowers have the right to prepay their obligations at any time. Mortgage-backed securities and collateralized mortgage obligations are typically issued with stated principal amounts and are backed by pools of mortgage loans and other loans with varying maturities. The term of the underlying mortgages and loans may vary significantly due to the ability of a borrower to prepay outstanding amounts. Monthly pay downs on mortgage-backed securities tend to cause the average life of the securities to be much different than the stated contractual maturity. During a period of increasing interest rates, fixed rate mortgage-backed securities do not tend to experience heavy prepayments of principal, and, consequently, the average life of this security is typically lengthened. If interest rates begin to fall, prepayments may increase, thereby shortening the estimated average life of this security. Other than securities issued by government agencies or government sponsored enterprises, we did not own securities of any one issuer for which aggregate adjusted cost exceeded 10.0% of consolidated stockholders' equity at December 31, 2018, or December 31, 2017. Additionally, we do not hold any Fannie Mae or Freddie Mac preferred stock, collateralized debt obligations, structured investment vehicles or second lien elements in the investment portfolio, nor does the investment portfolio contain any securities that are directly backed by subprime or Alt-A mortgages. Securities Carried at Fair Value through Income At December 31, 2018, and 2017, we held two fixed-rate community investment bonds totaling $11.4 million and $12.0 million, respectively. We elected the fair value option on these securities to offset corresponding changes in the fair value of related interest rate swap agreements. Deposits Deposits are the primary funding source used to fund our loans, investments and operating needs. We offer a variety of products designed to attract and retain both consumer and commercial deposit customers. These products consist of noninterest and interest-bearing checking accounts, savings deposits, money market accounts and time deposits. Deposits are primarily gathered from individuals, partnerships and corporations in our market areas. We also obtain deposits from local municipalities. Our policy also permits the acceptance of brokered deposits on a limited basis, and our current deposits labeled as brokered are relationship-based accounts that we believe are stable. We manage our interest expense on deposits through specific deposit product pricing that is based on competitive pricing, economic conditions and current and anticipated funding needs. We may use interest rates as a mechanism to attract or deter additional deposits based on our anticipated funding needs and liquidity position. We also consider potential interest rate risk caused by extended maturities of time deposits when setting the interest rates in periods of future economic uncertainty. The following table presents our deposit mix at the dates indicated: ____________________________ (1) Brokered time deposits of $7.9 million are included in the brokered category for December 31, 2018. The following schedule reflects the classification of our average deposits and the average rate paid on each deposit category for the periods indicated: Our average deposit balance was $3.66 billion for the year ended December 31, 2018, an increase of $200.0 million, or 5.8%, from $3.46 billion for the year ended December 31, 2017. This increase is primarily due to our continued relationship-based efforts to attract deposits within our markets. The average annualized rate paid on our interest-bearing deposits for the year ended December 31, 2018, was 1.10%, compared to 0.74% for the year ended December 31, 2017. The increase in the average cost of our deposits was primarily the result of increases in market interest rates that occurred during 2018, which caused us to increase the interest rates we paid on deposits to remain competitive with other depository institutions in our markets. Average noninterest-bearing deposits at December 31, 2018, were $948.6 million, compared to $841.4 million at December 31, 2017, an increase of $107.2 million, or 12.7%, and represented 25.9% and 24.3% of average total deposits for the years ended December 31, 2018, and 2017, respectively. The following table presents the maturity distribution of our time deposits as of December 31, 2018: ____________________________ (1) Includes $7.9 million of brokered time deposits. Borrowings Long-term and short-term advances from the FHLB increased by $198.7 million and $100.0 million, respectively, at December 31, 2018, compared to December 31, 2017. The increase in long-term advances was due to a $250.0 million FHLB advance obtained in the third quarter of 2018, which was re-deployed into higher yielding interest-earning assets and to replace existing higher rate FHLB advances. Short-term FHLB advances were utilized to provide short-term liquidity as we experienced a delay in the receipt of bank deposits from state and local municipalities compared to the timing of historical cash inflows. The short-term liquidity demand was driven primarily by significant loan growth during the fourth quarter of 2018. Borrowed funds are summarized as follows: ____________________________ (1) Includes an FHLB advance of $250.0 million at December 31, 2018, which has a final maturity in 2033 that may be called quarterly at the option of the FHLB beginning in the third quarter of 2019. Overnight repurchase agreements with depositors consist of obligations of ours to depositors and mature on a daily basis. These obligations to depositors carried a daily average interest rate of 0.86% and 0.29% for the years ended December 31, 2018 and 2017, respectively. Our long-term debt consists of advances from the FHLB with original maturities greater than one year. Interest rates for FHLB long-term advances outstanding at December 31, 2018, ranged from 1.65% to 5.72% and were subject to restrictions or penalties in the event of prepayment. As of December 31, 2018, we held 16 unfunded letters of credit from the FHLB totaling $186.6 million with expiration dates ranging from February 14, 2019, to November 30, 2020. These letters of credit either support pledges for our public fund deposits or confirm letters of credit we have issued to support our customers' businesses. Security for all indebtedness and outstanding commitments to the FHLB consists of a blanket floating lien on all of our first mortgage loans, commercial real estate and other real estate loans, as well as our investment in capital stock of the FHLB and deposit accounts at the FHLB. The net amounts available under the blanket floating lien as of December 31, 2018, and December 31, 2017, were $468.8 million and $649.0 million, respectively. Additionally, as of December 31, 2018, we had the ability to borrow $795.5 million from the discount window at the Federal Reserve Bank of Dallas ("FRB"), with $1.05 billion in commercial and industrial loans pledged as collateral. There were no borrowings against this line as of December 31, 2018. Liquidity Management oversees our liquidity position to ensure adequate cash and liquid assets are available to support our operations and satisfy current and future financial obligations, including demand for loan funding and deposit withdrawals. Management continually monitors, forecasts and tests our liquidity and non-core dependency ratios to ensure compliance with targets established by our Asset-Liability Management Committee and approved by our board of directors. Management measures our liquidity position by giving consideration to both on-balance sheet and off-balance sheet sources of and demands for funds on a daily and weekly basis. At December 31, 2018, and December 31, 2017, our cash and liquid securities totaled 5.0% and 5.7% of total assets, respectively, providing liquidity to support our existing operations. The Company, which is a separate legal entity apart from the Bank, must provide for its own liquidity, including payment of any dividends that may be declared for our common stockholders and interest and principal on any outstanding debt or trust preferred securities incurred by the Company. At December 31, 2018, and December 31, 2017, the Company had available cash balances of $5.9 million and $10.6 million, respectively. This cash is available for the general corporate purposes described above, as well as providing capital support to the Bank and financing potential future acquisitions. In addition, the Company has up to $50.0 million available under a line of credit. See Note 10 - Borrowings contained in Item 8 of this report for more information. There are regulatory restrictions on the ability of the Bank to pay dividends under federal and state laws, regulations and policies. See "Item 1. Business - Regulation and Supervision" above for more information. In addition to cash generated from operations, we utilize a number of funding sources to manage our liquidity, including core deposits, investment securities, cash and cash equivalents, loan repayments, federal funds lines of credit available from other financial institutions, as well as advances from the FHLB. We may also use the discount window at the FRB as a source of short-term funding. Core deposits, which are total deposits excluding time deposits greater than $250,000 and brokered deposits, are a major source of funds used to meet cash flow needs. Maintaining the ability to acquire these funds as needed in a variety of markets is the key to assuring our liquidity. The investment portfolio is another source for meeting our liquidity needs. Monthly payments on mortgage-backed securities are used for short-term liquidity, and our investments are generally traded in active markets that offer a readily available source of cash through sales, if needed. Securities in our investment portfolio are also used to secure certain deposit types, such as deposits from state and local municipalities. Other sources available for meeting liquidity needs include long- and short-term advances from the FHLB, and federal funds lines of credit. Long-term funds obtained from the FHLB are primarily used as an alternative source to fund long-term growth of the balance sheet by supporting growth in loans and other long-term interest-earning assets. We typically rely on such funding when the cost of such borrowings compares favorably to the rates that we would be required to pay for other funding sources, including certain deposits. See Note 10 - Borrowings contained in Item 8 of this report for additional borrowing capacity and outstanding advances at the FHLB. We also had unsecured federal funds lines of credit available to us, with no amounts outstanding at either date, please see Note 10 - Borrowings contained in Item 8 of this report for detail regarding our lines of credit. These lines of credit primarily provide short-term liquidity and in order to ensure availability of these funds, we test these lines of credit at least annually. Interest is charged at the prevailing market rate on federal funds purchased and FHLB advances. Additionally, we had the ability to borrow at the discount window of the FRB using our commercial and industrial loans as collateral. There were no borrowings against this line as of December 31, 2018. Off-Balance Sheet Arrangements and Contractual Obligations In the normal course of business as a financial services provider, we enter into financial instruments, such as certain contractual obligations and commitments to extend credit and letters of credit, to meet the financing needs of our customers. These commitments involve elements of credit risk, interest rate risk and liquidity risk. Some instruments may not be reflected in our consolidated financial statements until they are funded, and a significant portion of commitments to extend credit may expire without being drawn, although they expose us to varying degrees of credit risk and interest rate risk in much the same way as funded loans. The table below presents the funding requirements of our most significant financial commitments, excluding interest and purchase discounts, at the date indicated: ____________________________ (1) Included in the Greater than Five Years category is an FHLB advance of $250.0 million, which has a final maturity in 2033 that may be called quarterly at the option of the FHLB beginning in the third quarter of 2019. (2) These commitments represent amounts we are obligated to contribute to various limited partnership investments in accordance with the provisions of the respective limited partnership agreements. The capital contributions may be required at any time, and are therefore reflected in the Less than One Year category. Credit Related Commitments Commitments to extend credit include revolving commercial credit lines, non-revolving loan commitments issued mainly to finance the acquisition and development or construction of real property or equipment, and credit card and personal credit lines. The availability of funds under commercial credit lines and loan commitments generally depends on whether the borrower continues to meet credit standards established in the underlying contract and has not violated other contractual conditions. Loan commitments generally have fixed expiration dates or other termination clauses and may require payment of a fee by the borrower. Credit card and personal credit lines are generally subject to cancellation if the borrower's credit quality deteriorates. A number of commercial and personal credit lines are used only partially or, in some cases, not at all before they expire, and the total commitment amounts do not necessarily represent future cash requirements. A substantial majority of the letters of credit are standby agreements that obligate us to fulfill a customer's financial commitments to a third party if the customer is unable to perform. We issue standby letters of credit primarily to provide credit enhancement to our customers' other commercial or public financing arrangements and to help them demonstrate financial capacity to vendors of essential goods and services. The table below presents our commitments to extend credit by commitment expiration date for the date indicated: ____________________________ (1) Includes $360.2 million of unconditionally cancellable commitments at December 31, 2018. Stockholders' Equity Stockholders' equity provides a source of permanent funding, allows for future growth and provides a degree of protection to withstand unforeseen adverse developments. At December 31, 2018, stockholders' equity was $549.8 million, representing an increase of $94.5 million, or 20.8%, compared to $455.3 million at December 31, 2017. Initial Public Offering In May 2018, we completed the initial public offering of our common stock at a price to the public of $34.00 per share. We issued 3,045,426 shares in the offering, including 545,426 shares sold at the option of the underwriters, and certain selling stockholders sold 1,136,176 shares in the offering. We received net proceeds of $96.3 million, before expenses, in the offering. Our common stock became eligible for trading on May 9, 2018, on the Nasdaq Global Select Market under the symbol "OBNK." RCF Acquisition In July 2018, we acquired RCF, a Louisiana-based independent insurance agency, issuing 66,824 shares of our common stock at a price of $40.50 per share. Common stock outstanding and additional paid in capital increased by $334,000 and $2.4 million, respectively, in partial consideration of the acquisition. Preferred Stock In 2018, we redeemed all of the 48,260 shares of our Senior Non-Cumulative Perpetual Preferred Stock, Series SBLF ("SBLF Preferred Stock"). The aggregate redemption price of the SBLF Preferred Stock was $49.1 million, which included accrued dividends of $808,000. The SBLF Preferred Stock was redeemed from our surplus capital, which included the proceeds of our initial public offering and terminated our participation in the Small Business Lending Fund program. During 2018, all of the 901,644 shares of our outstanding Series D preferred stock were converted into shares of our common stock, on a one-for-one basis. As a result, no shares of Series D preferred stock were outstanding at December 31, 2018. Regulatory Capital Requirements Together with the Bank, we are subject to various regulatory capital requirements administered by federal banking agencies. These requirements are discussed in greater detail in "Item 1. Business - Regulation and Supervision". Failure to meet minimum capital requirements may result in certain actions by regulators that, if enforced, could have a direct material effect on our financial statements. At December 31, 2018 and 2017, we and the Bank were in compliance with all applicable regulatory capital requirements, and the Bank was classified as "well capitalized" for purposes of the prompt corrective action regulations of the Federal Deposit Insurance Corporation. As we deploy capital and continue to grow operations, regulatory capital levels may decrease depending on the level of earnings. However, we expect to monitor and control growth in order to remain "well capitalized" under applicable regulatory guidelines and in compliance with all applicable regulatory capital standards. The following table presents our regulatory capital ratios, as well as those of the Bank, at the dates indicated:

<s>[INST] The following discussion and analysis should be read in conjunction with our consolidated financial statements and related notes contained in Item 8 of this report. To the extent that this discussion describes prior performance, the descriptions relate only to the periods listed, which may not be indicative of our future financial outcomes. In addition to historical information, this discussion contains forwardlooking statements that involve risks, uncertainties and assumptions that could cause results to differ materially from management's expectations. Factors that could cause such differences are discussed in the sections titled "Cautionary Note Regarding ForwardLooking Statements" and "Item 1A. Risk Factors." We assume no obligation to update any of these forwardlooking statements. Critical Accounting Estimates Our consolidated financial statements are prepared in accordance with United States generally accepted accounting principles ("GAAP") and with general practices within the financial services industry. Application of these principles requires management to make estimates and assumptions that affect the amounts reported in the financial statements and accompanying notes. We base our estimates on historical experience and on various other assumptions that we believe to be reasonable under current circumstances. These assumptions form the basis for our judgments about the carrying values of assets and liabilities that are not readily available from independent, objective sources. We evaluate our estimates on an ongoing basis. Use of alternative assumptions may have resulted in significantly different estimates. Actual results may differ from these estimates. Please refer to Note 1 Significant Accounting Policies to our consolidated financial statements contained in Item 8 of this report for a full discussion of our accounting policies, including estimates. We have identified the following accounting estimates that, due to the difficult, subjective or complex judgments and assumptions inherent in those estimates and the potential sensitivity of the financial statements to those judgments and assumptions, are critical to an understanding of our financial condition and results of operations. We believe that the judgments, estimates and assumptions used in the preparation of the financial statements are appropriate. Allowance for Loan Losses. Our allowance for loan losses is established as losses are estimated to have occurred through a provision for loan losses charged to earnings. Subsequent recoveries, if any, are credited to the allowance. The allowance for loan losses is evaluated on a regular basis by management and is based upon management's periodic review of the collectability of the loans in light of historical experience, the nature and volume of the loan portfolio, adverse situations that may affect the borrower's ability to repay, estimated value of any underlying collateral, and prevailing economic conditions. This evaluation is inherently subjective as it requires estimates that are susceptible to significant revision as more information becomes available. Loans are charged against the allowance for loan losses when management believes the loss is confirmed. Mortgage Servicing Rights. We recognize as assets the rights to service mortgage loans based on the estimated fair value of the Mortgage Servicing Right ("MSR") when loans are sold and the associated servicing rights are retained. We elected to account for the MSR at fair value. The fair value of the MSR is determined using a valuation model administered by a third party that calculates the present value of estimated future net servicing income. The model incorporates assumptions that market participants use in estimating future net servicing income, including estimates of prepayment speeds, discount rate, default rates, cost to service (including delinquency and foreclosure costs), escrow account earnings, contractual servicing fee income and other ancillary income such as late fees. Management reviews all significant assumptions quarterly. Mortgage loan prepayment speeds, a key assumption in the model, is the annual rate at which borrowers are forecasted to repay their mortgage loan principal. The discount rate used to determine the present value of estimated future net servicing income, another key assumption in the model, is an estimate of the rate of return investors in the market would require for an asset with similar risk. Both assumptions can, and generally will, change as market conditions and interest rates change. An increase in either the prepayment speed or discount rate assumption will result in a decrease in the fair value of the MSR, while a decrease in either assumption will result in an increase in the fair value of the MSR. In recent years, there have been significant marketdriven fluctuations in loan prepayment speeds and discount rates. These fluctuations can be rapid and may continue to be significant. Therefore, estimating prepayment speed and/or discount rates within ranges that market participants would use in [/INST] Negative. </s>

Origin Bancorp, Inc.

2020-02-28

2019-12-31

Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations The following discussion and analysis presents our financial condition and results of operations on a consolidated basis. However, we conduct all of our material business operations through our wholly owned bank subsidiary, Origin Bank, and the discussion and analysis that follows primarily relates to activities conducted at the Bank level. The following discussion and analysis should be read in conjunction with our consolidated financial statements and related notes contained in Item 8 of this report. To the extent that this discussion describes prior performance, the descriptions relate only to the periods listed, which may not be indicative of our future financial outcomes. In addition to historical information, this discussion contains forward-looking statements that involve risks, uncertainties and assumptions that could cause results to differ materially from management's expectations. Factors that could cause such differences are discussed in the sections titled "Cautionary Note Regarding Forward-Looking Statements" and "Item 1A. Risk Factors." We assume no obligation to update any of these forward-looking statements. Critical Accounting Policies and Estimates Our consolidated financial statements are prepared in accordance with U.S. GAAP and with general practices within the financial services industry. Application of these principles requires management to make estimates and assumptions that affect the amounts reported in the financial statements and accompanying notes. We base our estimates on historical experience and on various other assumptions that we believe to be reasonable under current circumstances. These assumptions form the basis for our judgments about the carrying values of assets and liabilities that are not readily available from independent, objective sources. We evaluate our estimates on an ongoing basis. Use of alternative assumptions may have resulted in significantly different estimates. Actual results may differ from these estimates. Please refer to Note 1 - Significant Accounting Policies to our consolidated financial statements contained in Item 8 of this report for a full discussion of our accounting policies, including estimates. We have identified the following accounting estimates that, due to the difficult, subjective or complex judgments and assumptions inherent in those estimates and the potential sensitivity of the financial statements to those judgments and assumptions, are critical to an understanding of our financial condition and results of operations. We believe that the judgments, estimates and assumptions used in the preparation of the financial statements are appropriate. Allowance for Loan Losses. Our allowance for loan losses is established as losses are estimated to have occurred through a provision for loan losses charged to earnings. Subsequent recoveries, if any, are credited to the allowance. The allowance for loan losses is evaluated on a regular basis by management and is based upon management's periodic review of the collectability of the loans in light of historical experience, the nature and volume of the loan portfolio, adverse situations that may affect the borrower's ability to repay, estimated value of any underlying collateral, and prevailing economic conditions. This evaluation is inherently subjective as it requires estimates that are susceptible to significant revision as more information becomes available. Loan losses are charged against the allowance for loan losses when management believes the loss is confirmed. In addition, beginning January 1, 2020, our methodology for determining our allowance for loan losses changed due to the implementation of the CECL, accounting standard. As a result, we recognized a one-time, after tax cumulative effect adjustment of $760,000 to retained earnings at the beginning of the first quarter of 2020, increasing the allowance for credit losses by approximately $1.3 million and decreasing the off-balance sheet reserve by $382,000. Our adjustment to the allowance for credit losses at the transition date may vary from our estimate due to refinements in the loss estimation models or factors. Mortgage Servicing Rights. We recognize the rights to service mortgage loans based on the estimated fair value of the Mortgage Servicing Right ("MSR") when loans are sold and the associated servicing rights are retained. We elected to account for the MSR at fair value. The fair value of the MSR is determined using a valuation model administered by a third party that calculates the present value of estimated future net servicing income. The model incorporates assumptions that market participants use in estimating future net servicing income, including estimates of prepayment speeds, discount rate, default rates, cost to service (including delinquency and foreclosure costs), escrow account earnings, contractual servicing fee income and other ancillary income such as late fees. Management reviews all significant assumptions quarterly. Mortgage loan prepayment speeds, a key assumption in the model, is the annual rate at which borrowers are forecasted to repay their mortgage loan principal. The discount rate used to determine the present value of estimated future net servicing income, another key assumption in the model, is an estimate of the rate of return investors in the market would require for an asset with similar risk. Both assumptions can, and generally will, change as market conditions and interest rates change. An increase in either the prepayment speed or discount rate assumption will result in a decrease in the fair value of the MSR, while a decrease in these assumptions will result in an increase in the fair value of the MSR. In recent years, there have been significant market-driven fluctuations in loan prepayment speeds and discount rates. These fluctuations can be rapid and may continue to be significant. Therefore, estimating prepayment speed and/or discount rates within ranges that market participants would use in determining the fair value of the MSR requires significant management judgment. General We are a financial holding company headquartered in Ruston, Louisiana. Through our wholly owned bank subsidiary, Origin Bank, we provide a broad range of financial services to small and medium-sized businesses, municipalities, high net worth individuals and retail clients through 43 banking centers in Louisiana, Texas and Mississippi. As a financial holding company operating through one segment, we generate the majority of our revenue from interest earned on loans and investments, service charges and fees on deposit accounts. We incur interest expense on deposits and other borrowed funds and noninterest expense, such as salaries and employee benefits and occupancy expenses. We analyze our ability to maximize income generated from interest earning assets and expense of our liabilities through our net interest margin. Net interest margin is a ratio calculated as net interest income divided by average interest-earning assets. Net interest income is the difference between interest income on interest-earning assets, such as loans, securities and interest-bearing cash, and interest expense on interest-bearing liabilities, such as deposits and borrowings. Net interest spread is the average yield on interest-earning assets minus the average rate on interest-bearing liabilities. Changes in market interest rates and the interest rates we earn on interest-earning assets or pay on interest-bearing liabilities, as well as in the volume and types of interest-earning assets, interest-bearing and noninterest-bearing liabilities and stockholders' equity, are usually the largest drivers of periodic changes in net interest spread, net interest margin and net interest income. Fluctuations in market interest rates are driven by many factors, including governmental monetary policies, inflation, deflation, macroeconomic developments, changes in unemployment, the money supply, political and international conditions and conditions in domestic and foreign financial markets. Periodic changes in the volume and types of loans in our loan portfolio are affected by, among other factors, economic and competitive conditions, as well as developments affecting the real estate, technology, financial services, insurance, transportation and manufacturing sectors within our target markets. The following discussion and analysis presents the significant factors that affected our financial conditions as of December 31, 2019 and 2018, and results of operations for each of the years then ended. Refer to Managements' Discussion and Analysis of Results of Operations and Financial Condition included in our Annual Report on Form 10-K filed with the SEC on February 28, 2019 (the "2018 Form 10-K") for a discussion and analysis of the significant factors that affected periods prior to 2018. Comparison of Results of Operations for the Years Ended December 31, 2019, 2018 and 2017 Net Interest Income Year ended December 31, 2019, compared to year ended December 31, 2018 Net interest income for the year ended December 31, 2019, was $173.7 million, an increase of $20.3 million over the year ended December 31, 2018. The increase was driven by higher average outstanding balances in our loan portfolio, partially offset by higher rates paid on our deposits. Average loans held for investment totaled $3.97 billion for the year ended December 31, 2019, compared to $3.40 billion for the year ended December 31, 2018. The yield earned on our loans held for investment was 5.18% for the year ended December 31, 2019, compared to 4.96% for the year ended December 31, 2018. Increases in average loans held for investment provided approximately $28.8 million of the increase in the yield earned on loans held for investment while the increase in rates provided approximately $8.7 million of the increase in interest income. Commercial and industrial, construction/land/land development and commercial real estate loans contributed a total of $32.1 million of the increase. These increases were partially offset by an increase in the cost of funding. The average cost of our interest-bearing liabilities increased during the year ended December 31, 2019, compared to 2018, primarily due to higher overall deposit rates. The average rate paid on interest-bearing deposits was 1.53% for the year ended December 31, 2019, an increase of 43 basis points from 1.10% for the year ended December 31, 2018. The aggregate 75 basis point decrease in the Federal Reserve target fed funds rate during the second half of 2019 have impacted the yields earned on our commercial and industrial and residential real estate loan portfolios and the rates paid on our deposit products. Year ended December 31, 2018, compared to year ended December 31, 2017 Net interest income for the year ended December 31, 2018, was $153.5 million, an increase of $23.1 million over the year ended December 31, 2017. The increase was driven by higher yields and higher average outstanding balances in our loan portfolio. The yield earned on our loans held for investment was 4.96% for the year ended December 31, 2018, compared to 4.38% for the year ended December 31, 2017. Average loans held for investment totaled $3.40 billion for the year ended December 31, 2018, compared to $3.13 billion for the year ended December 31, 2017. Increases in the yield earned on loans held for investment provided approximately $19.5 million of the increase in interest income, while average loans held for investment provided approximately $11.6 million of the increase. Commercial and industrial and commercial real estate loans contributed a total of $20.0 million of the increase. These increases were partially offset by an increase in the cost of funding primarily driven by increases in market interest rates. The average cost of our interest-bearing liabilities increased for the year ended December 31, 2018, compared to 2017, primarily due to higher average savings and interest-bearing transaction account rates. The average rate paid on interest-bearing deposits was 1.10% for the year ended December 31, 2018, an increase of 36 basis points from 0.74% for the year ended December 31, 2017. The following table presents average balance sheet information, interest income, interest expense and the corresponding average yields earned and rates paid for the years ended December 31, 2019, 2018 and 2017. ____________________________ (1) Nonaccrual loans are included in their respective loan category for the purpose of calculating the yield earned. All average balances are daily average balances. (2) Includes Government National Mortgage Association ("GNMA") repurchase average balances of $26.0 million, $30.1 million and $26.1 million for the years ended December 31, 2019, 2018 and 2017, respectively. The GNMA repurchase asset and liability are recorded as equal offsetting amounts in the consolidated balance sheets, with the asset included in loans held for sale and the liability included in FHLB advances and other borrowings. For more information on the GNMA repurchase option, see Note 9 - Mortgage Banking in the notes to our consolidated financial statements. (3) In order to present pre-tax income and resulting yields on tax-exempt investments comparable to those on taxable investments, a tax-equivalent adjustment has been computed. This adjustment also includes income tax credits received on Qualified School Construction Bonds. Income from tax-exempt investments and tax credits were computed using a Federal income tax rate of 21% for the years ended December 31, 2019 and 2018, and 35% for the year ended December 31, 2017. The tax-equivalent net interest margin would have been 3.49% for the year ended December 31, 2017, if we had been subject to the 21% Federal income tax rate enacted for 2018, in the Tax Cuts and Jobs Act. Rate/Volume Analysis The following tables present the dollar amount of changes in interest income and interest expense for major components of interest-earning assets and interest-bearing liabilities. It distinguishes between the changes related to outstanding balances and those due to changes in interest rates. The change in interest attributable to rate changes has been determined by applying the change in rate between periods to average balances outstanding in the earlier period. The change in interest due to volume has been determined by applying the rate from the earlier period to the change in average balances outstanding between periods. For purposes of this table, changes attributable to both rate and volume that cannot be segregated have been allocated to rate. Provision for Credit Losses The provision for credit losses, which includes both the provision for loan losses and provision for off-balance sheet commitments, is based on management's assessment of the adequacy of both our allowance for loan losses and our reserve for off-balance sheet lending commitments. Factors impacting the provision include inherent risk characteristics in our loan portfolio, the level of nonperforming loans and net charge-offs, both current and historic, local economic and credit conditions, the direction of the change in collateral values, and the funding probability on unfunded lending commitments. The provision for credit losses is charged against earnings in order to maintain our allowance for loan losses, which reflects management's best estimate of probable losses inherent in our loan portfolio at the balance sheet date, and our reserve for off-balance sheet lending commitments, which reflects management's best estimate of probable losses inherent in our legally binding lending-related commitments. The allowance is increased by the provision for loan losses and decreased by charge-offs, net of recoveries. Year ended December 31, 2019, compared to year ended December 31, 2018 and 2017 We recorded provision expense of $9.6 million for the year ended December 31, 2019, compared to $1.0 million for the year ended December 31, 2018. We recorded provision expense of $1.0 million for the year ended December 31, 2018, a $7.3 million decrease from provision expense of $8.3 million for the year ended December 31, 2017. See the section captioned “Allowance for Loan Losses” elsewhere in this discussion for further analysis of the provision for loan losses. Noninterest Income Our primary sources of recurring noninterest income are service charges on deposit accounts, mortgage banking revenue, insurance commission and fee income, and other fee income. The table below presents the various components of and changes in our noninterest income for the periods indicated. ____________________________ N/M = Not meaningful. Year ended December 31, 2019, compared to year ended December 31, 2018 Noninterest income for the year ended December 31, 2019, increased by $5.2 million, or 12.7%, to $46.5 million, compared to $41.2 million for the year ended December 31, 2018. The increase in noninterest income during the year ended December 31, 2019, was largely driven by increases of $2.7 million, $2.5 million, $1.3 million and $1.1 million in mortgage banking revenue, insurance commission and fee income, swap fee income and service charges and fees, respectively. These increases were partially offset by a $1.6 million decrease in the fair value of equity investments. Mortgage banking revenue. The $2.7 million increase in mortgage banking revenue compared to the year ended December 31, 2018, was primarily driven by a $1.7 million increase in pipeline valuation income coupled with a $1.3 million increase in MSRs based on changes in significant model assumptions, including prepayment speed and discount rate. Insurance commission and fee income. The $2.5 million increase in insurance commission and fee income was primarily driven by our increased presence in the North Louisiana market after the acquisition of RCF, a Louisiana-based independent insurance agency offering commercial, personal, health and life insurance (the "RCF acquisition") in July 2018. Swap fee income. The $1.3 million increase in swap fee income during the year ended December 31, 2019, was driven by higher volume of back-to-back swaps executed with commercial customers in the current period, compared to the same period in 2018. Given the low interest rate environment, customers have the opportunity to lock in fixed rates through swaps, driving increases in swap fees. Service charges and fees. The $1.1 million increase in service charges and fees compared to the year ended December 31, 2018, was largely driven by increases in business account analysis fees and ATM interchange fees, which increased by $645,000 and $305,000, respectively. The increase in our account analysis fees is consistent with our strategy of focusing on commercial banking relationships in our Texas market, reflecting a $110.1 million increase in average business demand deposit accounts for the year ended December 31, 2019, when compared to the year ended December 31, 2018. Total average demand deposit accounts increased $113.8 million for the year ended December 31, 2019, when compared to the year ended December 31, 2018. Change in fair value of equity investments. During the year ended December 31, 2019, we recorded a positive valuation adjustment of $367,000 on a common stock investment compared to a positive valuation adjustment of $2.0 million recorded during the year ended December 31, 2018. Year ended December 31, 2018, compared to year ended December 31, 2017 Noninterest income for the year ended December 31, 2018, increased by $12.1 million, or 41.3%, to $41.2 million, compared to $29.2 million for the year ended December 31, 2017. The increase in noninterest income during the year ended December 31, 2018, was largely driven by $12.7 million in losses incurred on non-mortgage loans held for sale in 2017, with no comparable expense incurred during 2018. Insurance commission and fee income. Increases in insurance commission and fee income of 2.5 million was primarily driven by the RCF acquisition in July 2018, which significantly expanded the Company's insurance presence in the North Louisiana market. Change in fair value of equity investments. During the year ended December 31, 2018, we recorded a positive valuation adjustment of $2.0 million on a common stock investment due to an accounting standard change. Mortgage banking revenue. Partially offsetting the net increase in noninterest income was a $6.2 million decrease in mortgage banking revenue. This decrease was primarily due to a 67.2% decline in the volume of mortgage loans sold, resulting in a $5.0 million decrease in gains on the sale of mortgage loans. The reduction in volume was primarily driven by the closing of a loan production office outside of our core geographic footprint that accounted for a significant portion of mortgage production, as we shifted our focus to retail originations within our core geographic banking footprint. Also contributing to the decrease in volume on mortgage loans sold was a broader downturn in the mortgage industry. As part of this strategy, we also reduced the amount of third party originations in our mortgage pipeline during 2018 compared to 2017. Noninterest Expense The following table presents the significant components of noninterest expense for the periods indicated: ____________________________ N/M = Not meaningful. Year ended December 31, 2019, compared to year ended December 31, 2018 Noninterest expense increased by $12.8 million, or 9.8%, in 2019 to $144.1 million, primarily due to increases in salaries and employee benefits, occupancy and equipment, net, and loan related expenses. Salaries and employee benefits. Salaries and employee benefits increased by $8.5 million, or 10.5%, for the year ended December 31, 2019, compared to 2018. The addition of a Houston banking team and the RCF acquisition contributed $3.6 million to this increase. The residual $4.9 million increase was largely driven by a net increase of over $1.3 million for new hires, annual salary increases and promotions, and market-based salary adjustments for existing positions. Occupancy and equipment, net. The $1.3 million increase in occupancy and equipment, net during the year ended December 31, 2019, compared to the same period in 2018 was primarily due to the opening of two new banking centers during mid-2019, which contributed $689,000 of the total increase, while the RCF acquisition contributed $194,000 of the total increase. Loan related expenses. The $1.1 million increase in loan related expenses was driven by a $810,000 increase in loan related legal fees and a $336,000 increase in sub-servicing expense, respectively. The increase in legal costs was primarily due to costs associated with working out of two nonperforming loan relationships due to their bankruptcy during the year ended December 31, 2019, and the increase in sub-servicing expense was due to transferring the servicing of our mortgage loan portfolio to a sub-servicer in the fourth quarter of 2019. These increases were partially offset by a decrease of $763,000 in regulatory assessments expenses. During the 2019 year we recognized a $1.0 million benefit from the FDIC insurance fund, which offset our total FDIC insurance obligation. Year ended December 31, 2018, compared to year ended December 31, 2017 Noninterest expense increased by $562,000, or 0.4%, in 2018 to $131.2 million, primarily due to increases in salaries and employee benefits, advertising and marketing expenses and other noninterest expense. Salaries and employee benefits increased by $9.6 million, or 13.6%, for the year ended December 31, 2018, compared to 2017. The increase was driven by increases in the cost of salaries and incentive compensation. The increase in salary expense was driven by the addition of our Houston banking team, consummation of the RCF acquisition and additional headcount to support our recent growth. The increase in incentive compensation was driven by the overall improvement in the Company's performance during 2018 compared to 2017, which resulted in performance targets, such as return on assets, individual loan volume and credit quality goals, being met by more employees. The $1.4 million, or 46.3%, increase in advertising and marketing expense for the year ended December 31, 2018, compared to 2017, was due to a Company-wide expense management strategy that temporarily scaled back marketing expenditures in 2017. In March 2018, marketing efforts were resumed with the launch of a new advertising campaign. Other noninterest expense increased by $1.0 million, or 23.7%, during the year ended December 31, 2018, compared to 2017. The most significant driver was intangible asset amortization expense, which increased by $352,000 due to the RCF acquisition in 2018. These increases were partially offset by decreases of $10.0 million, $1.5 million and $1.4 million in litigation settlement expenses, professional services and loan related expenses, respectively. During the year ended December 31, 2017, we entered into a Settlement and Release Agreement with respect to litigation with the ResCap Liquidating Trust ("ResCap"), as successor to Residential Funding Company, LLC f/k/a Residential Funding Corporation. Under the agreement, we paid $10.0 million to fully resolve all claims under the lawsuit and to avoid the further costs, disruption and distraction of defending the ResCap litigation. We recorded a charge to noninterest expense in our consolidated statement of income in 2017 to recognize this settlement. There were no such charges recorded during the year ended December 31, 2018. During the year ended December 31, 2017, we incurred approximately $883,000 in consulting fees related to the marketing and sale of certain energy loans as part of our strategic initiative to reduce our exposure to nonperforming energy loans, and incurred approximately $613,000 in legal fees that were associated with the resolution of the ResCap litigation. Neither of these expenses were incurred during the year ended December 31, 2018. The largest driver of the decrease in loan related expenses was a $544,000 decrease in loan related legal fees. During 2017, the Company incurred legal costs in conjunction with the marketing and sale of energy loans which were not incurred during 2018. The remaining decreases in loan related expenses were not individually significant and generally resulted from a lower volume of mortgage loans sold during 2018 compared to 2017. Income Tax Expense For the year ended December 31, 2019, we recognized income tax expense of $12.7 million, compared to $10.8 million and $5.8 million for the years ended December 31, 2018 and 2017, respectively. Our effective tax rate for the year ended December 31, 2019, was 19.0%, compared to 17.4% and 28.4% for the years ended December 31, 2018 and 2017, respectively. The increase in our effective tax rate for the year ended December 31, 2019, was primarily due to the decrease in income from tax-exempt securities, increase in state income taxes and decrease in low income housing tax credits. The decrease in our effective tax rate for the year ended December 31, 2018, compared to the rate for the year 2017 was the result of the Tax Cuts and Jobs Act ("Tax Act"), which was enacted on December 22, 2017. The Tax Act lowered the Federal corporate income tax rate to 21% from 35% for tax years beginning in 2018. The Tax Act also required a revaluation of the Company's net deferred tax asset ("DTA") to account for the future impact of lower corporate income tax rates and other provisions of the legislation. The revaluation of the Company's DTA balance resulted in a $282,000 adjustment from accumulated other comprehensive income to retained earnings. Our effective income tax rates have differed from the applicable U.S. statutory rates of 21% at both December 31, 2019 and 2018, and 35% for December 31, 2017, due to the effect of tax-exempt income from securities, low income housing and qualified school construction bond tax credits, tax-exempt income from life insurance policies and income tax effects associated with stock-based compensation. Because of these items, we expect our effective income tax rate to continue to remain below the applicable U.S. statutory rate. These tax-exempt items can have a larger than proportional effect on the effective income tax rate as net income decreases. Comparison of Financial Condition at December 31, 2019, and December 31, 2018 General Total assets increased by $503.1 million, or 10.4%, to $5.32 billion at December 31, 2019, from $4.82 billion at December 31, 2018. The increase was primarily attributable to $354.1 million increase in loans held for investment and $183.7 million increase in interest-bearing deposits in banks partially offset by a decrease of $74.6 million in securities available for sale. Loan Portfolio Our loan portfolio is our largest category of interest-earning assets and interest income earned on our loan portfolio is our primary source of income. At December 31, 2019, 70.4% of the loan portfolio held for investment was comprised of commercial and industrial loans, mortgage warehouse lines of credit and commercial real estate loans, which were primarily originated within our market areas of North Louisiana, Texas and Mississippi. The following table presents the ending balance of our loan portfolio held for investment at the dates indicated. At December 31, 2019, total loans held for investment were $4.14 billion, an increase of $354.1 million, or 9.3%, compared to $3.79 billion at December 31, 2018. The increase was driven by organic growth in all markets and led by increases in construction/land/land development and commercial and industrial loans. In 2018, as a complement to our organic growth strategy, several lift-out teams were on-boarded in our Houston market and seasoned lending professionals and relationship managers were recruited in our Dallas and Shreveport markets. Our Houston banking team was responsible for $259.8 million and $130.3 million in loan growth during 2019 and 2018, respectively. Loan Portfolio Maturity Analysis The table below presents the maturity distribution of our loans held for investment at December 31, 2019. The table also presents the portion of our loans that have fixed interest rates, rather than interest rates that fluctuate over the life of the loans based on changes in the interest rate environment. Nonperforming Assets Nonperforming assets consist of nonperforming loans and property acquired through foreclosures or repossession. Our nonperforming loans are comprised of nonaccrual loans and accruing loans that are contractually 90 days or more past due. Loans are considered past due when principal and interest payments have not been received at the date such payments are contractually due. We discontinue accruing interest on loans when we determine the borrower's financial condition is such that collection of interest and principal payments in accordance with the terms of the loan are not reasonably assured. Loans may be placed on nonaccrual status even if the contractual payments are not past due if information becomes available that causes substantial doubt about the borrower's ability to meet the contractual obligations of the loan. All interest accrued but not collected for loans that are placed on nonaccrual status is reversed against interest income. Interest income is subsequently recognized only to the extent cash payments are received in excess of principal outstanding. Loans are returned to accrual status when all principal and interest amounts contractually due are brought current and future payments are reasonably assured. If a loan is determined by management to be uncollectible, regardless of size, the portion of the loan determined to be uncollectible is then charged to the allowance for loan losses. We manage the quality of our lending portfolio in part through a disciplined underwriting policy and through continual monitoring of loan performance and borrowers' financial condition. There can be no assurance, however, that our loan portfolio will not become subject to losses due to declines in economic conditions or deterioration in the financial condition of our borrowers. The following table shows our nonperforming loans and nonperforming assets at the dates indicated: At December 31, 2019, total nonperforming loans held for investment decreased by $710,000, or 2.2%, from December 31, 2018. The increase in other real estate owned was due to the foreclosure of a $1.3 million commercial real estate secured chiropractic clinic that occurred during the year ended December 31, 2019. Over the last three years, we have experienced improvements in impaired and past due loans to the point that we currently believe our overall credit profile has stabilized. Please see Note 4 - Loans within our consolidated financial statements for more information. Potential Problem Loans From a credit risk standpoint, we classify loans in one of five categories: pass, special mention, substandard, doubtful or loss. The classifications of loans reflect a judgment about the risks of default and loss associated with the loan. We review the ratings on loans and adjust them to reflect the degree of risk and loss that is felt to be inherent in each loan. The methodology is structured so that reserve allocations are increased in accordance with deterioration in credit quality (and a corresponding increase in risk and loss) or decreased in accordance with improvement in credit quality (and a corresponding decrease in risk and loss). Loans rated special mention reflect borrowers who exhibit credit weaknesses or downward trends deserving close attention. If left uncorrected, these potential weaknesses may result in deterioration of the repayment prospects for the asset or in the bank's credit position at some future date. While potentially weak, no loss of principal or interest is envisioned and these borrowers currently do not pose sufficient risk to warrant adverse classification. Loans rated substandard are those borrowers with deteriorating trends and well-defined weaknesses that jeopardize the orderly liquidation of debt. A substandard loan is inadequately protected by the current sound worth and paying capacity of the obligor or by the collateral pledged, if any. Normal repayment from the borrower might be in jeopardy, although no loss of principal is envisioned. Loans rated as doubtful have the weaknesses of substandard assets with the additional characteristic that the weaknesses make collection or liquidation in full questionable and there is a high probability of loss based on currently existing facts, conditions and values. Loans classified as loss are charged-off and we have no expectation of the recovery of any payments in respect to loans rated as loss. Information regarding the internal risk ratings of our loans at December 31, 2019, is included in Note 4 - Loans in the notes to our consolidated financial statements contained in Item 8 of this report. Allowance for Loan Losses We maintain an allowance for loan losses that represents management's estimate of loan losses inherent within the portfolio of loans held for investment at the respective balance sheet date. The allowance for loan losses is maintained at a level which management believes is adequate to absorb all existing probable losses on loans in the loan portfolio. The amount of the allowance for loan losses should not be interpreted as an indication that charge-offs in future periods will necessarily occur in those amounts, or at all. In determining the allowance for loan losses, we estimate losses on specific loans, or groups of loans, where the probable loss can be identified and reasonably determined. The balance of the allowance for loan losses is based on internally assigned risk classifications of loans, historical loan loss rates, changes in the nature of the loan portfolio, overall portfolio quality, industry concentrations, delinquency trends, current economic factors and the estimated impact of current economic conditions on certain historical loan loss rates. The amount of the allowance is affected by loan charge-offs, which decrease the allowance, recoveries on loans previously charged off, which increase the allowance, as well as the provision for loan losses charged to income, which increases the allowance. We distribute the allowance for loan losses either to specific allocations, or general allocations for each major loan category. In determining the provision for loan losses, management monitors fluctuations in the allowance resulting from actual charge-offs and recoveries and to periodically review the size and composition of the loan portfolio in light of current economic conditions. If actual losses exceed the amount of allowance for loan losses, it could materially and adversely affect our earnings. As a general rule, when it becomes evident that the full principal and accrued interest of a loan may not be collected, or at 90 days past due, we will reflect that loan as nonperforming. It will remain nonperforming until it performs in a manner that it is reasonable to expect that we will collect principal and accrued interest in full. When the amount or likelihood of a loss on a loan has been confirmed, a charge-off should be taken in the period it is determined. We establish general allocations for each major loan category and credit quality. The general allocation is based, in part, on historical charge-off experience and the expected loss given default, derived from our internal risk rating process. Other adjustments may be made to the allowance for pools of loans after an assessment of internal or external influences on credit quality that are not fully reflected in the historical loss or risk rating data. We give consideration to trends, changes in loan mix, delinquencies, prior losses and other related information. In connection with the review of our loan portfolio, we consider risk elements attributable to particular loan types or categories in assessing the quality of individual loans. Some of the risk elements we consider include: • for commercial real estate loans, the debt service coverage ratio, operating results of the owner in the case of owner occupied properties, the loan to value ratio, the age and condition of the collateral and the volatility of income, property value and future operating results typical of properties of that type; • for construction, land and land development loans, the perceived feasibility of the project including the ability to sell developed lots or improvements constructed for resale or the ability to lease property constructed for lease, the quality and nature of contracts for presale or prelease, if any, experience and ability of the developer and loan to value ratio; • for residential mortgage loans, the borrower's ability to repay the loan, including a consideration of the debt to income ratio and employment and income stability, the loan-to-value ratio, and the age, condition and marketability of the collateral; and • for commercial and industrial loans, the debt service coverage ratio (income from the business in excess of operating expenses compared to loan repayment requirements), the operating results of the commercial, industrial or professional enterprise, the borrower's business, professional and financial ability and expertise, the specific risks and volatility of income and operating results typical for businesses in that category and the value, nature and marketability of collateral. The following table presents the allowance for loan loss by loan category: ____________________________ (1) Represents the ratio of each loan type to total loans held for investment. Our allowance for loan losses increased by $3.3 million, or 9.7%, to $37.5 million at December 31, 2019, from $34.2 million at December 31, 2018. The ratio of allowance for loan losses to total loans held for investment at December 31, 2019 and 2018, was 0.91% and 0.90%, respectively. The increase in the total allowance for loan losses was driven by a $3.5 million increase in general reserves primarily due to significant growth in our loan portfolio. Our specific reserve was $199,000, at December 31, 2019, compared to $366,000, at December 31, 2018. Our general reserve totaled $37.3 million and $33.8 million at December 31, 2019 and 2018, respectively. We recognized a one-time after tax cumulative effect adjustment of $760,000 to retained earnings at the beginning of the first quarter of 2020, increasing the allowance for credit losses by approximately $1.3 million and decreasing the off-balance sheet reserve by $382,000 due to the adoption of Accounting Standards Update ("ASU") No. 2016-13, Financial Instruments - Credit Losses (Topic 326): Measurement of Credit Losses on Financial Instruments. Our investment securities were not materially affected by the adoption of this ASU due to the nature of the portfolio. Our adjustment to the allowance for credit losses at the transition date may vary from our estimate due to refinements in the loss estimation models or factors. The following table presents an analysis of the allowance for loan losses and other related data as of the periods indicated. Securities Our securities portfolio is the second largest component of earning assets and provides a significant source of revenue. We use the securities portfolio to provide a source of liquidity, provide an appropriate return on funds invested, manage interest rate risk and meet collateral as well as regulatory capital requirements. We manage the securities portfolio to optimize returns while maintaining an appropriate level of risk. Securities within the portfolio are classified as either held-to-maturity, available-for-sale or at fair value through income, based on the intent and objective of the investment and the ability to hold to maturity. Unrealized gains and losses arising in the available for sale portfolio as a result of changes in the fair value of the securities are reported on an after-tax basis as a component of accumulated other comprehensive income in stockholders' equity while securities classified as held to maturity are carried at amortized cost. For further discussion of the valuation components and classification of investment securities, see Note 1 - Significant Accounting Policies in the consolidated financial statements contained in Item 8 of this report. Our securities portfolio totaled $541.2 million at December 31, 2019, representing a decrease of $65.0 million, or 10.7%, from $606.2 million at December 31, 2018. For additional information regarding our securities portfolio, please see Note 3 - Securities in the consolidated financial statements contained in Item 8 of this report. The following table sets forth the composition of our securities portfolio at the dates indicated. The following table presents the fair value of securities available for sale and amortized cost of securities held to maturity and their corresponding yields at December 31, 2019. The securities are grouped by contractual maturity and use amortized cost for all yield calculations. Mortgage backed securities and collateralized mortgage obligations, which do not have contractual payments due at a single maturity date, are shown at the date the last underlying mortgage matures. ____________________________ (1) Tax-exempt security yields are calculated without consideration of their tax benefit status. The contractual maturity of mortgage-backed securities and collateralized mortgage obligations is not a reliable indicator of their expected life because borrowers have the right to prepay their obligations at any time. Mortgage-backed securities and collateralized mortgage obligations are typically issued with stated principal amounts and are backed by pools of mortgage loans and other loans with varying maturities. The term of the underlying mortgages and loans may vary significantly due to the ability of a borrower to prepay outstanding amounts. Monthly pay downs on mortgage-backed securities tend to cause the average life of the securities to be much different than the stated contractual maturity. During a period of increasing interest rates, fixed rate mortgage-backed securities do not tend to experience heavy prepayments of principal, and, consequently, the average life of this security is typically lengthened. If interest rates begin to fall, prepayments may increase, thereby shortening the estimated average life of this security. Other than securities issued by government agencies or government sponsored enterprises, we did not own securities of any one issuer for which aggregate adjusted cost exceeded 10.0% of consolidated stockholders' equity at December 31, 2019 or 2018. Additionally, we do not hold any Fannie Mae or Freddie Mac preferred stock, collateralized debt obligations, structured investment vehicles or second lien elements in the investment portfolio, nor does the investment portfolio contain any securities that are directly backed by subprime or Alt-A mortgages. Securities Carried at Fair Value through Income At December 31, 2019 and 2018, we held two fixed-rate community investment bonds totaling $11.5 million and $11.4 million, respectively. We elected the fair value option on these securities to offset corresponding changes in the fair value of related interest rate swap agreements. Deposits Deposits are the primary funding source used to fund our loans, investments and operating needs. We offer a variety of products designed to attract and retain both consumer and commercial deposit customers. These products consist of noninterest and interest-bearing checking accounts, savings deposits, money market accounts and time deposits. Deposits are primarily gathered from individuals, partnerships and corporations in our market areas. We also obtain deposits from local municipalities. Our policy also permits the acceptance of brokered deposits on a limited basis, and our current deposits labeled as brokered are relationship-based accounts that we believe are stable. We manage our interest expense on deposits through specific deposit product pricing that is based on competitive pricing, economic conditions and current and anticipated funding needs. We may use interest rates as a mechanism to attract or deter additional deposits based on our anticipated funding needs and liquidity position. We also consider potential interest rate risk caused by extended maturities of time deposits when setting the interest rates in periods of future economic uncertainty. The following table presents our deposit mix at the dates indicated: ____________________________ (1) Brokered time deposits of $7.9 million are included in the brokered category for December 31, 2018. There were no brokered time deposits at December 31, 2019 or 2017. Business money market account balances increased $304.3 million, or 85.3%, for the year ended December 31, 2019, compared to business money market account balances for the year ended December 31, 2018. The increase was primarily due to shifting our focus to generating business relationships and deposits in order to reduce our reliance on brokered deposits. Brokered deposits decreased $179.8 million, or 54.1%, for the year ended December 31, 2019, when compared to the same period in 2018. The following schedule reflects the classification of our average deposits and the average rate paid on each deposit category for the periods indicated: Our average deposit balance was $3.98 billion for the year ended December 31, 2019, an increase of $323.2 million, or 8.8%, from $3.66 billion for the year ended December 31, 2018. This increase is primarily due to our continued relationship-based efforts to attract deposits within our markets. The average rate paid on our interest-bearing deposits for the year ended December 31, 2019, was 1.53%, compared to 1.10% for the year ended December 31, 2018. The increase in the average cost of our deposits was primarily the result of increases in market interest rates that occurred during 2018 and 2019, which caused us to increase the interest rates we paid on deposits to remain competitive with other depository institutions in our markets. Average noninterest-bearing deposits at December 31, 2019, were $1.1 billion, compared to $948.6 million at December 31, 2018, an increase of $106.3 million, or 11.2%, and represented 26.5% and 25.9% of average total deposits for the years ended December 31, 2019 and 2018, respectively. The following table presents the maturity distribution of our time deposits as of December 31, 2019: Borrowings Long-term advances from the FHLB decreased by $1.6 million, or 0.6%, at December 31, 2019, compared to December 31, 2018. Borrowed funds are summarized as follows: ____________________________ (1) Short-term FHLB advances at December 31, 2019, carried a fixed interest rate of 1.35% and matured on January 2, 2020; at December 31, 2018, short-term FHLB advances carried a fixed interest rate of 2.70%, and matured on January 2, 2019. (2) Includes a FHLB advance of $250.0 million at both December 31, 2019 and 2018, callable quarterly with a final maturity in 2033, carrying a rate of 1.65%. Overnight repurchase agreements with depositors consist of obligations of ours to depositors and mature on a daily basis. These obligations to depositors carried a daily average interest rate of 1.20% and 0.86% for the years ended December 31, 2019 and 2018, respectively. Our long-term debt consists of advances from the FHLB with original maturities greater than one year. Interest rates for FHLB long-term advances outstanding at December 31, 2019, ranged from 1.65% to 5.72% and were subject to restrictions or penalties in the event of prepayment. As of December 31, 2019, we held 21 unfunded letters of credit from the FHLB totaling $241.3 million with expiration dates ranging from January 15, 2020, to February 25, 2021. These letters of credit either support pledges for our public fund deposits or confirm letters of credit we have issued to support our customers' businesses. Security for all indebtedness and outstanding commitments to the FHLB consists of a blanket floating lien on all of our first mortgage loans, commercial real estate and other real estate loans, as well as our investment in capital stock of the FHLB and deposit accounts at the FHLB. The net amounts available under the blanket floating lien as of December 31, 2019 and 2018, were $601.9 million and $468.8 million, respectively. Additionally, as of December 31, 2019, we had the ability to borrow $855.1 million from the discount window at the Federal Reserve Bank of Dallas ("FRB"), with $1.09 billion in commercial and industrial loans pledged as collateral. There were no borrowings against this line as of December 31, 2019. Liquidity Management oversees our liquidity position to ensure adequate cash and liquid assets are available to support our operations and satisfy current and future financial obligations, including demand for loan funding and deposit withdrawals. Management continually monitors, forecasts and tests our liquidity and non-core dependency ratios to ensure compliance with targets established by our Asset-Liability Management Committee and approved by our board of directors. Management measures our liquidity position by giving consideration to both on-balance sheet and off-balance sheet sources of and demands for funds on a daily and weekly basis. At December 31, 2019 and 2018, our cash and liquid securities totaled 8.4% and 5.0% of total assets, respectively, providing liquidity to support our existing operations. The Company, which is a separate legal entity apart from the Bank, must provide for its own liquidity, including payment of any dividends that may be declared for our common stockholders and interest and principal on any outstanding debt or trust preferred securities incurred by the Company. The Company had available cash balances of $5.9 million at both December 31, 2019 and 2018. This cash is available for the general corporate purposes described above, as well as providing capital support to the Bank and financing potential future acquisitions. In addition, the Company has up to $50.0 million available under a line of credit. See Note 11 - Borrowings contained in Item 8 of this report for more information. There are regulatory restrictions on the ability of the Bank to pay dividends under federal and state laws, regulations and policies. See "Item 1. Business - Regulation and Supervision" above for more information. In addition to cash generated from operations, we utilize a number of funding sources to manage our liquidity, including core deposits, investment securities, cash and cash equivalents, loan repayments, federal funds lines of credit available from other financial institutions, as well as advances from the FHLB. We may also use the discount window at the FRB as a source of short-term funding. Core deposits, which are total deposits excluding time deposits greater than $250,000 and brokered deposits, are a major source of funds used to meet cash flow needs. Maintaining the ability to acquire these funds as needed in a variety of markets is the key to assuring our liquidity. The investment portfolio is another source for meeting our liquidity needs. Monthly payments on mortgage-backed securities are used for short-term liquidity, and our investments are generally traded in active markets that offer a readily available source of cash through sales, if needed. Securities in our investment portfolio are also used to secure certain deposit types, such as deposits from state and local municipalities. Other sources available for meeting liquidity needs include long- and short-term advances from the FHLB, and federal funds lines of credit. Long-term funds obtained from the FHLB are primarily used as an alternative source to fund long-term growth of the balance sheet by supporting growth in loans and other long-term interest-earning assets. We typically rely on such funding when the cost of such borrowings compares favorably to the rates that we would be required to pay for other funding sources, including certain deposits. See Note 11 - Borrowings contained in Item 8 of this report for additional borrowing capacity and outstanding advances at the FHLB. We also had unsecured federal funds lines of credit available to us, with no amounts outstanding at either date, please see Note 11 - Borrowings contained in Item 8 of this report for detail regarding our lines of credit. These lines of credit primarily provide short-term liquidity and in order to ensure availability of these funds, we test these lines of credit at least annually. Interest is charged at the prevailing market rate on federal funds purchased and FHLB advances. Additionally, we had the ability to borrow at the discount window of the FRB using our commercial and industrial loans as collateral. There were no borrowings against this line as of December 31, 2019. Off-Balance Sheet Arrangements and Contractual Obligations In the normal course of business as a financial services provider, we enter into financial instruments, such as certain contractual obligations and commitments to extend credit and letters of credit, to meet the financing needs of our customers. These commitments involve elements of credit risk, interest rate risk and liquidity risk. Some instruments may not be reflected in our consolidated financial statements until they are funded, and a significant portion of commitments to extend credit may expire without being drawn, although they expose us to varying degrees of credit risk and interest rate risk in much the same way as funded loans. The table below presents the funding requirements of our most significant financial commitments, excluding interest and purchase discounts, at the date indicated: ____________________________ (1) Includes a long-term FHLB advance totaling $250.0 million at December 31, 2019, callable quarterly with a final maturity of 15 years and carries an interest rate of 1.65%. and a short-term $100.0 million FHLB advance at December 31, 2019, and carries an interest rate of 1.35% and matured on January 2, 2020. (2) These commitments represent amounts we are obligated to contribute to various limited partnership investments in accordance with the provisions of the respective limited partnership agreements. The capital contributions may be required at any time, and are therefore reflected in the Less than One Year category. Credit Related Commitments Commitments to extend credit include revolving commercial credit lines, non-revolving loan commitments issued mainly to finance the acquisition and development or construction of real property or equipment, and credit card and personal credit lines. The availability of funds under commercial credit lines and loan commitments generally depends on whether the borrower continues to meet credit standards established in the underlying contract and has not violated other contractual conditions. Loan commitments generally have fixed expiration dates or other termination clauses and may require payment of a fee by the borrower. Credit card and personal credit lines are generally subject to cancellation if the borrower's credit quality deteriorates. A number of commercial and personal credit lines are used only partially or, in some cases, not at all before they expire, and the total commitment amounts do not necessarily represent future cash requirements. A substantial majority of the letters of credit are standby agreements that obligate us to fulfill a customer's financial commitments to a third party if the customer is unable to perform. We issue standby letters of credit primarily to provide credit enhancement to our customers' other commercial or public financing arrangements and to help them demonstrate financial capacity to vendors of essential goods and services. The table below presents our commitments to extend credit by commitment expiration date for the date indicated: ____________________________ (1) Includes $425.6 million of unconditionally cancellable commitments at December 31, 2019. LIBOR Transition On July 27, 2017, the United Kingdom’s Financial Conduct Authority, which regulates London Interbank Offered Rate (“LIBOR”), announced that it will no longer persuade or require banks to submit rates for the calculation of LIBOR after 2021. For additional information related to the potential impact surrounding the transition from LIBOR on our business, see the section titled "Item 1A. Risk Factors" in this report. Stockholders' Equity Stockholders' equity provides a source of permanent funding, allows for future growth and provides a degree of protection to withstand unforeseen adverse developments. At December 31, 2019, stockholders' equity was $599.3 million, representing an increase of $49.5 million, or 9.0%, compared to $549.8 million at December 31, 2018. Net income of $53.9 million and other comprehensive income of $8.8 million for the year ended December 31, 2019, were the primary drivers of the increase in stockholders' equity compared to December 31, 2018, and were partially offset by the $10.1 million repurchase of our common stock and the dividend paid on our common stock that occurred during the period. Initial Public Offering In May 2018, we completed the initial public offering of our common stock at a price to the public of $34.00 per share. We issued 3,045,426 shares in the offering, including 545,426 shares sold at the option of the underwriters, and certain selling stockholders sold 1,136,176 shares in the offering. We received net proceeds of $96.3 million, before expenses, in the offering. Our common stock became eligible for trading on May 9, 2018, on the Nasdaq Global Select Market under the symbol "OBNK." Stock Repurchases In a transaction that was consummated on August 2, 2019, we repurchased 300,000 shares of our common stock pursuant to our stock buyback program at a price per share of $33.50 for an aggregate purchase price of $10.1 million. As of the date of this report, approximately $29.9 million may still be purchased under the stock buyback program. RCF Acquisition In July 2018, we acquired RCF, a Louisiana-based independent insurance agency, in a cash and stock transaction by issuing 66,824 shares of our common stock at a price of $40.50 per share. Our common stock outstanding and additional paid in capital increased by $334,000 and $2.4 million, respectively, as a result of the transaction. Preferred Stock In 2018, we redeemed all of the 48,260 shares of our Senior Non-Cumulative Perpetual Preferred Stock, Series SBLF ("SBLF Preferred Stock"). The aggregate redemption price of the SBLF Preferred Stock was $49.1 million, which included accrued dividends of $808,000. The SBLF Preferred Stock was redeemed from our surplus capital, which included the proceeds of our initial public offering and terminated our participation in the Small Business Lending Fund program. During 2018, all of the 901,644 shares of our outstanding Series D preferred stock were converted into shares of our common stock, on a one-for-one basis. As a result, no shares of Series D preferred stock were outstanding at December 31, 2018. Regulatory Capital Requirements Together with the Bank, we are subject to various regulatory capital requirements administered by federal banking agencies. These requirements are discussed in greater detail in "Item 1. Business - Regulation and Supervision". Failure to meet minimum capital requirements may result in certain actions by regulators that, if enforced, could have a direct material effect on our financial statements. At December 31, 2019 and 2018, we and the Bank were in compliance with all applicable regulatory capital requirements, and the Bank was classified as "well capitalized" for purposes of the prompt corrective action regulations of the Federal Deposit Insurance Corporation. As we deploy capital and continue to grow operations, regulatory capital levels may decrease depending on the level of earnings. However, we expect to monitor and control growth in order to remain "well capitalized" under applicable regulatory guidelines and in compliance with all applicable regulatory capital standards. The following table presents our regulatory capital ratios, as well as those of the Bank, at the dates indicated: On February 6, 2020, Origin Bank, our wholly owned subsidiary, announced the completion of an offering of $70 million in aggregate principal amount of fixed-to-floating rate subordinated notes which will count as tier 2 risk based capital for the Bank. Please see Note 23 - Subsequent Events for further information.

<s>[INST] The following discussion and analysis should be read in conjunction with our consolidated financial statements and related notes contained in Item 8 of this report. To the extent that this discussion describes prior performance, the descriptions relate only to the periods listed, which may not be indicative of our future financial outcomes. In addition to historical information, this discussion contains forwardlooking statements that involve risks, uncertainties and assumptions that could cause results to differ materially from management's expectations. Factors that could cause such differences are discussed in the sections titled "Cautionary Note Regarding ForwardLooking Statements" and "Item 1A. Risk Factors." We assume no obligation to update any of these forwardlooking statements. Critical Accounting Policies and Estimates Our consolidated financial statements are prepared in accordance with U.S. GAAP and with general practices within the financial services industry. Application of these principles requires management to make estimates and assumptions that affect the amounts reported in the financial statements and accompanying notes. We base our estimates on historical experience and on various other assumptions that we believe to be reasonable under current circumstances. These assumptions form the basis for our judgments about the carrying values of assets and liabilities that are not readily available from independent, objective sources. We evaluate our estimates on an ongoing basis. Use of alternative assumptions may have resulted in significantly different estimates. Actual results may differ from these estimates. Please refer to Note 1 Significant Accounting Policies to our consolidated financial statements contained in Item 8 of this report for a full discussion of our accounting policies, including estimates. We have identified the following accounting estimates that, due to the difficult, subjective or complex judgments and assumptions inherent in those estimates and the potential sensitivity of the financial statements to those judgments and assumptions, are critical to an understanding of our financial condition and results of operations. We believe that the judgments, estimates and assumptions used in the preparation of the financial statements are appropriate. Allowance for Loan Losses. Our allowance for loan losses is established as losses are estimated to have occurred through a provision for loan losses charged to earnings. Subsequent recoveries, if any, are credited to the allowance. The allowance for loan losses is evaluated on a regular basis by management and is based upon management's periodic review of the collectability of the loans in light of historical experience, the nature and volume of the loan portfolio, adverse situations that may affect the borrower's ability to repay, estimated value of any underlying collateral, and prevailing economic conditions. This evaluation is inherently subjective as it requires estimates that are susceptible to significant revision as more information becomes available. Loan losses are charged against the allowance for loan losses when management believes the loss is confirmed. In addition, beginning January 1, 2020, our methodology for determining our allowance for loan losses changed due to the implementation of the CECL, accounting standard. As a result, we recognized a onetime, after tax cumulative effect adjustment of $760,000 to retained earnings at the beginning of the first quarter of 2020, increasing the allowance for credit losses by approximately $1.3 million and decreasing the offbalance sheet reserve by $382,000. Our adjustment to the allowance for credit losses at the transition date may vary from our estimate due to refinements in the loss estimation models or factors. Mortgage Servicing Rights. We recognize the rights to service mortgage loans based on the estimated fair value of the Mortgage Servicing Right ("MSR") when loans are sold and the associated servicing rights are retained. We elected to account for the MSR at fair value. The fair value of the MSR is determined using a valuation model administered by a third party that calculates the present value of estimated future net servicing income. The model incorporates assumptions that market participants use in estimating future net servicing income, including estimates of prepayment speeds, discount rate, default rates, cost to service (including delinquency and foreclosure costs), escrow account earnings, contractual servicing fee income and other ancillary income such as late fees. Management reviews all significant assumptions quarterly. Mortgage loan prepayment speeds, a key assumption in the model, is the annual rate at which borrowers are forecasted to repay their mortgage loan principal. The discount rate used to determine the present value of estimated future net servicing income, another key assumption in the model, is an estimate of [/INST] Negative. </s>

Entasis Therapeutics Holdings Inc.

2019-03-29

2018-12-31

Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations The following information should be read in conjunction with the consolidated financial information and the notes thereto appearing elsewhere in this Annual Report on Form 10-K. This discussion contains certain forward-looking statements that involve risks and uncertainties. We make such forward-looking statements pursuant to the safe harbor provisions of the Private Securities Litigation Reform Act of 1995 and other federal securities laws. Forward-looking statements are identified by words such as “believe,” “will,” “may,” “estimate,” “continue,” “anticipate,” “intend,” “should,” “plan,” “expect,” “predict,” “could,” “potentially” or the negative of these terms or similar expressions. You should read these statements carefully because they discuss future expectations, contain projections of future results of operations or financial condition, or state other “forward- looking” information. These statements relate to our future plans, objectives, expectations, intentions and financial performance and the assumptions that underlie these statements. These forward-looking statements are subject to certain risks and uncertainties that could cause actual results to differ materially from those anticipated in the forward-looking statements. Factors that might cause such a difference include, but are not limited to, those discussed in the “Risk Factors” section in this Annual Report on Form 10-K. Forward-looking statements are based on our management’s beliefs and assumptions and on information currently available to our management. These statements, like all statements in this report, speak only as of their date, and except as required by law, we undertake no obligation to update or revise these statements in light of future developments. We caution investors that our business and financial performance are subject to substantial risks and uncertainties. Overview We are a clinical-stage biopharmaceutical company focused on the discovery, development and commercialization of novel antibacterial products to treat serious infections caused by multidrug-resistant Gram-negative bacteria. Leveraging our targeted-design platform, we have engineered and developed product candidates that target clinically validated mechanisms to address antibiotic resistance. Our lead product candidate, ETX2514, as well as one of our other product candidates, ETX0282, inhibit one of the most prevalent forms of bacterial resistance, β-lactamase enzymes, so named because of their ability to inactivate β-lactam antibiotics, one of the most commonly used classes of antibiotics. By blocking this resistance mechanism, these product candidates, when administered in combination with β-lactam antibiotics, are designed to restore the efficacy of those antibiotics. Our other product candidate, zoliflodacin, targets the validated mechanism of action of the fluoroquinolone class of antibiotics, but does so in a novel manner to avoid existing fluoroquinolone resistance. ETX2514SUL is a fixed-dose combination of ETX2514, a novel broad-spectrum intravenous, or IV, β-lactamase inhibitor, or BLI, with sulbactam, an IV β-lactam antibiotic, that we are developing for the treatment of a variety of serious multidrug-resistant infections caused by Acinetobacter baumannii, or Acinetobacter. We have completed three separate Phase 1 clinical trials, including one evaluating the penetration of ETX2514SUL into the lung and one in renally impaired patients. In addition, we have completed a Phase 2 clinical trial in patients with complicated urinary tract infections, or UTIs. Based on a series of discussions with the U.S. Food and Drug Administration, or FDA, including an end-of-Phase-2 meeting, we are in the process of initiating a single Phase 3 clinical trial with data expected in the second half of 2020. Zoliflodacin, is a novel orally administered molecule that inhibits bacterial gyrase, an essential enzyme in bacterial reproduction, for the treatment of drug-resistant Neisseria gonorrhoeae, the bacterial pathogen responsible for gonorrhea. Intramuscular ceftriaxone now represents the last-resort treatment option for gonorrhea, although resistant strains are beginning to emerge. We believe that there is a growing unmet need for an oral antibiotic that will reliably treat patients with gonorrhea, including multidrug-resistant gonorrhea. We have completed several Phase 1 clinical trials and a Phase 2 clinical trial of zoliflodacin in patients with uncomplicated gonorrhea. The results of the Phase 2 clinical trial were published in the New England Journal of Medicine in November 2018. We intend to initiate a Phase 3 clinical trial in mid-2019 with data expected in 2021. The Phase 3 clinical trial will be funded by our nonprofit collaborator, the Global Antibiotic Research and Development Partnership, or GARDP. We are also developing ETX0282CPDP for the treatment of complicated UTIs, including those caused by extended-spectrum β-lactamase, or ESBL, producing bacterial strains or carbapenem-resistant Enterobacteriaceae, or CRE. ETX0282CPDP is an oral, fixed-dose combination of ETX0282, a novel oral BLI, with cefpodoxime proxetil, an oral β-lactam antibiotic. We believe there is a significant unmet need for new oral antibiotics that reliably treat patients with multidrug-resistant Gram-negative infections. We initiated a multi-part Phase 1 clinical trial of ETX0282CPDP in Australia in the second quarter of 2018 and expect to receive data from the Phase 1 trial in mid-2019. We are using our targeted-design platform in an attempt to develop a novel class of antibiotics, non β-lactam inhibitors of the penicillin binding proteins, or NBPs. Penicillin binding proteins, or PBPs, are clinically validated targets of β-lactam antibiotics, such as penicillins and carbapenems. Due to their differentiated chemical structure, our NBPs are not subject to inactivation by β-lactamases, unlike β-lactam antibiotics. Accordingly, we believe our NBPs constitute a potential new class of Gram-negative antibacterial agents with no pre-existing resistance that are designed to target a broad spectrum of pathogens, including Pseudomonas aeruginosa, or Pseudomonas. We expect to select an initial clinical candidate from our NBP program in 2019. Since our inception in May 2015, we have devoted substantially all of our resources to organizing and staffing our company, business planning, raising capital, acquiring or discovering product candidates and securing related intellectual property rights, conducting discovery and development activities for our programs and planning for potential commercialization. We do not have any products approved for sale and have not generated any revenue from product sales. As of December 31, 2018, we have funded our operations primarily with net cash proceeds of $104.2 million from the sale of our preferred stock and net cash proceeds of approximately $65.6 million from the sale of common stock in our initial public offering. We have also either directly received funding or financial commitments from, or have had our program activities conducted and funded by, the U.S. government through our arrangements with the U.S. National Institute of Allergy and Infectious Diseases, or NIAID, the Combating Antibiotic Resistant Bacteria Biopharmaceutical Accelerator program, or CARB-X, and the U.S. Department of Defense, and have received non-profit awards from GARDP, and an upfront payment from our license and collaboration agreement with Zai Lab (Shanghai), Co., Ltd., or Zai Lab. Since our inception, we have incurred significant operating losses. Our ability to generate product revenue sufficient to achieve profitability will depend heavily on the successful development and eventual commercialization of one or more of our current or future product candidates and programs. Our net loss was $33.0 million for the year ended December 31, 2018. As of December 31, 2018, we had an accumulated deficit of $90.1 million. We anticipate that a substantial portion of our capital resources and efforts in the foreseeable future will be focused on completing the necessary development, obtaining regulatory approval and preparing for potential commercialization of our product candidates. We expect to continue to incur significant expenses and increasing operating losses for at least the next several years. Our net losses may fluctuate significantly from period to period, depending on the timing of our planned clinical trials and expenditures on other research and development activities. We expect our expenses will increase substantially over time as we: · continue our ongoing and planned preclinical and clinical development of our product candidates; · initiate preclinical studies and clinical trials for any additional product candidates that we may pursue in the future; · seek to discover and develop additional product candidates; · seek regulatory approvals for any product candidates that successfully complete clinical trials; · ultimately establish a sales, marketing and distribution infrastructure and scale up external manufacturing capabilities to commercialize any product candidate for which we may obtain regulatory approval and intend to commercialize on our own; · maintain, expand and protect our intellectual property portfolio; · hire additional clinical, scientific and chemistry, manufacturing and controls personnel; and · add additional operational, financial and management information systems and personnel, including personnel to support our product development and planned future commercialization efforts. Furthermore, we now incur additional costs associated with operating as a public company that we did not previously incur or previously incurred at lower rates, including significant legal, accounting, investor relations and other expenses that we did not incur as a private company. Initial Public Offering; Reverse Stock Split On September 28, 2018, we completed our initial public offering, in which we issued and sold 5,000,000 shares of common stock at a price to the public of $15.00 per share. The aggregate net proceeds to us from the initial public offering were approximately $65.6 million after deducting underwriting discounts and commissions and offering expenses payable by us. The shares began trading on The Nasdaq Global Market on September 26, 2018. Upon the completion of the initial public offering, all of our outstanding shares of redeemable convertible preferred stock, including accrued dividends, automatically converted into 8,084,414 shares of our common stock. In September 2018, we also effected a 1-for-20.728 reverse stock split of our issued and outstanding common stock. All of our historical share and per share information shown in the accompanying consolidated financial statements and related notes have been retroactively adjusted to give effect to the reverse stock split. The Corporate Reorganization We completed a corporate reorganization on April 23, 2018. As part of the corporate reorganization, we formed Entasis Therapeutics Holdings Inc., a Delaware corporation, in March 2018 with nominal assets and liabilities for the purpose of consummating the corporate reorganization described herein. In connection with the corporate reorganization, the existing shareholders of Entasis Therapeutics Limited exchanged their shares for the same number and classes of newly issued shares in Entasis Therapeutics Holdings Inc. As a result, Entasis Therapeutics Limited became a wholly owned subsidiary of Entasis Therapeutics Holdings Inc. Upon completion of the corporate reorganization on April 23, 2018, the historical consolidated financial statements of Entasis Therapeutics Limited became the historical consolidated financial statements of Entasis Therapeutics Holdings Inc. Funding Arrangements In December 2016, we entered into a funding arrangement with the U.S. Army Medical Research Acquisition Activity, or USAMRAA, a division of the U.S. Department of Defense, through which we received a grant. This grant covers funding for up to $1.1 million of specified research expenditures incurred from December 2016 through June 2019, or the performance period. Specified research expenditures are the reimbursable expenses associated with agreed upon activities needed to advance the research project supported by the grant. These expenditures can include internal labor, laboratory supplies and equipment, travel, consulting and third-party vendor research and development support costs. We have until September 30, 2022 to obtain reimbursements from USAMRAA for the fully paid, specified research expenditures incurred during the performance period. As of December 31, 2018, we had received $0.9 million of funding and we had recorded $1.0 million of grant income under this grant. In March 2017 and October 2017, we entered into funding arrangements with the Trustees of Boston University to utilize funds from the U.S. government, through the CARB-X program, for support of the ETX0282 and NBP programs. These funding arrangements will cover up to $16.4 million of our specified research expenditures from April 2017 through September 2021. As of December 31, 2018, we had received $4.5 million in funding and we had recorded $5.7 million of grant income under this grant. In July 2017, we entered into a collaboration agreement with GARDP for the development and commercialization of a product candidate containing zoliflodacin in certain countries. Under the terms of the collaboration agreement, GARDP will fully fund the Phase 3 clinical trial, including the manufacture and supply of the product candidate containing zoliflodacin, in uncomplicated gonorrhea. In April 2018, we entered into a license and collaboration agreement with Zai Lab (Shanghai) Co., Ltd., or Zai Lab, pursuant to which Zai Lab licensed exclusive rights to ETX2514 and ETX2514SUL in the Asia-Pacific region. Under the terms of the agreement, Zai Lab will fund most of our clinical trial costs in China for ETX2514SUL, including all costs in China for our planned Phase 3 clinical trial of ETX2514SUL, with the exception of patient drug supply. As of December 31, 2018, we had received payments of $4.5 million, the $5.0 million upfront payment and $0.3 million of research support payments, less applicable taxes, from Zai Lab and we had recognized revenue of $5.0 million under the agreement. Components of Results of Operations Revenue All of our revenue has been derived from our license and collaboration agreement with Zai Lab. To date, we have not generated any revenue from product sales, and we do not expect to generate any revenue from the sale of products in the near future. If our development efforts for our product candidates and preclinical program are successful and result in regulatory approval, we may generate revenue in the future from product sales. Operating Expenses Research and Development Expenses Research and development expenses consist primarily of costs incurred for our research activities, including our product discovery efforts and the development of our preclinical and clinical product candidates. These expenses include: · employee-related expenses, including salaries and benefits, travel and stock-based compensation expense for employees engaged in research and development functions; · fees paid to consultants for services directly related to our product development and regulatory efforts; · expenses incurred under agreements with contract research organizations, or CROs, as well as contract manufacturing organizations, or CMOs, and consultants that conduct and provide supplies for our preclinical studies and clinical trials; · costs associated with preclinical activities and development activities; · costs associated with our technology and our intellectual property portfolio; · costs related to compliance with regulatory requirements; and · facilities-related expenses, which include allocated rent and maintenance of facilities and other operating costs. Costs associated with research and development activities are expensed as incurred. Costs for certain development activities, such as clinical trials, are recognized based on an evaluation of the progress to completion of specific tasks using data such as patient enrollment, clinical site activations or other information provided to us by our vendors. Nonrefundable advance payments for goods or services to be received in the future for use in research and development activities are recorded as prepaid expenses. Such amounts are recognized as an expense as the goods are delivered or the related services are performed, or until it is no longer expected that the goods will be delivered, or the services rendered. Our direct research and development expenses are tracked on a program-by-program basis for our product candidates and preclinical program and consist primarily of external costs, such as fees paid to outside consultants, CROs, CMOs and central laboratories in connection with our preclinical development, process development, manufacturing and clinical development activities. Our direct research and development expenses by program also include fees incurred under service, license or option agreements. We do not allocate employee costs or facility expenses to specific programs because these costs are deployed across multiple programs and, accordingly, are not separately classified. We primarily use internal resources and our own employees to conduct our research and discovery as well as for managing our preclinical development, process development, manufacturing and clinical development activities. To date, substantially all of our research and development expenses have been related to the preclinical and clinical development of our product candidates and preclinical program. The following table shows our research and development expenses by development program and type of activity for the years ended December 31, 2018 and 2017: Research and development activities are central to our business model. Product candidates in later stages of clinical development generally have higher development costs than those in earlier stages of clinical development, primarily due to the increased size and duration of later-stage clinical trials. We expect our research and development expenses to increase over the next several years as we progress our product candidates through clinical development. However, it is difficult to determine with certainty the duration and completion costs of our current or future preclinical programs and clinical trials of our product candidates, or if, when or to what extent we will generate revenues from the commercialization and sale of any of our product candidates that obtain regulatory approval. We may never succeed in achieving regulatory approval for any of our product candidates. The duration, costs and timing of clinical trials and development of our product candidates and preclinical program will depend on a variety of factors that include, but are not limited to, the following: · the number of trials required for approval and any requirement for extension trials; · per-patient trial costs; · the number of patients that participate in the trials; · the number of sites included in the trials; · the countries in which the trials are conducted; · the length of time required to enroll eligible patients; · the number of doses that patients receive; · the drop-out or discontinuation rates of patients; · potential additional safety monitoring or other studies requested by regulatory agencies; · the duration of patient follow-up; and · the efficacy and safety profiles of the product candidates. Any changes in the outcome of any of these factors with respect to the development of our product candidates could mean a significant change in the costs and timing associated with the development of these product candidates. In addition, the probability of success for each product candidate will depend on numerous factors, including competition, manufacturing and supply, and commercial viability. We will determine which programs to pursue and how much to fund each program based on the scientific and clinical success of each product candidate, as well as an assessment of each candidate’s commercial potential. General and Administrative Expenses General and administrative expenses consist of salaries and benefits, travel and stock-based compensation expense for personnel in executive, finance and administrative functions. General and administrative costs also include facilities-related costs not otherwise included in research and development expenses, professional fees for legal, patent, consulting and accounting and audit services. We anticipate that our general and administrative expenses will increase in the future as we increase our headcount to support our continued research activities and development of our product candidates. We also anticipate that we will continue to incur increased accounting, audit, legal, regulatory, compliance and director and officer insurance costs as well as investor and public relations expenses associated with being a public company. Additionally, if and when we believe a regulatory approval of a product candidate appears likely, we anticipate an increase in payroll and other employee-related expenses as a result of our preparation for commercial operations, especially as it relates to the sales and marketing functions for that product candidate. Other Income Grant Income Grant income consists of income recognized in connection with grants we received under our funding arrangements with USAMRAA and the Trustees of Boston University through the CARB-X program. Grant income is recognized in the period during which the related specified expenses are incurred, provided that the conditions under which the grants were provided have been met. Interest Income Interest income consists of interest earned on our cash and investment balances. Our interest income has not been significant due to low interest earned on invested balances. Income Taxes Income taxes consist of China withholding taxes on the upfront payment under our license and collaboration agreement with Zai Lab. Results of Operations Years Ended December 31, 2018 and 2017 The following table summarizes our results of operations for the years ended December 31, 2018 and 2017: Revenue We recognized revenue of $5.0 million for the year ended December 31, 2018 compared to zero for the prior year. The revenue in 2018 was attributable to executing the exclusive license and completing the initial technology transfer of licensed know-how pursuant to the collaboration agreement with Zai Lab, which we entered into in April 2018. Research and Development Expenses Research and development expenses were $33.0 million for the year ended December 31, 2018, compared to $25.7 million for the year ended December 31, 2017. The increase of $7.3 million was primarily due to an increase of $6.0 million in preclinical and clinical development expenses related to the advancement of ETX2514SUL and our NBP and other preclinical programs, an increase of $1.2 million in personnel expenses associated with higher headcount and higher stock-based compensation primarily related to 2017 and 2018 option grants, and an increase of $0.8 million associated with higher facility costs and an increase in loss on disposal of fixed assets, offset in part by a decrease of $0.7 million in preclinical and clinical development expenses associated with our ETX0282CPDP product candidate. The increase in preclinical and clinical development expenses of $6.0 million was associated with the advancement of ETX2514SUL and our NBP and other preclinical programs and was primarily due to an increase of $3.0 million in clinical development costs, an increase of $2.3 million in drug manufacturing costs and an increase of $0.7 million in preclinical expenses. General and Administrative Expenses General and administrative expenses were $10.2 million for the year ended December 31, 2018, compared to $5.6 million for the year ended December 31, 2017. The increase of $4.6 million was primarily due to increases of $2.5 million in legal and professional fees associated with our initial public offering and preparation for becoming a public company and the preparation, audit and review of our consolidated financial statements, $0.6 million in salaries and benefits resulting from higher headcount, $0.5 million in stock-based compensation expense resulting from options granted during the years ended December 31, 2017 and December 31, 2018, $0.3 million in value-added taxes associated with payments received from Zai Lab and $0.7 million in other costs, such as facilities and insurance. Other Income Other income was $5.7 million for the year ended December 31, 2018, compared to $1.4 million for the year ended December 31, 2017. The increase of $4.3 million was due to an increase in grant income of $3.9 million associated with our grant agreements with the CARB-X program and an increase in interest income of $0.4 million resulting from higher cash balances during the year ended December 31, 2018. Income Taxes Income taxes consists of China withholding taxes on the upfront payment under our license and collaboration agreement with Zai Lab. Liquidity and Capital Resources Overview As of December 31, 2018, we had raised aggregate net cash proceeds of $104.2 million from the sale of redeemable convertible preferred stock and approximately $65.6 million of net proceeds from the sale of common stock in our initial public offering, which we have used to fund our operations. In addition, we have also either directly received funding or financial commitments from, or have had our program activities conducted and funded by, the U.S. government through our arrangements with NIAID, CARB-X and the U.S. Department of Defense, and have received non-profit awards from GARDP and an upfront payment from Zai Lab. As of December 31, 2018, we had cash, cash equivalents and short-term investments of $85.1 million. We have incurred operating losses and experienced negative operating cash flows since our inception and anticipate that we will continue to incur losses for at least the next several years. Our net loss was $33.0 million for the year ended December 31, 2018. As of December 31, 2018, we had an accumulated deficit of $90.1 million. We believe that our existing cash, cash equivalents and short-term investments will enable us to fund our operating expenses and capital expenditure requirements into the fourth quarter of 2020. We have based this estimate on assumptions that may prove to be wrong, and we could exhaust our available capital resources sooner than we expect. Funding Requirements Our primary uses of capital are, and we expect will continue to be, compensation and related expenses, third-party clinical research and development services, laboratory and related supplies, manufacturing development costs, legal and other regulatory expenses and general administrative costs. The successful development of our product candidates is highly uncertain. At this time, we cannot reasonably estimate or know the nature, timing and estimated costs of the efforts that will be necessary to complete the clinical development of our product candidates and obtain regulatory approvals. We are also unable to predict when, if ever, net cash inflows will commence from product sales. This is due to the numerous risks and uncertainties associated with developing drugs, including, among others, the uncertainty of: · successful enrollment in, and completion of clinical trials; · performing preclinical studies and clinical trials in compliance with the FDA, the EMA or any comparable regulatory authority requirements; · the ability of collaborators to manufacture sufficient quantity of product for development, clinical trials or potential commercialization; · obtaining marketing approvals with labeling for sufficiently broad patient populations and indications, without unduly restrictive distribution limitations or safety warnings, such as black box warnings or a Risk Evaluation and Mitigation Strategies program; · obtaining and maintaining patent, trademark and trade secret protection and regulatory exclusivity for our product candidates; · making arrangements with third parties for manufacturing capabilities; · launching commercial sales of products, if and when approved, whether alone or in collaboration with others; · acceptance of the therapies, if and when approved, by physicians, patients and third-party payors; · competing effectively with other therapies; · obtaining and maintaining healthcare coverage and adequate reimbursement; · protecting our rights in our intellectual property portfolio; and · maintaining a continued acceptable safety profile of our drugs following approval. A change in the outcome of any of these variables with respect to the development of any of our product candidates would significantly change the costs and timing associated with the development of that product candidate. We will not generate revenue from product sales unless and until we or a collaborator successfully complete clinical development and obtain regulatory approval for our current and future product candidates. If we obtain regulatory approval for any of our product candidates that we intend to commercialize on our own, we will incur significant expenses related to commercialization, including developing our internal commercialization capability to support product sales, marketing and distribution. As a result, we will need substantial additional funding to support our continuing operations and to pursue our growth strategy. Until such time, if ever, when we can generate substantial product revenue, we expect to finance our cash needs through a combination of equity offerings, debt financings and potential collaboration, license and development agreements. To the extent that we raise additional capital through the sale of equity or convertible debt securities, your ownership interest will be diluted, and the terms of these securities may include liquidation or other preferences that adversely affect your rights as a stockholder. Debt financing and preferred equity financing, if available, may involve agreements that include covenants limiting or restricting our ability to take specific actions, such as incurring additional debt, making capital expenditures or declaring dividends. If we raise additional funds through collaborations, strategic alliances or marketing, distribution or licensing arrangements with third parties, we may be required to relinquish valuable rights to our technologies, future revenue streams, research programs or product candidates or to grant licenses on terms that may not be favorable to us. If we are unable to raise additional funds through equity or debt financings when needed, we may be required to delay, limit, reduce or terminate our drug development or future commercialization efforts or grant rights to a third party to develop and market product candidates that we would otherwise prefer to develop and market ourselves. Our failure to raise capital as and when needed would compromise our ability to pursue our business strategy. We will also continue to incur costs as a public company that we did not previously incur or previously incurred at lower rates, including increased fees payable to the nonemployee members of our board of directors, increased personnel costs, increased director and officer insurance premiums, audit and legal fees, investor relations fees and expenses for compliance with public-company reporting requirements under the Exchange Act and rules implemented by the SEC and Nasdaq. Because of the numerous risks and uncertainties associated with product development, we are unable to predict the timing or amount of increased expenses or when or if we will be able to achieve or maintain profitability. Even if we are able to generate product sales, we may not become profitable. If we fail to become profitable or are unable to sustain profitability on a continuing basis, we may be unable to continue our operations at planned levels and be forced to reduce or terminate our operations. Cash Flows The following table summarizes our cash flows for the periods presented (in thousands): Operating Activities During the year ended December 31, 2018, operating activities used $35.8 million of cash, resulting from our net loss of $33.0 million and net cash used for changes in operating assets and liabilities of $4.5 million, partially offset by non-cash charges of $1.6 million. Net cash used for changes in operating assets and liabilities for the year ended December 31, 2018 consisted primarily of a $2.3 million decrease in accrued expenses and other current liabilities, a $1.5 million increase in prepaid expenses and other assets and a $1.0 million increase in grants receivable. These were partially offset by a $0.1 million increase in accounts payable and a $0.1 million increase in deferred rent. During the year ended December 31, 2017, operating activities used $27.2 million of cash, resulting from our net loss of $29.9 million, partially offset by non-cash charges of $0.6 million and net cash provided by changes in operating assets and liabilities of $2.2 million. Net cash provided by changes in operating assets and liabilities for the year ended December 31, 2017 consisted primarily of a $3.4 million increase in accrued expenses and a $0.4 million increase in accounts payable, mainly due to an increase in clinical trial costs and associated drug manufacturing costs for the advancement of ETX2514 and ETX0282. These increases were partially offset by an increase of $0.7 million in grants receivable, an increase of $0.3 million in prepaid expenses and a decrease of $0.6 million in due to related party. Investing Activities During the year ended December 31, 2018, net cash used in investing activities was $36.1 million, consisting of our purchases of property and equipment of $0.4 million and short-term investments of $35.7 million. During the year ended December 31, 2017, net cash used in investing activities was $0.3 million, consisting of our purchases of property and equipment. Financing Activities During the year ended December 31, 2018, net cash provided by financing activities was $66.2 million, which consisted primarily of $66.1 million of proceeds from our initial public offering net of issuance costs paid in the period. During the year ended December 31, 2017, net cash provided by financing activities was $56.3 million, which related to sales of redeemable convertible preferred stock. In August 2017, we issued and sold 42,372,882 shares of Series B-1 Tranche A redeemable convertible preferred stock for net proceeds of $24.4 million and in December 2017, we received net cash proceeds of $31.9 million from the sale of 54,067,796 shares of Series B-1 Tranche B redeemable convertible preferred stock. Contractual Obligations and Commitments As a smaller reporting company, we are not required to provide the disclosure required by Item 303(a)(5) of Regulation S-K. Off-Balance Sheet Arrangements We did not have during the periods presented, and we do not currently have, any off-balance sheet arrangements, as defined in the rules and regulations of the SEC. Critical Accounting Policies and Significant Judgments and Estimates Our consolidated financial statements are prepared in accordance with generally accepted accounting principles in the United States. The preparation of our consolidated financial statements and related disclosures requires us to make estimates and judgments that affect the reported amounts of assets, liabilities, costs and expenses, and the disclosure of contingent assets and liabilities in our consolidated financial statements. We base our estimates on historical experience, known trends and events and various other factors that we believe are reasonable under the circumstances, the results of which form the basis for making judgments about the carrying values of assets and liabilities that are not readily apparent from other sources. We evaluate our estimates and assumptions on an ongoing basis. Our actual results may differ from these estimates under different assumptions or conditions. While our significant accounting policies are described in more detail in Note 2 to our consolidated financial statements appearing at the end of this Annual Report on Form 10-K, we believe that the following accounting policies are those most critical to the judgments and estimates used in the preparation of our consolidated financial statements. Revenue Recognition Effective January 1, 2018, we adopted Accounting Standards Codification, or ASC, Topic 606, Revenue from Contracts with Customers, or ASC 606. This standard applies to all contracts with customers, except for contracts that are within the scope of other standards, such as leases, insurance, and financial instruments. Under ASC 606, we recognize revenue when a customer obtains control of promised goods or services, in an amount that reflects the consideration that we expect to receive in exchange for those goods or services. To determine revenue recognition for arrangements that we determine are within the scope of ASC 606, we perform the following five steps: (i) identify the contract(s) with a customer; (ii) identify the performance obligations in the contract; (iii) determine the transaction price; (iv) allocate the transaction price to the performance obligations in the contract; and (v) recognize revenue when (or as) we satisfy a performance obligation. We only apply the five-step model to contracts when it is probable that we will collect the consideration we are entitled to in exchange for the goods or services it transfers to the customer. At contract inception, once the contract is determined to be within the scope of ASC 606, we assess the goods or services promised within each contract and determine those that are performance obligations, and assesses whether each promised good or service is distinct. We then recognize as revenue the amount of the transaction price that is allocated to the respective performance obligation when (or as) the performance obligation is satisfied as services are rendered. We enter into collaboration agreements for research, development, manufacturing and commercial services that are within the scope of ASC 606, under which we license certain rights to our product candidates to third parties. The terms of these arrangements typically include payment to us of one or more of the following: non-refundable, upfront license fees; reimbursement of certain costs; customer option exercise fees; development, regulatory and commercial milestone payments; and royalties on net sales of licensed products. The amount of variable consideration is constrained until it is probable that the revenue is not at a significant risk of reversal in a future period. The contracts into which we enter generally do not include significant financing components. As part of the accounting for these arrangements, we may be required to use significant judgment to determine: (a) the performance obligations in the contract under step (ii) above, (b) the transaction price under step (iii) above and (c) the timing of revenue recognition, including the appropriate measure of progress in step (v) above. We use judgment to determine whether milestones or other variable consideration, except for royalties, should be included in the transaction price, as described further below. The transaction price is allocated to each performance obligation on a relative stand-alone selling price basis, for which we recognize revenue as or when the performance obligations under the contract are satisfied. If a milestone or other variable consideration relates specifically to our efforts to satisfy a single performance obligation or to a specific outcome from satisfying the performance obligation, we generally allocate the milestone amount entirely to that performance obligation once it is probable that a significant revenue reversal would not occur. Amounts received prior to revenue recognition are recorded as deferred revenue. Amounts expected to be recognized as revenue within the 12 months following the balance sheet date would be classified as current portion of deferred revenue in our consolidated balance sheets. Amounts not expected to be recognized as revenue within the 12 months following the balance sheet date would be classified as deferred revenue, net of current portion. Licenses of intellectual property In assessing whether a license is distinct from the other promises, we consider factors such as the research, development, manufacturing and commercialization capabilities of the collaboration partner and the availability of the associated expertise in the general marketplace. In addition, we consider whether the collaboration partner can benefit from a license for its intended purpose without the receipt of the remaining promise(s), whether the value of the license is dependent on the unsatisfied promise(s), whether there are other vendors that could provide the remaining promise(s), and whether it is separately identifiable from the remaining promise(s). For licenses that are combined with other promises, we utilize judgment to assess the nature of the combined performance obligation to determine whether the combined performance obligation is satisfied over time or at a point in time and, if over time, the appropriate method of measuring progress for purposes of recognizing revenue. We evaluate the measure of progress each reporting period and, if necessary, adjust the measure of performance and related revenue recognition. Customer options If an arrangement is determined to contain customer options that allow the customer to acquire additional goods or services, the goods and services underlying the customer options are not considered to be performance obligations at the outset of the arrangement, as they are contingent upon option exercise. We evaluate the customer options for material rights, or options to acquire additional goods or services for free or at a discount. If the customer options are determined to represent or include a material right, the material right is recognized as a separate performance obligation at the outset of the arrangement. We allocate the transaction price to material rights based on the relative standalone selling price, which is determined based on the identified discount and the probability that the customer will exercise. Amounts allocated to a material right are not recognized as revenue until, at the earliest, the option is exercised. Milestone payments At the inception of each arrangement that includes development milestone payments, we evaluate whether the milestones are considered probable of being achieved and estimate the amount to be included in the transaction price using the most likely amount method. If it is probable that a significant reversal of cumulative revenue would not occur, the associated milestone value is included in the transaction price. Milestone payments that are not within our control, such as regulatory approvals, are not considered probable of being achieved until those approvals are received. We evaluate factors such as the scientific, clinical, regulatory, commercial, and other risks that must be overcome to achieve the particular milestone in making this assessment. There is considerable judgment involved in determining whether it is probable that a significant reversal of cumulative revenue would not occur. At the end of each subsequent reporting period, we reevaluate the probability of achievement of all milestones subject to constraint and, if necessary, adjusts its estimate of the overall transaction price. Any such adjustments are recorded on a cumulative catch-up basis, which would affect revenue and earnings in the period of adjustment. Research and Development Expenses All research and development expenses are expensed as incurred. Research and development expenses comprise costs incurred in performing research and development activities, including compensation, benefits and other employee costs; equity-based compensation expense; laboratory and clinical supplies and other direct expenses; facilities expenses; overhead expenses; fees for contractual services, including preclinical studies, clinical trials, clinical manufacturing and raw materials; and other external expenses. Nonrefundable advance payments for research and development activities are capitalized and expensed over the related service period or as goods are received. When third-party service providers’ billing terms do not coincide with our period-end, we are required to make estimates of our obligations to those third parties, including clinical trial costs, contractual service costs and costs for supply of our drug candidates, incurred in a given accounting period and record accruals at the end of the period. We base our estimates on our knowledge of the research and development programs, services performed for the period and the expected duration of the third-party service contract, where applicable. Stock-Based Compensation We measure stock-based awards granted to employees and directors based on the estimated fair value of the award on the date of the grant and recognize compensation expense for those awards over the requisite service period, which is generally the vesting period of the respective award. Forfeitures are accounted for as they occur. We estimate the fair value of each stock option grant using the Black-Scholes option-pricing model. We consider the fair value of our common stock, an input to the Black-Scholes option pricing model, a critical accounting estimate. Valuation of Common Stock As there was no public market for our common stock prior to the initial public offering of our common stock, the estimated fair value of our common stock was determined by our board of directors as of the date of each option grant, with input from management, considering third-party valuations of our common stock as well as our board of directors’ assessment of additional objective and subjective factors that it believed were relevant and which may have changed from the date of the most recent third-party valuation through the date of the grant. These third-party valuations were performed in accordance with the guidance outlined in the American Institute of Certified Public Accountants’ Accounting and Valuation Guide, Valuation of Privately-Held-Company Equity Securities Issued as Compensation. Our board of directors considered various objective and subjective factors to determine the fair value of our common stock as of each grant date, including: · any recent valuations of our common stock performed by an independent third-party valuation firm; · our financial position, including cash-on-hand, and our historical and forecasted performance and operating results; · the status of research and development efforts; · our stage of development and business strategy; · the material risks related to our business; · the prices at which we sold our redeemable convertible preferred stock to outside investors in arm’s length transactions and the rights, preferences and privileges of the redeemable convertible preferred stock relative to those of our common stock, including the liquidation preferences of the redeemable convertible preferred stock; · the illiquid nature of our common stock; · the value of companies we consider peers based on a number of factors, including similarity to us with respect to industry, business model, stage of growth, company size, financial risk and other factors; · trends and market conditions affecting our industry; and · the likelihood of achieving a liquidity event for the holders of our common stock, such as an initial public offering or the sale of our company. The assumptions underlying these valuations represent management’s best estimates, which involve inherent uncertainties and the application of management judgment. As a result, if factors or expected outcomes change and we use significantly different assumptions or estimates, our stock-based compensation expense could be materially different. Following the closing of the initial public offering, the fair value of our common stock is determined based on the quoted market price of our common stock. Recent Accounting Pronouncements Refer to Note 2, “Summary of Significant Accounting Policies,” in the accompanying notes to our consolidated financial statements appearing elsewhere in this Annual Report on Form 10-K for a discussion of recent accounting pronouncements. Emerging Growth Company Status The Jumpstart Our Business Startups Act of 2012 permits an “emerging growth company” such as us to take advantage of an extended transition period to comply with new or revised accounting standards applicable to public companies until those standards would otherwise apply to private companies. We have irrevocably elected to “opt out” of this provision and, as a result, we will comply with new or revised accounting standards when they are required to be adopted by public companies that are not emerging growth companies.

<s>[INST] This discussion contains certain forwardlooking statements that involve risks and uncertainties. We make such forwardlooking statements pursuant to the safe harbor provisions of the Private Securities Litigation Reform Act of 1995 and other federal securities laws. Forwardlooking statements are identified by words such as “believe,” “will,” “may,” “estimate,” “continue,” “anticipate,” “intend,” “should,” “plan,” “expect,” “predict,” “could,” “potentially” or the negative of these terms or similar expressions. You should read these statements carefully because they discuss future expectations, contain projections of future results of operations or financial condition, or state other “forward looking” information. These statements relate to our future plans, objectives, expectations, intentions and financial performance and the assumptions that underlie these statements. These forwardlooking statements are subject to certain risks and uncertainties that could cause actual results to differ materially from those anticipated in the forwardlooking statements. Factors that might cause such a difference include, but are not limited to, those discussed in the “Risk Factors” section in this Annual Report on Form 10K. Forwardlooking statements are based on our management’s beliefs and assumptions and on information currently available to our management. These statements, like all statements in this report, speak only as of their date, and except as required by law, we undertake no obligation to update or revise these statements in light of future developments. We caution investors that our business and financial performance are subject to substantial risks and uncertainties. Overview We are a clinicalstage biopharmaceutical company focused on the discovery, development and commercialization of novel antibacterial products to treat serious infections caused by multidrugresistant Gramnegative bacteria. Leveraging our targeteddesign platform, we have engineered and developed product candidates that target clinically validated mechanisms to address antibiotic resistance. Our lead product candidate, ETX2514, as well as one of our other product candidates, ETX0282, inhibit one of the most prevalent forms of bacterial resistance, βlactamase enzymes, so named because of their ability to inactivate βlactam antibiotics, one of the most commonly used classes of antibiotics. By blocking this resistance mechanism, these product candidates, when administered in combination with βlactam antibiotics, are designed to restore the efficacy of those antibiotics. Our other product candidate, zoliflodacin, targets the validated mechanism of action of the fluoroquinolone class of antibiotics, but does so in a novel manner to avoid existing fluoroquinolone resistance. ETX2514SUL is a fixeddose combination of ETX2514, a novel broadspectrum intravenous, or IV, βlactamase inhibitor, or BLI, with sulbactam, an IV βlactam antibiotic, that we are developing for the treatment of a variety of serious multidrugresistant infections caused by Acinetobacter baumannii, or Acinetobacter. We have completed three separate Phase 1 clinical trials, including one evaluating the penetration of ETX2514SUL into the lung and one in renally impaired patients. In addition, we have completed a Phase 2 clinical trial in patients with complicated urinary tract infections, or UTIs. Based on a series of discussions with the U.S. Food and Drug Administration, or FDA, including an endofPhase2 meeting, we are in the process of initiating a single Phase 3 clinical trial with data expected in the second half of 2020. Zoliflodacin, is a novel orally administered molecule that inhibits bacterial gyrase, an essential enzyme in bacterial reproduction, for the treatment of drugresistant Neisseria gonorrhoeae, the bacterial pathogen responsible for gonorrhea. Intramuscular ceftriaxone now represents the lastresort treatment option for gonorrhea, although resistant strains are beginning to emerge. We believe that there is a growing unmet need for an oral antibiotic that will reliably treat patients with gonorrhea, including multidrugresistant gonorrhea. [/INST] Negative. </s>

Entasis Therapeutics Holdings Inc.

2020-03-11

2019-12-31

Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations The following information should be read in conjunction with the consolidated financial information and the notes thereto appearing elsewhere in this Annual Report on Form 10-K. This discussion contains certain forward-looking statements that involve risks and uncertainties. We make such forward-looking statements pursuant to the safe harbor provisions of the Private Securities Litigation Reform Act of 1995 and other federal securities laws. Forward-looking statements are identified by words such as “believe,” “will,” “may,” “estimate,” “continue,” “anticipate,” “intend,” “should,” “plan,” “expect,” “predict,” “could,” “potentially” or the negative of these terms or similar expressions. You should read these statements carefully because they discuss future expectations, contain projections of future results of operations or financial condition, or state other “forward- looking” information. These statements relate to our future plans, objectives, expectations, intentions and financial performance and the assumptions that underlie these statements. These forward-looking statements are subject to certain risks and uncertainties that could cause actual results to differ materially from those anticipated in the forward-looking statements. Factors that might cause such a difference include, but are not limited to, those discussed in the “Risk Factors” section in this Annual Report on Form 10-K. Forward-looking statements are based on our management’s beliefs and assumptions and on information currently available to our management. These statements, like all statements in this report, speak only as of their date, and except as required by law, we undertake no obligation to update or revise these statements in light of future developments. We caution investors that our business and financial performance are subject to substantial risks and uncertainties. Overview We are an advanced, clinical-stage biopharmaceutical company focused on the discovery, development and commercialization of novel antibacterial products that address high unmet medical needs to treat serious infections caused by multidrug-resistant Gram-negative bacteria. Leveraging our targeted-design platform, our strategy is to discover and develop novel molecules that overcome mechanisms of antibiotic resistance in specific bacterial pathogens. Our lead product candidate, sulbactam-durlobactam, or SUL-DUR, is a fixed-dose intravenous, or IV, combination of sulbactam, an IV β-lactam antibiotic, and durlobactam, a novel broad-spectrum intravenous β-lactamase inhibitor, or BLI, that we are developing for the treatment of multidrug-resistant infections caused by Acinetobacter baumannii, or Acinetobacter. Based on current carbapenem resistance rates, we estimate there are between 90,000 and 120,000 hospital-treated carbapenem-resistant Acinetobacter infections annually in the United States and Europe for which significant morbidity and mortality exists due to limited treatment options. We initiated ATTACK, our single Phase 3 registration trial in April 2019, with data readout expected in early 2021. This is a change from our previous guidance of a data readout during the second half of 2020 due to the coronavirus outbreak in countries where we are actively conducting the ATTACK registration trial. We believe that the data from the ATTACK trial, along with data from our other clinical trials of SUL-DUR, will be sufficient to submit a new drug application, or NDA, to the U.S. Food and Drug Administration, or FDA. Our second late-stage product candidate, zoliflodacin, is a novel orally administered molecule being developed for the treatment of uncomplicated gonorrhea. The bacterial pathogen responsible for gonorrhea is Neisseria gonorrhoeae, or N. gonorrhoeae, including multidrug-resistant strains. Intramuscular injections of ceftriaxone now represent the only U.S. Centers for Disease Control and Prevention, or CDC, recommended treatment option for the estimated 1.1 million annual cases of gonorrhea in the U.S. We believe there is a growing unmet need for a single-dose oral antibiotic that will reliably treat patients with gonorrhea, including infections caused by multidrug-resistant strains of N. gonorrhoeae, which are emerging globally. The Phase 3 registration trial is being funded by our nonprofit collaborator, the Global Antibiotic Research and Development Partnership, or GARDP, and was initiated in September 2019 with data expected in 2021, which we believe, along with data from our other clinical trials of zoliflodacin, will be sufficient for submitting an NDA. We are also developing ETX0282CPDP for the treatment of complicated urinary tract infections, or cUTIs, including those caused by carbapenem-resistant Enterobacteriaceae, or CRE. ETX0282CPDP is an oral, fixed-dose combination of ETX0282 with cefpodoxime proxetil. We believe there is a significant unmet need for new oral antibiotics to reliably treat the estimated 3 to 4 million patients diagnosed annually with cUTIs. We reported preliminary trial results in June 2019 and are now progressing with modified release formulation work. Lastly, we are using our targeted-design platform to develop a novel class of antibiotics, non β-lactam inhibitors of penicillin-binding proteins, or NBPs. We believe our NBPs constitute a potential new class of Gram-negative antibacterial agents with no pre-existing resistance that are designed to target a broad spectrum of pathogens, including Pseudomonas aeruginosa, or Pseudomonas. During the fourth quarter of 2019 we selected ETX0462 as a clinical candidate for this program. Since our inception in May 2015, we have devoted substantially all of our resources to organizing and staffing our company, business planning, raising capital, acquiring or discovering product candidates and securing related intellectual property rights, conducting discovery and development activities for our programs and planning for potential commercialization. We do not have any products approved for sale and have not generated any revenue from product sales. As of December 31, 2019, we have funded our operations primarily with net cash proceeds of $104.2 million from the sale of our preferred stock and net cash proceeds of $65.6 million from the sale of common stock in our initial public offering. We have also either directly received funding or financial commitments from, or have had our program activities conducted and funded by, the U.S. government through our arrangements with the U.S. National Institute of Allergy and Infectious Diseases, or NIAID, the Combating Antibiotic Resistant Bacteria Biopharmaceutical Accelerator program, or CARB-X, and the U.S. Department of Defense, and have received non-profit awards from GARDP, and upfront and milestone payments from our license and collaboration agreement with Zai Lab (Shanghai), Co., Ltd., or Zai Lab. Funding Arrangements CARB-X In March 2017 and October 2017, we entered into funding arrangements with the Trustees of Boston University to utilize funds from the U.S. government, through the CARB-X program, for support of our ETX0282 and NBP programs. These funding arrangements could cover up to $16.8 million of our specified research expenditures from April 2017 through September 2021. As of December 31, 2019, we had received $7.0 million in payments and we have recorded $8.0 million of grant income under these funding arrangements. USAMRAA In December 2016, we entered into a funding arrangement with the U.S. Army Medical Research Acquisition Activity, or USAMRAA, a division of the U.S. Department of Defense, through which we received a grant. This grant covers funding for up to $1.1 million of specified research expenditures incurred from December 2016 through June 2019, or the performance period. Specified research expenditures are the reimbursable expenses associated with agreed upon activities needed to advance the research project supported by the grant. These expenditures can include internal labor, laboratory supplies and equipment, travel, consulting and third-party vendor research and development support costs. We received the final reimbursement payment for this grant in May 2019. Through December 31, 2019, we have recorded $1.1 million of grant income and we have received payments of $1.1 million under this grant. License and Collaboration Agreements GARDP In July 2017, we entered into a collaboration agreement with GARDP for the development and commercialization of a product candidate containing zoliflodacin in certain countries. Under the terms of the collaboration agreement, GARDP will fully fund the ongoing Phase 3 registration trial, including the manufacture and supply of the product candidate containing zoliflodacin, in uncomplicated gonorrhea. Zai Lab In April 2018, we entered into a license and collaboration agreement with Zai Lab (Shanghai) Co., Ltd., or Zai Lab, pursuant to which Zai Lab licensed exclusive rights to durlobactam and SUL-DUR in the Asia-Pacific region. Under the terms of the agreement, Zai Lab will fund most of our clinical trial costs in China for SUL-DUR, including all costs in China for our Phase 3 registration trial of SUL-DUR, with the exception of Phase 3 patient drug supply of licensed product. As of December 31, 2019, we have received net payments of $11.3 million, representing the $5.0 million upfront payment, $7.0 million of milestone payments, $0.6 million of research support payments and $0.6 million of certain other reimbursable clinical trial costs, less applicable taxes, from Zai Lab and we have recognized revenue of $12.0 million under the agreement. Components of Results of Operations Revenue All of our revenue has been derived from our license and collaboration agreement with Zai Lab. To date, we have not generated any revenue from product sales, and we do not expect to generate any revenue from the sale of products in the near future. If our development efforts for our product candidates and preclinical program are successful and result in regulatory approval, we may generate revenue in the future from product sales. Operating Expenses Research and Development Expenses Research and development expenses consist primarily of costs incurred for our research activities, including our product discovery efforts and the development of our preclinical and clinical product candidates. These expenses include: · employee-related expenses, including salaries and benefits, travel and stock-based compensation expense for employees engaged in research and development functions; · fees paid to consultants for services directly related to our product development and regulatory efforts; · expenses incurred under agreements with contract research organizations, or CROs, as well as contract manufacturing organizations, or CMOs, and consultants that conduct and provide supplies for our preclinical studies and clinical trials; · costs associated with preclinical activities and development activities; · costs associated with our technology and our intellectual property portfolio; · costs related to compliance with regulatory requirements; and · facilities-related expenses, which include allocated rent and maintenance of facilities and other operating costs. Costs associated with research and development activities are expensed as incurred. Costs for certain development activities, such as clinical trials, are recognized based on an evaluation of the progress to completion of specific tasks using data such as patient enrollment, clinical site activations or other information provided to us by our vendors. Nonrefundable advance payments for goods or services to be received in the future for use in research and development activities are recorded as prepaid expenses. Such amounts are recognized as an expense as the goods are delivered or the related services are performed, or until it is no longer expected that the goods will be delivered, or the services rendered. Our direct research and development expenses are tracked on a program-by-program basis for our product candidates and preclinical program and consist primarily of external costs, such as fees paid to outside consultants, CROs, CMOs and central laboratories in connection with our preclinical development, process development, manufacturing and clinical development activities. Our direct research and development expenses by program also include fees incurred under service, license or option agreements. We do not allocate employee costs or facility expenses to specific programs because these costs are deployed across multiple programs and, accordingly, are not separately classified. We primarily use internal resources and our own employees to conduct our research and discovery as well as for managing our preclinical development, process development, manufacturing and clinical development activities. To date, substantially all of our research and development expenses have been related to the preclinical and clinical development of our product candidates and preclinical program. The following table shows our research and development expenses by development program and type of activity for the years ended December 31, 2019 and 2018: Research and development activities are central to our business model. Product candidates in later stages of clinical development generally have higher development costs than those in earlier stages of clinical development, primarily due to the increased size and duration of later-stage clinical trials. We expect our research and development expenses to remain elevated over the next several years as we continue to progress two of our product candidates through Phase 3 registration trials and into the follow-on NDA filing activities. However, it is difficult to determine with certainty the duration and completion costs of our current or future preclinical programs and clinical trials of our product candidates, or if, when or to what extent we will generate revenues from the commercialization and sale of any of our product candidates that obtain regulatory approval. We may never succeed in achieving regulatory approval for any of our product candidates. The duration, costs and timing of clinical trials and development of our product candidates and preclinical program will depend on a variety of factors that include, but are not limited to, the following: · the number of trials required for approval and any requirement for extension trials; · per-patient trial costs; · the number of patients that participate in the trials; · the number of sites included in the trials; · the countries in which the trials are conducted; · the length of time required to enroll eligible patients; · the number of doses that patients receive; · the drop-out or discontinuation rates of patients; · potential additional safety monitoring or other studies requested by regulatory agencies; · the duration of patient follow-up; and · the efficacy and safety profiles of the product candidates. Any changes in the outcome of any of these factors with respect to the development of our product candidates could mean a significant change in the costs and timing associated with the development of these product candidates. In addition, the probability of success for each product candidate will depend on numerous factors, including competition, manufacturing and supply, and commercial viability. We will determine which programs to pursue and how much to fund each program based on the scientific and clinical success of each product candidate, as well as an assessment of each candidate’s commercial potential. General and Administrative Expenses General and administrative expenses consist of salaries and benefits, travel and stock-based compensation expense for personnel in executive, finance and administrative functions. General and administrative costs also include facilities-related costs not otherwise included in research and development expenses, professional fees for legal, patent, consulting and accounting and audit services. We anticipate that our general and administrative expenses will increase in the future as we increase our headcount to support our continued research, development and commercialization activities of our product candidates. We also anticipate that we will continue to incur increased accounting, audit, legal, regulatory, compliance and director and officer insurance costs as well as investor and public relations expenses associated with being a public company. Additionally, if and when we believe a regulatory approval of a product candidate appears likely, we anticipate an increase in payroll and other employee-related expenses as a result of our preparation for commercial operations, especially as it relates to the sales and marketing functions for that product candidate. Other Income Grant Income Grant income consists of income recognized in connection with grants we received under our funding arrangements with USAMRAA and the Trustees of Boston University through the CARB-X program. Grant income is recognized in the period during which the related specified expenses are incurred, provided that the conditions under which the grants were provided have been met. Interest Income Interest income consists of interest earned on our cash and investment balances, which are primarily held in money market funds and U.S. Treasury Securities. Provision for Income Taxes The provision for income taxes primarily consists of provisions for foreign withholding income taxes on payments related to our agreement with Zai Lab. Results of Operations Years Ended December 31, 2019 and 2018 The following table summarizes our results of operations for the years ended December 31, 2019 and 2018: Revenue We recognized revenue of $7.0 million for the year ended December 31, 2019, compared to $5.0 million for the year ended December 31, 2018. The increase of $2.0 million was due to milestones achieved pursuant to the collaboration agreement with Zai Lab, which we entered into in April 2018. Research and Development Expenses Research and development expenses were $40.2 million for the year ended December 31, 2019, compared to $33.0 million for the year ended December 31, 2018. The increase of $7.1 million was primarily due to an increase of $8.3 million in clinical development expenses related to the advancement of our SUL-DUR product candidate and an increase of $2.7 million in personnel expenses associated with higher headcount, higher salaries and higher stock-based compensation expense resulting from options granted during the year ended December 31, 2019; offset in part by a decrease of $3.0 million in preclinical and clinical development expenses associated with our ETX0282CPDP product candidate, a decrease of $0.6 million in facility costs and a decrease of $0.2 million in other preclinical program spending. The increase in clinical development expenses of $8.3 million associated with the advancement of SUL-DUR was primarily due to an increase of $7.0 million in clinical development costs and an increase of $1.2 million in drug manufacturing costs. The decrease in preclinical and clinical development expenses of $3.0 million associated with the advancement of our ETX0282CPDP product candidate was primarily due to a decrease of $2.5 million in drug manufacturing costs and a decrease of $0.7 million in other preclinical expenses, offset in part by an increase of $0.2 million in clinical development expenses. General and Administrative Expenses General and administrative expenses were $13.8 million for the year ended December 31, 2019, compared to $10.2 million for the year ended December 31, 2018. The increase of $3.6 million was driven by an increase of $3.2 million in personnel expenses associated with higher headcount, higher salaries and higher stock-based compensation expense resulting from options granted during the year ended December 31, 2019, an increase of $0.6 million in insurance costs associated with operating as a public company, and an increase of $0.6 million in VAT and other tax. These increases were offset by a decrease of $0.8 million in legal fees primarily associated with the April 2018 corporate reorganization. Other Income Other income was $3.8 million for the year ended December 31, 2019, compared to $5.7 million for the year ended December 31, 2018. The decrease of $2.0 million was due to a decrease in grant income of $3.0 million associated with the CARB-X and USAMRAA programs, offset by an increase of $1.1 million in interest income. Provision for Income Taxes Provision for income taxes was $0.7 million for the year ended December 31, 2019, compared to $0.5 million for the year ended December 31, 2018. The $0.2 million increase was due to the timing of milestone payments received in connection with our ongoing license and collaboration agreement with Zai Lab. Our losses before income taxes were generated in the United States and United Kingdom. Consistent with all prior periods, we did not record any income tax benefit for its operating losses due to the uncertainty regarding future taxable income. Accordingly, a full valuation allowance has been established against the deferred tax assets as of December 31, 2019. Liquidity and Capital Resources Overview As of December 31, 2019, we had raised aggregate net cash proceeds of $104.2 million from the sale of redeemable convertible preferred stock and $65.6 million of net proceeds from the sale of common stock in our initial public offering, which we have used to fund our operations. In addition, we have also either directly received funding or financial commitments from, or have had our program activities conducted and funded by, the U.S. government through our arrangements with NIAID, CARB-X and the U.S. Department of Defense, and have received non-profit awards from GARDP and upfront and milestone payments from Zai Lab. As of December 31, 2019, we had cash, cash equivalents and short-term investments of $41.0 million. Going Concern Since our inception, we have incurred recurring losses and negative cash flows from operations. Our net loss was $43.9 million for the year ended December 31, 2019. As of December 31, 2019, we had an accumulated deficit of $134.0 million. We anticipate that a substantial portion of our capital resources and efforts in the foreseeable future will be focused on completing the necessary development, obtaining regulatory approval and preparing for potential commercialization of our product candidates. Based on our current operating plan, we believe that our existing cash, cash equivalents and short-term investments will be sufficient to fund our operating expenses and capital expenditure requirements into the fourth quarter of 2020. These conditions and events raise substantial doubt about our ability to continue as a going concern for the one-year period following the issuance of our consolidated financial statements for the year ended December 31, 2019. Our current funds will not be sufficient to enable us to complete all necessary development activities and commercially launch any of our product candidates. To finance our operations beyond that point, we will need to raise additional capital, which cannot be assured. To the extent that we raise additional capital through future equity offerings, the ownership interest of common stockholders will be diluted, which dilution may be significant. See Note 1 of the notes to our consolidated financial statements included elsewhere in this Annual Report on Form 10-K for additional information on our assessment. Our consolidated financial statements do not include any adjustments that might result from the outcome of this uncertainty. Accordingly, the consolidated financial statements have been prepared on a basis that assumes the Company will continue as a going concern and that contemplates the realization of assets and satisfaction of liabilities and commitments in the ordinary course of business. We expect to continue to incur significant expenses and increasing operating losses for at least the next several years. Our net losses may fluctuate significantly from period to period, depending on the timing of our planned clinical trials and expenditures on other research and development activities. We expect our expenses may increase over time as we: · continue our ongoing and planned preclinical and clinical development of our product candidates; · initiate preclinical studies and clinical trials for any additional product candidates that we may pursue in the future; · seek to discover and develop additional product candidates; · seek regulatory approvals for any product candidates that successfully complete clinical trials; · ultimately establish a sales, marketing and distribution infrastructure and scale up external manufacturing capabilities to commercialize any product candidate for which we may obtain regulatory approval and intend to commercialize on our own; · maintain, expand and protect our intellectual property portfolio; · hire additional clinical, scientific and chemistry, manufacturing and controls personnel; and · add additional operational, financial and management information systems and personnel, including personnel to support our product development and planned future commercialization efforts. Funding Requirements Our primary uses of capital are, and we expect will continue to be, compensation and related expenses, third-party clinical research and development services, laboratory and related supplies, manufacturing development costs, legal and other regulatory expenses and general administrative costs. The successful development of our product candidates is highly uncertain. At this time, we cannot reasonably estimate or know the nature, timing and estimated costs of the efforts that will be necessary to complete the clinical development of our product candidates and obtain regulatory approvals. We are also unable to predict when, if ever, net cash inflows will commence from product sales. This is due to the numerous risks and uncertainties associated with developing drugs, including, among others, the uncertainty of: · successful enrollment in, and completion of clinical trials; · performing preclinical studies and clinical trials in compliance with the FDA, the European Medicines Agency, or EMA, or any comparable regulatory authority requirements; · the ability of collaborators to manufacture sufficient quantity of product for development, clinical trials or potential commercialization; · obtaining marketing approvals with labeling for sufficiently broad patient populations and indications, without unduly restrictive distribution limitations or safety warnings, such as black box warnings or a risk evaluation and mitigation strategies program; · obtaining and maintaining patent, trademark and trade secret protection and regulatory exclusivity for our product candidates; · making arrangements with third parties for manufacturing capabilities; · launching commercial sales of products, if and when approved, whether alone or in collaboration with others; · acceptance of the therapies, if and when approved, by physicians, patients and third-party payors; · competing effectively with other therapies; · obtaining and maintaining healthcare coverage and adequate reimbursement; · protecting our rights in our intellectual property portfolio; and · maintaining a continued acceptable safety profile of our drugs following approval. A change in the outcome of any of these variables with respect to the development of any of our product candidates would significantly change the costs and timing associated with the development of that product candidate. We will not generate revenue from product sales unless and until we or a collaborator successfully complete clinical development and obtain regulatory approval for our current and future product candidates. If we obtain regulatory approval for any of our product candidates that we intend to commercialize on our own, we will incur significant expenses related to commercialization, including developing our internal commercialization capability to support product sales, marketing and distribution. As a result, we will need substantial additional funding to support our continuing operations and to pursue our growth strategy. Until such time, if ever, when we can generate substantial product revenue, we expect to finance our cash needs through a combination of equity offerings, debt financings and potential collaboration, license and development agreements. Debt financing and preferred equity financing, if available, may involve agreements that include covenants limiting or restricting our ability to take specific actions, such as incurring additional debt, making capital expenditures or declaring dividends. If we raise additional funds through collaborations, strategic alliances or marketing, distribution or licensing arrangements with third parties, we may be required to relinquish valuable rights to our technologies, future revenue streams, research programs or product candidates or to grant licenses on terms that may not be favorable to us. If we are unable to raise additional funds through equity or debt financings when needed, we may be required to delay, limit, reduce or terminate our drug development or future commercialization efforts or grant rights to a third party to develop and market product candidates that we would otherwise prefer to develop and market ourselves. Our failure to raise capital as and when needed would compromise our ability to pursue our business strategy. We will also continue to incur costs as a public company that we did not previously incur or previously incurred at lower rates, including increased fees payable to the nonemployee members of our board of directors, increased personnel costs, increased director and officer insurance premiums, audit and legal fees, investor relations fees and expenses for compliance with public-company reporting requirements under the Exchange Act and rules implemented by the SEC and Nasdaq. Because of the numerous risks and uncertainties associated with product development, we are unable to predict the timing or amount of increased expenses or when or if we will be able to achieve or maintain profitability. Even if we are able to generate product sales, we may not become profitable. If we fail to become profitable or are unable to sustain profitability on a continuing basis, we may be unable to continue our operations at planned levels and be forced to reduce or terminate our operations. Aspire Common Stock Purchase Agreement In October 2019, we entered into a common stock purchase agreement, or CSPA, with Aspire Capital Fund, LLC, or Aspire, which provides that, upon the terms and subject to the conditions and limitations set forth therein, Aspire is committed to purchase up to an aggregate of $20.0 million of shares of our common stock over the 30-month term of the CSPA. Under the CSPA, on any trading day selected by us on which the closing price of our common stock is equal to or greater than $0.25 per share, we have the right, in our sole discretion, to present Aspire with a purchase notice directing Aspire to purchase up to 50,000 shares of our common stock per business day, at a purchase price equal to the lesser of the lowest sale price of common stock on the purchase date, or the arithmetic average of the three lowest closing sale prices during the 10 consecutive business days ending on the trading day immediately preceding the purchase date. We and Aspire also may mutually agree to increase the number of shares that may be sold to as much as 2,000,000 shares per business day. In addition, on any date on which we submit a purchase notice to Aspire in an amount equal to 50,000 shares, we also have the right, in our sole discretion, to present Aspire with a volume-weighted average price purchase notice, or VWAP Purchase Notice, directing Aspire to purchase an amount of stock equal to up to 30% of the aggregate shares of our common stock traded on its principal market on the next trading day, or the VWAP Purchase Date, subject to a maximum number of shares we may determine. The purchase price per share pursuant to such VWAP Purchase Notice is generally 97% of the volume-weighted average price for our common stock traded on its principal market on the VWAP Purchase Date. We control the timing and amount of any sales to Aspire, and we are not limited with respect to use of proceeds or by any financial or business covenants, restrictions on future financings, rights of first refusal, participation rights, penalties or liquidated damages in the CSPA. The CSPA may be terminated by us at any time, at our discretion, without any cost to us. Aspire has no trading volume requirements or restrictions, and has no right to require any sales by Entasis but is obligated to make purchases as directed by us in accordance with the CSPA. Aspire has agreed that neither it nor any of its agents, representatives and affiliates shall engage in any direct or indirect short-selling or hedging of common stock during any time prior to the termination of the CSPA. As consideration for Aspire’s obligation under the CSPA, we issued 104,167 shares of common stock to Aspire as a commitment fee, or Commitment Shares. This $0.6 million commitment fee and $0.1 million in other transaction costs were deferred and charged against the gross proceeds received upon exercise as costs of equity financing within additional paid-in capital. The CSPA further provides that the number of shares that may be sold pursuant to the CSPA will be limited to 2,626,165 shares, including the Commitment Shares, which represents 19.99% of our outstanding shares of common stock as of October 21, 2019, unless stockholder approval is obtained to issue more than 19.99%. This limitation will not apply under certain circumstances specified in the CSPA. As of December 31, 2019, 50,000 shares had been purchased by Aspire pursuant to the CSPA resulting in total gross proceeds of $0.3 million. Concurrently with entering into the CSPA, we also entered into a registration rights agreement with Aspire, pursuant to which we filed with the SEC a prospectus supplement to our effective shelf registration statement on Form S-3 (File No. 333-234041), registering all of the shares of common stock that may be offered to Aspire from time to time under the CSPA, including the Commitment Shares. Cash Flows The following table summarizes our cash flows for the periods presented (in thousands): Operating Activities During the year ended December 31, 2019, operating activities used $44.7 million of cash, resulting from our net loss of $43.9 million and net cash used for changes in operating assets and liabilities of $2.8 million, partially offset by non-cash charges of $1.9 million. Net cash used for changes in operating assets and liabilities for the year ended December 31, 2019 consisted primarily of a $3.2 million increase in prepaid expenses, a $2.7 million increase in other current assets and a $0.2 million decrease in deferred rent. These were partially offset by a $2.9 million increase in accrued expenses and other current liabilities and a $0.5 million decrease in grants receivable. During the year ended December 31, 2018, operating activities used $35.8 million of cash, resulting from our net loss of $33.0 million and net cash used for changes in operating assets and liabilities of $4.5 million, partially offset by non-cash charges of $1.6 million. Net cash used for changes in operating assets and liabilities for the year ended December 31, 2018 consisted primarily of a $2.3 million decrease in accrued expenses and other current liabilities, a $0.9 million increase in prepaid expenses, a $0.6 million increase in other current assets and a $1.0 million increase in grants receivable. These were partially offset by a $0.1 million increase in accounts payable and a $0.1 million increase in deferred rent. Investing Activities During the year ended December 31, 2019, net cash provided by investing activities was $11.4 million, consisting of proceeds from maturities of short-term investments of $56.4 million, offset by purchases of short-term investments of $45.0 million. During the year ended December 31, 2018, net cash used in investing activities was $36.1 million, consisting of our purchases of property and equipment of $0.4 million and short-term investments of $35.7 million. Financing Activities During the year ended December 31, 2019, net cash provided by financing activities was $0.1 million, which consisted of $0.2 million of proceeds from the sale of shares of our common stock under our CPSA with Aspire and $0.1 million of proceeds from stock option exercises, partially offset by $0.2 million of payments of initial public offering costs. During the year ended December 31, 2018, net cash provided by financing activities was $66.2 million, which consisted primarily of $66.1 million of proceeds from our initial public offering net of issuance costs paid in the period and $0.1 million of proceeds from stock option exercises. Contractual Obligations and Commitments As a smaller reporting company, we are not required to provide the disclosure required by Item 303(a)(5) of Regulation S-K. Off-Balance Sheet Arrangements We did not have during the periods presented, and we do not currently have, any off-balance sheet arrangements, as defined in the rules and regulations of the SEC. Critical Accounting Policies and Significant Judgments and Estimates Our consolidated financial statements are prepared in accordance with generally accepted accounting principles in the United States. The preparation of our consolidated financial statements and related disclosures requires us 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 consolidated financial statements. We base our estimates on historical experience, known trends and events and various other factors that we believe are reasonable under the circumstances, the results of which form the basis for making judgments about the carrying values of assets and liabilities that are not readily apparent from other sources. We evaluate our estimates and assumptions on an ongoing basis. Our actual results may differ from these estimates under different assumptions or conditions. While our significant accounting policies are described in more detail in Note 2 to our consolidated financial statements appearing at the end of this Annual Report on Form 10-K, we believe that the following accounting policies are those most critical to the judgments and estimates used in the preparation of our consolidated financial statements. Revenue Recognition We follow Accounting Standards Codification, or ASC, Topic 606, Revenue from Contracts with Customers, or ASC 606. This standard applies to all contracts with customers, except for contracts that are within the scope of other standards, such as leases, insurance, and financial instruments. Under ASC 606, we recognize revenue when a customer obtains control of promised goods or services, in an amount that reflects the consideration that we expect to receive in exchange for those goods or services. To determine revenue recognition for arrangements that we determine are within the scope of ASC 606, we perform the following five steps: (i) identify the contract(s) with a customer; (ii) identify the performance obligations in the contract; (iii) determine the transaction price; (iv) allocate the transaction price to the performance obligations in the contract; and (v) recognize revenue when (or as) we satisfy a performance obligation. We only apply the five-step model to contracts when it is probable that we will collect the consideration we are entitled to in exchange for the goods or services it transfers to the customer. At contract inception, once the contract is determined to be within the scope of ASC 606, we assess the goods or services promised within each contract and determine those that are performance obligations, and assesses whether each promised good or service is distinct. We then recognize as revenue the amount of the transaction price that is allocated to the respective performance obligation when (or as) the performance obligation is satisfied as services are rendered. We enter into collaboration agreements for research, development, manufacturing and commercial services that are within the scope of ASC 606, under which we license certain rights to our product candidates to third parties. The terms of these arrangements typically include payment to us of one or more of the following: non-refundable, upfront license fees; reimbursement of certain costs; customer option exercise fees; development, regulatory and commercial milestone payments; and royalties on net sales of licensed products. The amount of variable consideration is constrained until it is probable that the revenue is not at a significant risk of reversal in a future period. The contracts into which we enter generally do not include significant financing components. As part of the accounting for these arrangements, we may be required to use significant judgment to determine: (a) the performance obligations in the contract under step (ii) above, (b) the transaction price under step (iii) above and (c) the timing of revenue recognition, including the appropriate measure of progress in step (v) above. We use judgment to determine whether milestones or other variable consideration, except for royalties, should be included in the transaction price, as described further below. The transaction price is allocated to each performance obligation on a relative stand-alone selling price basis, for which we recognize revenue as or when the performance obligations under the contract are satisfied. If a milestone or other variable consideration relates specifically to our efforts to satisfy a single performance obligation or to a specific outcome from satisfying the performance obligation, we generally allocate the milestone amount entirely to that performance obligation once it is probable that a significant revenue reversal would not occur. Amounts received prior to revenue recognition are recorded as deferred revenue. Amounts expected to be recognized as revenue within the 12 months following the balance sheet date would be classified as current portion of deferred revenue in our consolidated balance sheets. Amounts not expected to be recognized as revenue within the 12 months following the balance sheet date would be classified as deferred revenue, net of current portion. Licenses of intellectual property In assessing whether a license is distinct from the other promises, we consider factors such as the research, development, manufacturing and commercialization capabilities of the collaboration partner and the availability of the associated expertise in the general marketplace. In addition, we consider whether the collaboration partner can benefit from a license for its intended purpose without the receipt of the remaining promise(s), whether the value of the license is dependent on the unsatisfied promise(s), whether there are other vendors that could provide the remaining promise(s), and whether it is separately identifiable from the remaining promise(s). For licenses that are combined with other promises, we utilize judgment to assess the nature of the combined performance obligation to determine whether the combined performance obligation is satisfied over time or at a point in time and, if over time, the appropriate method of measuring progress for purposes of recognizing revenue. We evaluate the measure of progress each reporting period and, if necessary, adjust the measure of performance and related revenue recognition. Customer options If an arrangement is determined to contain customer options that allow the customer to acquire additional goods or services, the goods and services underlying the customer options are not considered to be performance obligations at the outset of the arrangement, as they are contingent upon option exercise. We evaluate the customer options for material rights, or options to acquire additional goods or services for free or at a discount. If the customer options are determined to represent or include a material right, the material right is recognized as a separate performance obligation at the outset of the arrangement. We allocate the transaction price to material rights based on the relative standalone selling price, which is determined based on the identified discount and the probability that the customer will exercise. Amounts allocated to a material right are not recognized as revenue until, at the earliest, the option is exercised. Milestone payments At the inception of each arrangement that includes development milestone payments, we evaluate whether the milestones are considered probable of being achieved and estimate the amount to be included in the transaction price using the most likely amount method. If it is probable that a significant reversal of cumulative revenue would not occur, the associated milestone value is included in the transaction price. Milestone payments that are not within our control, such as regulatory approvals, are not considered probable of being achieved until those approvals are received. We evaluate factors such as the scientific, clinical, regulatory, commercial, and other risks that must be overcome to achieve the particular milestone in making this assessment. There is considerable judgment involved in determining whether it is probable that a significant reversal of cumulative revenue would not occur. At the end of each subsequent reporting period, we reevaluate the probability of achievement of all milestones subject to constraint and, if necessary, adjusts its estimate of the overall transaction price. Any such adjustments are recorded on a cumulative catch-up basis, which would affect revenue and earnings in the period of adjustment. Research and Development Expenses All research and development expenses are expensed as incurred. Research and development expenses comprise costs incurred in performing research and development activities, including compensation, benefits and other employee costs; equity-based compensation expense; laboratory and clinical supplies and other direct expenses; facilities expenses; overhead expenses; fees for contractual services, including preclinical studies, clinical trials, clinical manufacturing and raw materials; and other external expenses. Nonrefundable advance payments for research and development activities are capitalized and expensed over the related service period or as goods are received. When third-party service providers’ billing terms do not coincide with our period-end, we are required to make estimates of our obligations to those third parties, including clinical trial costs, contractual service costs and costs for supply of our drug candidates, incurred in a given accounting period and record accruals at the end of the period. We base our estimates on our knowledge of the research and development programs, services performed for the period and the expected duration of the third-party service contract, where applicable. Stock-Based Compensation We measure stock-based awards granted to employees and directors based on the estimated fair value of the award on the date of the grant and recognize compensation expense for those awards ratably over the requisite service period, which is generally the vesting period of the respective award. We use the Black-Scholes option pricing model to value our stock option awards. Use of this valuation methodology requires that we make assumptions as to the fair value of our common stock. Valuation of Common Stock As there was no public market for our common stock prior to the initial public offering of our common stock, the estimated fair value of our common stock was determined by our board of directors as of the date of each option grant, with input from management, considering third-party valuations of our common stock as well as our board of directors’ assessment of additional objective and subjective factors that it believed were relevant and which may have changed from the date of the most recent third-party valuation through the date of the grant. These third-party valuations were performed in accordance with the guidance outlined in the American Institute of Certified Public Accountants’ Accounting and Valuation Guide, Valuation of Privately-Held-Company Equity Securities Issued as Compensation. Our board of directors considered various objective and subjective factors to determine the fair value of our common stock as of each grant date, including: · any recent valuations of our common stock performed by an independent third-party valuation firm; · our financial position, including cash-on-hand, and our historical and forecasted performance and operating results; · the status of research and development efforts; · our stage of development and business strategy; · the material risks related to our business; · the prices at which we sold our redeemable convertible preferred stock to outside investors in arm’s length transactions and the rights, preferences and privileges of the redeemable convertible preferred stock relative to those of our common stock, including the liquidation preferences of the redeemable convertible preferred stock; · the illiquid nature of our common stock; · the value of companies we consider peers based on a number of factors, including similarity to us with respect to industry, business model, stage of growth, company size, financial risk and other factors; · trends and market conditions affecting our industry; and · the likelihood of achieving a liquidity event for the holders of our common stock, such as an initial public offering or the sale of our company. The assumptions underlying these valuations represent management’s best estimates, which involve inherent uncertainties and the application of management judgment. As a result, if factors or expected outcomes change and we use significantly different assumptions or estimates, our stock-based compensation expense could be materially different. Following the closing of the initial public offering, the fair value of our common stock is determined based on the quoted market price of our common stock. Recent Accounting Pronouncements Refer to Note 2, “Summary of Significant Accounting Policies,” in the accompanying notes to our consolidated financial statements appearing elsewhere in this Annual Report on Form 10-K for a discussion of recent accounting pronouncements. Emerging Growth Company Status The Jumpstart Our Business Startups Act of 2012 permits an “emerging growth company” such as us to take advantage of an extended transition period to comply with new or revised accounting standards applicable to public companies until those standards would otherwise apply to private companies. We have irrevocably elected to “opt out” of this provision and, as a result, we will comply with new or revised accounting standards when they are required to be adopted by public companies that are not emerging growth companies.

<s>[INST] This discussion contains certain forwardlooking statements that involve risks and uncertainties. We make such forwardlooking statements pursuant to the safe harbor provisions of the Private Securities Litigation Reform Act of 1995 and other federal securities laws. Forwardlooking statements are identified by words such as “believe,” “will,” “may,” “estimate,” “continue,” “anticipate,” “intend,” “should,” “plan,” “expect,” “predict,” “could,” “potentially” or the negative of these terms or similar expressions. You should read these statements carefully because they discuss future expectations, contain projections of future results of operations or financial condition, or state other “forward looking” information. These statements relate to our future plans, objectives, expectations, intentions and financial performance and the assumptions that underlie these statements. These forwardlooking statements are subject to certain risks and uncertainties that could cause actual results to differ materially from those anticipated in the forwardlooking statements. Factors that might cause such a difference include, but are not limited to, those discussed in the “Risk Factors” section in this Annual Report on Form 10K. Forwardlooking statements are based on our management’s beliefs and assumptions and on information currently available to our management. These statements, like all statements in this report, speak only as of their date, and except as required by law, we undertake no obligation to update or revise these statements in light of future developments. We caution investors that our business and financial performance are subject to substantial risks and uncertainties. Overview We are an advanced, clinicalstage biopharmaceutical company focused on the discovery, development and commercialization of novel antibacterial products that address high unmet medical needs to treat serious infections caused by multidrugresistant Gramnegative bacteria. Leveraging our targeteddesign platform, our strategy is to discover and develop novel molecules that overcome mechanisms of antibiotic resistance in specific bacterial pathogens. Our lead product candidate, sulbactamdurlobactam, or SULDUR, is a fixeddose intravenous, or IV, combination of sulbactam, an IV βlactam antibiotic, and durlobactam, a novel broadspectrum intravenous βlactamase inhibitor, or BLI, that we are developing for the treatment of multidrugresistant infections caused by Acinetobacter baumannii, or Acinetobacter. Based on current carbapenem resistance rates, we estimate there are between 90,000 and 120,000 hospitaltreated carbapenemresistant Acinetobacter infections annually in the United States and Europe for which significant morbidity and mortality exists due to limited treatment options. We initiated ATTACK, our single Phase 3 registration trial in April 2019, with data readout expected in early 2021. This is a change from our previous guidance of a data readout during the second half of 2020 due to the coronavirus outbreak in countries where we are actively conducting the ATTACK registration trial. We believe that the data from the ATTACK trial, along with data from our other clinical trials of SULDUR, will be sufficient to submit a new drug application, or NDA, to the U.S. Food and Drug Administration, or FDA. Our second latestage product candidate, zoliflodacin, is a novel orally administered molecule being developed for the treatment of uncomplicated gonorrhea. The bacterial pathogen responsible for gonorrhea is Neisseria gonorrhoeae, or N. gonorrhoeae, including multidrugresistant strains. Intramuscular injections of ceftriaxone now represent the only U.S. Centers for Disease Control and Prevention, or CDC, recommended treatment option for the estimated 1.1 million annual cases of gonorrhea in the U.S. We believe there is a growing unmet need for a singledose oral antibiotic that will reliably treat patients with gonorrhea, including infections caused by multidrugresistant strains of N. gonorrhoeae, which are emerging globally. The Phase 3 registration trial is being funded by our nonprofit collaborator, the Global Ant [/INST] Negative. </s>

ONESPAWORLD HOLDINGS Ltd

2019-05-06

2018-12-31

ITEM 7. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS General The following discussion and analysis of our audited financial condition and results of operations should be read in conjunction with the information presented in “Selected Historical Financial Information” and our combined financial statements and the notes thereto included elsewhere in this report. In addition to historical information, the following discussion contains forward-looking statements, such as statements regarding our expectation for future performance, liquidity and capital resources, that involve risks, uncertainties and assumptions that could cause actual results to differ materially from those contained in or implied by any forward-looking statements. Factors that could cause such differences include those identified below and those described in the sections entitled “Cautionary Note Regarding Forward-Looking Statements” and “Risk Factors.” We assume no obligation to update any of these forward-looking statements. The information for the years ended December 31, 2018, 2017 and 2016 are derived from OSW Predecessor’s audited combined financial statements and the notes thereto included elsewhere in this report. Any reference to “OneSpaWorld” refers to OneSpaWorld Holdings Limited and our consolidated subsidiaries on a forward-looking basis or, as the context requires, to the historical results of OSW Predecessor. Any reference to “OSW Predecessor” refers to the entities comprising the “OneSpaWorld” business prior to the consummation of the Business Combination. Overview We are the pre-eminent global operator of health and wellness centers onboard cruise ships and a leading operator of health and wellness centers at destination resorts worldwide. Our highly-trained and experienced staff offer guests a comprehensive suite of premium health, fitness, beauty and wellness services and products onboard 163 cruise ships and at 67 destination resorts globally as of December 31, 2018. With over 80% market share in the highly attractive outsourced maritime health and wellness market, we are the market leader at approximately 10x the size of our closest maritime competitor. Over the last 50 years, we have built our leading market position on our depth of staff expertise, broad and innovative service and product offerings, expansive global recruitment, training and logistics platform as well as decades-long relationships with cruise and destination resort partners. Throughout our history, our mission has been simple-helping guests look and feel their best during and after their stay. At our core, we are a global services company. We serve a critical role for our cruise line and destination resort partners, operating a highly complex and increasingly important aspect of our cruise line and destination resort partners’ overall guest experience. Decades of investment and know-how have allowed us to construct an unmatched global infrastructure to manage the complexity of our operations, which in 2018 included nearly 8,000 annual voyages with visits to over 1,100 ports of call around the world. We have consistently expanded our onboard offerings with innovative and leading-edge service and product introductions, and developed the powerful back-end recruiting, training and logistics platforms to manage our operational complexity, maintain our industry-leading quality standards, and maximize revenue per center. The combination of our renowned recruiting and training platform, deep labor pool, global logistics and supply chain infrastructure and proven revenue management capabilities represents a significant competitive advantage that we believe is not economically feasible to replicate. Matters Affecting Comparability Supply Agreement We purchase beauty products for resale from an entity (the “Supplier Entity”) that was, during the periods presented, a wholly-owned subsidiary of Steiner Leisure. OSW Predecessor and the Supplier Entity entered into an agreement, effective as of January 1, 2017 (subsequently amended in 2018), which established the prices at which beauty products will be purchased by us from the Supplier Entity for a term of 10 years (the “Supply Agreement”). The Supply Agreement has had a positive impact on our business as it has reduced the cost of products for retail goods and has lowered the cost of products used in services. The prices of beauty products purchased by OSW Predecessor from the Supplier Entity prior to 2017 were not comparable to those set forth under the Supply Agreement and applicable to future periods. As a result, our operations and financial condition in periods prior to January 1, 2017 differ materially from those ended after that date. The Supply Agreement was effective as of January 1, 2017, however, existing inventories of products purchased prior to the effectiveness of the Supply Agreement were not fully depleted until the end of the third quarter of 2017. Beginning October 1, 2017, the cost of products used in services and cost of products reflect the actual pricing under the Supply Agreement because, at that time, all inventory on hand was purchased under the terms of the Supply Agreement. In order to quantify the impact of the Supply Agreement on the comparability of our financial statements between periods, the following table sets forth the decrease in cost of products used in services and cost of products that would have been reflected in the financial statements of us for the periods presented if all inventory on hand during such periods was purchased under the terms of the Supply Agreement (i.e., as if no existing inventories of products purchased prior to the effectiveness of the Supply Agreement were sold during the periods presented): In order to further quantify the impact of the Supply Agreement on the comparability of our financial statements between periods, the following table sets forth the increase in cost of products used in services and cost of products that would have been reflected in the financial statements of us for the periods presented if all inventory on hand during such periods was purchased prior to the effectiveness of the Supply Agreement: timetospa.com Business Model As a result of our planned separation from Steiner Leisure, we are no longer operating timetospa.com as a standalone e-commerce business with focused marketing efforts and paid search advertising through December 31, 2017. timetospa.com is now a post-cruise sales tool where guests may continue their wellness journey after disembarking. Revenue and net income in the years ended December 31, 2017 and 2016 are not directly comparable to revenue and net income in the year ended December 31, 2018 due to this change in the timetospa.com business model. Key Performance Indicators In assessing the performance of our business, we consider several key performance indicators used by management. These key indicators include: • Ship Count. The number of ships, both on average during the period and at period end, on which we operate health and wellness centers. This is a key metric that impacts revenue and profitability. • Average Weekly Revenue Per Ship. A key indicator of productivity per ship. Revenue per ship can be affected by the various sizes of health and wellness centers and categories of ships on which we serve. • Average Revenue Per Shipboard Staff Per Day. We utilize this performance metric to assist in determining the productivity of our onboard staff, which we believe is a critical element of our operations. • Destination Resort Count. The number of destination resorts, both on average during the period and at period end, on which we operate the health and wellness centers. This is a key metric that impacts revenue and profitability. • Average Weekly Revenue Per Destination Resort Health and Wellness Center. A key indicator of productivity per destination resort health and wellness center. Revenue per destination resort health and wellness center in a period can be affected by the mix of North American and Asian centers for such period because North American centers are typically larger and produce substantially more revenues per center than Asian centers. Additionally, average weekly revenue can also be negatively impacted by renovations of our destination resort health and wellness centers. The following table sets forth the above key performance indicators for the periods presented: Key Financial Definitions Revenues. Revenues consist primarily of sales of services and sales of products to cruise ship passengers and destination resort guests. The following is a brief description of the components of our revenues: • Service revenues. Service revenues consist primarily of sales of health and wellness services, including a full range of massage treatments, facial treatments, nutritional/weight management consultations, teeth whitening, mindfulness services and medi-spa services to cruise ship passengers and destination resort guests. We bill our services at rates which inherently include an immaterial charge for products used in the rendering of such services, if applicable. • Product revenues. Product revenues consist primarily of sales of health and wellness products, such as facial skincare, body care, orthotics and detox supplements to cruise ship passengers, destination resort guests and timetospa.com customers. Cost of services. Cost of services consists primarily of an allocable portion of payments to cruise lines (which are derived as a percentage of service revenues or a minimum annual rent or a combination of both), an allocable portion of wages paid to shipboard employees, an allocable portion of staff-related shipboard expenses, costs related to recruitment and training of shipboard employees, wages paid directly to destination resort employees, payments to destination resort venue owners, the allocable cost of products consumed in the rendering of a service and health and wellness center depreciation. Cost of services has historically been highly variable; increases and decreases in cost of services are primarily attributable to a corresponding increase or decrease in service revenues. Cost of services has tended to remain consistent as a percentage of service revenues. Cost of products. Cost of products consists primarily of the cost of products sold through our various methods of distribution, an allocable portion of wages paid to shipboard employees and an allocable portion of payments to cruise lines and destination resort partners (which are derived as a percentage of product revenues or a minimum annual rent or a combination of both). Cost of products has historically been highly variable, increases and decreases in cost of products are primarily attributable to a corresponding increase or decrease in product revenues. Cost of products has tended to remain consistent as a percentage of product revenues. Administrative. Administrative expenses are comprised of expenses associated with corporate and administrative functions that support our business, including fees for professional services, insurance, headquarter rent and other general corporate expenses. We expect administrative expenses to increase due to additional legal, accounting, insurance and other expenses related to becoming a public company. Salary and payroll taxes. Salary and payroll taxes are comprised of employee expenses associated with corporate and administrative functions that support our business, including fees for employee salaries, bonuses, payroll taxes, pension/401K and other employee costs. Amortization of intangible assets. Amortization of intangible assets are comprised of the amortization of intangible assets with definite useful lives (e.g. customer contracts, trade names, long-term leases) and amortization expenses associated with the 2015 Transaction. Other income (expense), net. Other income (expense) consists of royalty income, interest income, interest expense and minority interest expense. Provision for income taxes. Provision for income taxes includes current and deferred federal income tax expenses, as well as state and local income taxes. See “-Critical Accounting Policies-Income Taxes” included elsewhere in this Annual Report on Form 10-K. Net income. Net income consists of income from operations less other income (expense) and provision for income taxes. Revenue Drivers and Business Trends Our revenues and financial performance are impacted by a multitude of factors, including, but not limited to: • The number of ships and destination resorts in which we operate health and wellness centers. Revenue is impacted by net new ship growth and the increase in the number of destination resort health and wellness centers in each period. • The size and offerings of new health and wellness centers. We have focused our attention on the innovation and provision of higher value added and price point services such as medi-spa and advanced facial techniques, which require treatment rooms equipped with specific equipment and staff trained to perform these services. As our cruise line partners continue to invest in new ships with enhanced health and wellness centers that allows for more advanced treatment rooms and larger staff sizes, we are able to increase the availability of these services, driving an overall shift towards a more attractive service mix. • Expansion of value-added services and products across modalities in existing health and wellness centers. We continue to expand our higher value added and price point offerings in existing health and wellness centers, including introducing premium medi-spa services, resulting in higher guest spending. • The mix of ship count across contemporary, premium, luxury and budget categories. Revenue generated per shipboard health and wellness center differs across contemporary, premium, luxury and budget ship categories due to the size of the health and wellness centers, services offered, guest demographics and guest spending patterns. • The mix of cruise geography and itinerary. Revenue generated per shipboard health and wellness center is influenced by each cruise itinerary including the number of sea versus port days, which impacts center utilization, as well as the geographic sailing region which may impact offerings of services and products to best address guest preferences. • Collaboration with cruise line partners including targeted marketing and promotion initiatives as well as implementation of proprietary technologies to increase center utilization via pre-booking and pre-payment. We are now directly marketing and distributing promotions to onboard passengers as a result of enhanced collaboration with select cruise line partners. We have also begun to implement proprietary pre-booking and pre-payment technology platforms that interface with our cruise line partners’ pre-cruise planning systems. These areas of increased collaboration with cruise line partners are resulting in higher revenue generation across our health and wellness centers. • The impact of weather. Our health and wellness centers onboard cruise ships and in select destination resorts may be negatively affected by hurricanes. The negative impact of hurricanes is highest during peak hurricane season from August to October. The effect of each of these factors on our revenues and financial performance varies from period to period. Results of Operations Comparison of Results for the Years Ended December 31, 2018 (audited) and December 31, 2017 (audited) Revenues. Revenues increased approximately 6.7%, or $34.1 million, to $540.8 million in 2018, from $506.7 million in 2017. The increase was driven by six incremental net new shipboard health and wellness centers added to the fleet, 14 incremental net new destination resort health and wellness centers opened, a continued trend towards larger and enhanced shipboard health and wellness centers as well as increased guest spending on higher-priced services, product innovation and improved collaboration with partners such as the continued rollout of new direct marketing initiatives onboard. The revenue increase was offset by one-time changes in the business model for the timetospa.com website. For the year ended December 31, 2018, the 20 incremental net new health and wellness centers contributed $20.1 million, the increase in average price of services and products sold contributed $15.3 million and the increase in the volume of services sold at existing health and wellness centers contributed $1.0 million in increased revenue, respectively, offset by a decrease of $2.2 million due to the change in the timetospa.com website business model. The revenue growth over this time period was relatively proportional between service and product revenues: • Service revenues. Service revenues increased approximately 7.1%, or $27.2 million, to $410.9 million in 2018, from $383.7 million in 2017. • Product revenues. Product revenues increased approximately 5.6%, or $6.9 million, to $129.9 million in 2018, from $123.0 million in 2017. The productivity of shipboard health and wellness centers increased for 2018 compared to 2017 as evidenced by an increase in both average weekly revenues and revenues per shipboard staff per day. Average weekly revenues increased by 6.0% to $60,421 in 2018, from $56,999 in 2017, and revenues per shipboard staff per day increased by 6.3% over the same time period. We had an average of 2,852 shipboard staff members in service in 2018 compared to an average of 2,809 shipboard staff members in service in 2017. The productivity of destination resort health and wellness centers, measured by average weekly revenues, decreased 12.9% to $13,927 in 2018, from $16,400 in 2017. The decrease in productivity was primarily driven by one large destination resort health and wellness center being under renovation as well as the addition of smaller health and wellness centers in Asia that generate lower revenue and the closure of a large health and wellness center in Las Vegas. Cost of services. Cost of services increased $20.0 million in 2018 compared to 2017. The increase was primarily attributable to an increase in service revenues which accounted for an increase of $23.6 million, offset by the effect of reduced costs under the Supply Agreement which decreased cost of services by $4.2 million. Cost of services as a percentage of service revenues decreased to 85.8% in 2018, from 86.6% in 2017. The decrease was primarily attributable to the effect of the Supply Agreement. Cost of products. Cost of products increased $2.8 million in 2018 compared to 2017. The increase was primarily attributable to an increase in product revenues which accounted for an increase of $6.1 million and an increase in payments to cruise and destination resort partners of $3.0 million, offset by the effect of the Supply Agreement which decreased cost of products by $5.2 million. Cost of products as a percentage of product revenues decreased to 85.3% in 2018, from 87.8% in 2017. The decrease was attributable to the effect of reduced costs under the Supply Agreement. Administrative. Administrative expenses increased $0.7 million in 2018 compared to 2017. The increase in administrative expenses was driven primarily by expenses incurred in connection with the Business Combination. Salary and payroll taxes. Salary and payroll taxes increased $0.3 million in 2018 compared to 2017. The increase was primarily related to additional merit-based compensation. Amortization of intangible assets. Amortization of intangible assets remained flat at $3.5 million in 2018 and 2017. Other income (expense), net. Other income (expense), net decreased $33.9 million in 2018 compared to 2017. This decrease was primarily attributable to an increase in interest expense related to internal restructuring, which resulted in debt previously held at the parent level being assigned to us in anticipation of the Business Combination. Provision for income taxes. Provision for income taxes decreased $4.2 million in 2018 compared to 2017. This decrease was primarily due to a favorable impact of the Act which resulted in a lower U.S. federal tax rate effective January 1, 2018. Cash taxes as a percentage of income before provision for income taxes for the years ended December 31, 2018 and 2017 were 4.9% and 1.2%, respectively. Net income. Net income was $13.7 million in 2018 compared to net income of $33.2 million in 2017. This decrease in net income was due to all of the factors described above. Comparison of Results for the Years Ended December 31, 2017 (audited) and December 31, 2016 (audited) Revenues. Revenues increased approximately 6.4%, or $30.4 million, to $506.7 million in 2017, from $476.3 million in 2016. The increase was driven by one incremental net new shipboard health and wellness center added to the fleet, four net new destination health and wellness resort centers opened, a continued trend towards larger and enhanced health and wellness centers, as well as increased guest spending on higher-priced services, product innovation and improved collaboration with partners, such as continued rollout of new direct marketing initiatives onboard. For the year ended December 31, 2017, the five incremental net new health and wellness centers contributed $5.7 million, the increase in average price of services and products sold contributed $12.6 million and the increase in the volume of services sold at existing health and wellness centers contributed $12.0 million in increased revenue. The revenue growth over this time period was driven more from products than services: • Service revenues. Service revenues increased approximately 5.8%, or $21.0 million, to $383.7 million in 2017, from $362.7 million in 2016. • Product revenues. Product revenues increased approximately 8.3%, or $9.4 million, to $123.0 million in 2017, from $113.6 million in 2016. The productivity of shipboard health and wellness centers increased for 2017 compared to 2016, as evidenced by an increase in both average weekly revenues and revenues per shipboard staff per day. Average weekly revenues increased by 6.1% to $56,999 in 2017, from $53,741 in 2016, and revenues per shipboard staff per day increased by 4.3% over the same time period. We had an average of 2,809 shipboard staff members in service in 2017 compared to an average of 2,708 shipboard staff members in service in 2016. The productivity of destination resort health and wellness centers, measured by average weekly revenues, decreased 12.6% to $16,400 in 2017, from $18,765 in 2016. The decrease in productivity was primarily driven by one large destination resort health and wellness center being under renovation, the addition of smaller health and wellness centers in Asia that generate lower revenue and the impact of hurricanes in 2017. Cost of services. Cost of services increased $14.4 million in 2017 compared to 2016. The increase was primarily attributable to an increase in service revenues which accounted for an increase of $18.4 million, offset by the effect of reduced costs under the Supply Agreement which decreased cost of services by $3.6 million. Cost of services as a percentage of service revenues decreased to 86.6% in 2017, from 87.7% in 2016. The decrease was primarily attributable to the effect of reduced costs under the Supply Agreement and an increase in higher margin services. Cost of products. Cost of products increased $1.7 million in 2017 compared to 2016. The increase was primarily attributable to an increase in product revenues which accounted for an increase of $7.1 million, offset by the effect of reduced costs under the Supply Agreement which decreased cost of products by $5.4 million. Cost of products as a percentage of product revenues decreased to 87.8% in 2017, from 93.5% in 2016. The decrease was attributable to the effect of reduced costs under the Supply Agreement. Administrative. Administrative expenses decreased $1.2 million in 2017 compared to 2016. The decrease in administrative expenses was driven partially by a continued decrease in corporate marketing expenses and corporate overhead related to the timetospa.com business. Salary and payroll taxes. Salary and payroll taxes increased $0.8 million in 2017 compared to 2016. The increase in salary and payroll taxes was driven primarily by additional merit-based compensation and headcount additions to support growth in the business. Amortization of intangible assets. Amortization of intangible assets remained flat at $3.5 million in 2017 and 2016. Other income (expense), net. Other income (expense), net remained flat at income of $0.2 million in 2017 and 2016. Provision for income taxes. Provision for income taxes decreased $0.4 million in 2017 compared to 2016, driven primarily by the reevaluation of deferred tax assets in 2017 in connection with a decrease in the U.S. federal tax rate, offset by the effect of a reduction in tax reserves related to an examination by a foreign taxing authority of dividends paid by a wholly-owned subsidiary of Steiner Leisure. Cash taxes as a percentage of income before provision for income taxes for the years ended December 31, 2017 and 2016 was 1.2% and 2.7%, respectively. Net income. Net income was $33.2 million in 2017 compared to net income of $18.2 million in 2016. This increase in net income was due to all of the factors described above. Liquidity and Capital Resources Overview We have historically funded our operations with cash flow from operations, except with respect to certain expenses and operating costs that had been paid by Steiner Leisure on our behalf, and, when needed, with borrowings under our credit facility. Steiner Leisure has paid on our behalf expenses associated with the allocation of Parent corporate overhead and costs associated with the purchase of products from related parties and forgiven by Steiner Leisure. Historical operating cash flows exclude OSW Predecessor’s expenses and operating costs paid by Steiner Leisure on behalf of us. Consequently, our combined historical cash flows may not be indicative of cash flows had we been a separate stand-alone entity, or of our future cash flows. Our principal uses for liquidity have been distributions to Steiner Leisure, debt service and working capital. We believe our sources of liquidity and capital will be sufficient to finance our continued operations, growth strategy and additional expenses we expect to incur as a public company for at least the next 12 months. Cash Flows The following table shows summary cash flow information for the years ended December 31, 2018, 2017 and 2016 (audited). (1) Allocation of Parent Corporate Overhead was paid by Steiner Leisure on our behalf. Additionally, Change in Working Capital was benefited by costs associated with the purchase of inventory from related parties and forgiven by Steiner Leisure, which were reported as a non-cash reduction to accounts payable-related parties of $0, $0 and $32,987, for the years ended December 31, 2018, 2017 and 2016, respectively. The amounts related to the allocation of Parent corporate overhead and costs associated with the purchase of products from related parties and forgiven by Steiner Leisure were considered non-cash contributions and enabled us to make increased cash distributions to Steiner Leisure, which are classified in financing cash outflows. Comparison of Results for the Years Ended December 31, 2018 (audited) and December 31, 2017 (audited) Operating activities. Our net cash provided by operating activities decreased $37.7 million to $32.4 million in 2018, from $70.1 million in 2017. This decrease was due primarily to an unfavorable change in operating assets and liabilities, as well as a lower net income. The unfavorable change in operating assets and liabilities was largely driven by a change in the payment terms, the effect of reduced costs under the Supply Agreement and the depletion of existing inventories of products purchased prior to the effectiveness of the Supply Agreement of $9.4 million in 2017. The unfavorable change in net income was primarily due to interest expense of $34.1 million in 2018 related to an internal restructuring, which resulted in debt previously held at the parent level being assigned to us in anticipation of the Business Combination. Investing activities. Our net cash used by investing activities increased $2.3 million to $5.0 million in 2018, from $2.7 million in 2017. This increase was largely driven by the renovation of a destination resort health and wellness center. Financing activities. Our net cash used by financing activities decreased $44.9 million to $20.6 million in 2018, from $65.5 million in 2017. This decrease was largely due to a decrease in distributions to Steiner Leisure and its affiliates. Comparison of Results for the Years Ended December 31, 2017 (audited) and December 31, 2016 (audited) Operating activities. Our net cash provided by operating activities decreased $6.5 million to $70.1 million in 2017, from $76.7 million in 2016. This decrease was due primarily to an unfavorable change in operating assets and liabilities, partially offset by higher net income. The unfavorable change in operating assets and liabilities was largely driven by a change in the payment terms, the effect of reduced costs under the Supply Agreement and the depletion of existing inventories of products purchased prior to the effectiveness of the Supply Agreement of $9.4 million in 2017. The increase in net income was due to the reasons described above under “-Results of Operations-Comparison of Results for the Years Ended December 31, 2017 (audited) and December 31, 2016 (audited).” Investing activities. Our net cash used by investing activities decreased $5.8 million to $2.7 million in 2017, from $8.5 million in 2016. This decrease was due to a loan from us to a wholly-owned subsidiary of Steiner Leisure for €5.0 million in 2016. Financing activities. Our net cash used by financing activities decreased $6.0 million to $65.5 million in 2017, from $71.5 million in 2016. This decrease was due to distributions to Steiner Leisure and its affiliates. Seasonality A significant portion of our revenues are generated onboard cruise ships. Certain cruise lines, and, as a result, we have experienced varying degrees of seasonality as the demand for cruises is stronger in the Northern Hemisphere during the summer months and during holidays. Accordingly, the third quarter and holiday periods generally result in the highest revenue yields for us. Further, cruises and destination resort health and wellness centers have been negatively affected by the frequency and intensity of hurricanes. The negative impact of hurricanes is highest during peak hurricane season from August to October. Off-Balance Sheet Arrangements Other than the operating lease arrangements described below, we have no off-balance sheet arrangements that have or are reasonably likely to have a current or future material effect on our financial condition, changes in financial condition, income or expenses, results of operations, liquidity, capital expenditures or capital resources. Contractual Obligations The following table summarizes certain of our obligations as of December 31, 2018 and the estimated timing and effect that such obligations are expected to have on liquidity and cash flows in future periods (in millions): (1) Cruise Line Agreements. A large portion of our revenues are generated on cruise ships. We have entered into agreements of varying terms with the cruise lines under which services and products are paid for by cruise passengers. These agreements provide for us to pay the cruise line commissions for use of their shipboard facilities, as well as fees for staff shipboard meals and accommodations. These commissions are based on a percentage of revenue, a minimum annual amount, or a combination of both. Some of the minimum commissions are calculated as a flat dollar amount, while others are based upon minimum passenger per diems for passengers actually embarked on each cruise of the respective vessel. Staff shipboard meals and accommodations are charged by the cruise lines on a per staff per day basis. We recognize all expenses related to cruise line commissions, minimum arrears payment, and staff shipboard meals and accommodations, generally, as they are incurred and include such expenses in cost of revenues in the accompanying combined statements of income. For cruises in process at period end, an accrual is made to record such expenses in a manner that approximates a pro-rata basis. In addition, staff-related expenses such as shipboard employee commissions are recognized in the same manner. (2) Operating Leases. We lease office and warehouse space, as well as office equipment and automobiles, under operating leases. We also make certain payments to the owners of the destination resorts where destination resort health and wellness centers are located. Destination resort health and wellness centers generally require rent based on a percentage of revenues. In addition, as part of the rental arrangements for some of the destination resort health and wellness centers, we are required to pay a minimum annual rental regardless of whether such amount would be required to be paid under the percentage rent arrangement. Substantially all of these arrangements include renewal options ranging from three to five years. Rental expense incurred under operating leases for the years ended December 31, 2018, 2017 and 2016 were $9.5 million, $8.8 million and $9.5 million, respectively. (3) The amounts presented represent minimum annual commitments under our cruise line agreements and operating lease obligations. Certain minimum annual commitments, if any, are not currently determinable for fiscal years other than 2019. Critical Accounting Policies General. Our combined financial statements include the accounts of the wholly-owned direct and indirect subsidiaries of Steiner Leisure listed in Note 1 and include the accounts of a company partially owned by OneSpaWorld Medispa (Bahamas) Limited, in which OneSpaWorld (Bahamas) Limited (100% owner of OneSpaWorld Medispa (Bahamas) Limited) has a controlling interest. The combined financial statements also include the accounts and results of operations associated with the timetospa.com website owned by Elemis USA, Inc. Our combined financial statements do not represent the financial position and results of operations of a legal entity but rather a combination of entities under our common control that have been “carved out” of Steiner Leisure’s consolidated financial statements and reflect significant assumptions and allocations. All significant intercompany transactions and balances have been eliminated in combination. Our combined financial statements include the assets, liabilities, revenues and expenses specifically related to our operations. We receive services and support from various functions performed by Steiner Leisure and costs associated with these functions have been allocated to us. These allocations are necessary to reflect all of the costs of doing business and include costs related to certain Steiner Leisure corporate functions including, but not limited to, senior management, legal, human resources, finance, IT and other shared services that have been allocated to us based on direct usage or benefit where identifiable, with the remainder allocated on a pro rata basis determined by an estimate of the percentage of time Steiner Leisure employees devoted to us, as compared to total time available or by the headcount of employees at Steiner Leisure’s corporate headquarters that are fully dedicated to our entities in relation to the total employee headcount. These allocated costs are reflected in salary and payroll taxes and administrative expenses in the combined statements of income. Management considers these allocations to be a reasonable reflection of the utilization of services by or benefit provided to us. However, the allocations may not be indicative of the actual expenses that would have been incurred had we operated as an independent, stand-alone entity. We believe the assumptions and allocations underlying the accompanying combined financial statements and notes to the combined financial statements are reasonable, appropriate and consistently applied for the periods presented. We believe the combined financial statements reflect all costs of doing business. Our combined financial statements have been prepared in conformity with GAAP. We have identified the policies outlined below as critical to our business operations and an understanding of our results of operations. This discussion is not intended to be a comprehensive description of all accounting policies. In many cases, the accounting treatment of a particular transaction is specifically dictated by accounting principles generally accepted in the United States, with no need for management’s judgment in their application. The impact on our business operations and any associated risks related to these policies is discussed under results of operations, below, where such policies affect our reported and expected financial results. For a detailed discussion on the application of these and other accounting policies, please see Note 2 in the Notes to the Combined Financial Statements. Note that our preparation of our combined financial statements included in this Annual Report on Form 10-K requires us to make estimates and assumptions that affect the reported amount of assets and liabilities, disclosure of contingent assets and liabilities at the date of our financial statements, and the reported amounts of revenue and expenses during the reporting period. There can be no assurance that actual results will be consistent with those estimates. Cost of revenues includes: • Cost of services. Cost of services consists primarily of the cost of product consumed in the rendering of a service, an allocable portion of wages paid to shipboard employees, an allocable portion of payments to cruise lines (which are derived as a percentage of service revenues or a minimum annual rent or a combination of both), an allocable portion of staff-related shipboard expenses, costs related to recruitment and training of shipboard employees, wages paid directly to destination resort employees, payments to destination resort venue owners, and health and wellness facility depreciation. • Cost of products. Cost of products consists primarily of the cost of products sold through our various methods of distribution, an allocable portion of wages paid to shipboard employees, an allocable portion of payments to cruise lines and destination resort partners (which are derived as a percentage of product revenues or a minimum annual rent or a combination of both). Cost of revenues may be affected by, among other things, sales mix, production levels, exchange rates, changes in supplier prices and discounts, purchasing and manufacturing efficiencies, tariffs, duties, freight and inventory costs and increases in fuel costs. Certain cruise line and destination resort health and wellness center agreements provide for increases in the percentages of services and products revenues and/or, as the case may be, the amount of minimum annual payments over the terms of those agreements. These payments may also be increased under new agreements with cruise lines and destination resort health and wellness center owners that replace expiring agreements. Cost of products includes the cost of products sold through various methods of distribution. Operating expenses include administrative expenses, salaries and payroll taxes. In addition, operating expenses include amortization of certain intangibles relating to acquisitions. Revenue Recognition. We recognize revenues earned as services are provided and as products are sold. All taxable revenue transactions are presented on a net-of tax basis. Revenue from gift certificate sales is recognized upon gift certificate redemption and upon recognition of “breakage” (non-redemption of a gift certificate after a specified period of time). We do not charge administrative fees on unused gift cards, and our gift cards do not have an expiration date. Based on historical redemption rates, a relatively stable percentage of gift certificates will never be redeemed. We use the redemption recognition method for recognizing breakage related to certain gift certificates for which it has sufficient historical information. Under the redemption recognition method, revenue is recorded in proportion to, and over the time period gift cards are actually redeemed. Breakage is recognized only if OSW Predecessor determines that it does not have a legal obligation to remit the value of unredeemed gift certificates to government agencies under the unclaimed property laws in the relevant jurisdictions. OSW Predecessor determines the gift certificate breakage rate based upon historical redemption patterns. At least three years of historical data, which is updated annually, is used to estimate redemption patterns. Long-Lived Assets. OSW Predecessor reviews long-lived assets for impairment whenever events or changes in circumstances indicate, based on estimated future cash flows, that the carrying amount of these assets may not be fully recoverable. Recoverability of assets to be held and used is measured by a comparison of the carrying amount of an asset (asset group) to future undiscounted cash flows expected to be generated by the asset (asset group). An asset group is the lowest level of assets and liabilities for which identifiable cash flows are largely independent of the cash flows of other assets and liabilities. When estimating future cash flows, OSW Predecessor considers: • only the future cash flows that are directly associated with and that are expected to arise as a direct result of the use and eventual disposition of the asset group; • potential events and changes in circumstance affecting key estimates and assumptions; and • the existing service potential of the asset (asset group) at the date tested. If an asset (asset group) is considered to be impaired, the impairment to be recognized is measured by the amount by which the carrying amount of the asset (asset group) exceeds our fair value. When determining the fair value of the asset (asset group), we consider the highest and best use of the assets from a market-participant perspective. The fair value measurement is generally determined through the use of independent third-party appraisals or an expected present value technique, both of which may include a discounted cash flow approach, which reflects assumptions of what market participants would utilize to price the asset (asset group). Assets to be disposed of are reported at the lower of the carrying amount or fair value less costs to sell. Assets to be abandoned, or from which no further benefit is expected, are written down to zero at the time that the determination is made and the assets are removed entirely from service. Income Taxes. Our U.S. entities, other than those that are domiciled in U.S. territories, file their U.S. tax return as part of a consolidated tax filing group, while our entities that are domiciled in U.S. territories file specific returns. In addition, our foreign entities file income tax returns in their respective countries of incorporation, where required. For the purposes of our combined financial statements included in this Annual Report on Form 10-K, we account for income taxes under the separate return method of accounting. This method requires the allocation of current and deferred taxes to us as if it were a separate taxpayer. Under this method, the resulting portion of current income taxes payable that is not actually owed to the tax authorities is written-off through equity. Taxes payable in the combined balance sheets, as of December 31, 2018 and 2017 reflects current income tax amounts actually owed to the tax authorities, as of those dates, as well as the accrual for uncertain tax positions. The write-off of current income taxes payable not actually owed to the tax authorities is included in net Parent investment in the accompanying combined balance sheets, as of December 31, 2018 and 2017. Deferred income taxes are recognized based upon the tax consequences of “temporary differences” by applying enacted statutory rates applicable to future years to differences between the financial statement carrying amounts and the tax bases of existing assets and liabilities. Deferred income tax provisions and benefits are based on the changes to the asset or liability from period to period. A valuation allowance is provided on deferred tax assets if it is determined that it is more likely than not that the deferred tax assets will not be realized. The majority of our income is generated outside of the United States. We believe a large percentage of our shipboard service income is foreign-source income, not effectively connected to a business we conduct in the United States and, therefore, not subject to U.S. income taxation. We recognize interest and penalties within the provision for income taxes in the combined statements of income. To the extent interest and penalties are not assessed with respect to uncertain tax positions, amounts accrued will be reduced and reflected as a reduction of the overall income tax provision. We recognize liabilities for uncertain tax positions based on a two-step process. The first step is to evaluate the tax position for recognition by determining if the weight of available evidence indicates it is more likely than not that the position will be sustained on audit, including resolution of related appeals or litigation processes, if any. The second step is to measure the tax benefit as the largest amount of benefit, determined on a cumulative probability basis, which is more than 50% likely of being realized upon ultimate settlement. Recently Issued Accounting Pronouncements With the exception of those discussed below, there have been no recent accounting pronouncements or changes in accounting pronouncements during the year ended December 31, 2018 that are of significance, or potential significance, to us based on our current operations. The following summary of recent accounting pronouncements is not intended to be an exhaustive description of the respective pronouncement. In May 2014, the FASB issued ASU 2014-09. The core principle of the guidance in ASU 2014-09 is that an entity should recognize revenue to depict the transfer of promised goods or services to customers in an amount that reflects the consideration to which the entity expects to be entitled in exchange for those goods or services. The guidance in this ASU supersedes the revenue recognition requirements in Topic 605, Revenue Recognition, and most industry specific guidance throughout the Industry Topics of the ASC. Additionally, ASU 2014-09 supersedes some cost guidance included in Subtopic 605-35, Revenue Recognition-Construction-Type and Production-Type Contracts. In periods subsequent to the initial issuance of this ASU, the FASB has issued additional ASU’s clarifying items within Topic 606, as follows: • In March 2016, the FASB issued ASU 2016-08, “Revenue from Contracts with Customers (Topic 606): Principal versus Agent Considerations” (“ASU 2016-08”). The amendments in ASU 2016-08 serve to clarify the implementation guidance on principal versus agent considerations. • In April 2016, the FASB issued ASU 2016-10, “Revenue from Contracts with Customers (Topic 606): Identifying Performance Obligations and Licensing” (“ASU 2016-10”). The purpose of ASU 2016-10 is to clarify two aspects of Topic 606: identifying performance obligations and the licensing implementation guidance (while retaining the related principles for those areas). • In May 2016, the FASB issued ASU 2016-12, “Revenue from Contracts with Customers (Topic 606)” (“ASU 2016-12”). The purpose of ASU 2016-12 is to address certain issues identified to improve Topic 606 by enhancing guidance on assessing collectability, presentation of sales taxes and other similar taxes collected from customers, noncash consideration and completed contracts and contract modifications at transition. The FASB issued updates ASU 2016-08, ASU 2016-10 and ASU 2016-12 to provide guidance to improve the operability and understandability of the implementation guidance included in ASU 2014-09. ASU 2016-08, ASU 2016-10 and ASU 2016-12 have the same effective date and transition requirements of ASU 2015-14, which defers the effective date and transition of ASU 2014-09 annual reporting periods beginning after December 15, 2018, and interim periods within annual periods beginning after December 15, 2019, with early adoption permitted. The Company plans to adopt this standard, other related revenue standard clarifications and technical guidance effective for the annual period ending December 31, 2019 and quarterly periods beginning January 1, 2020. The Company has elected the modified retrospective transition approach. Under this method, the standard will be applied only to the most current period presented and the cumulative effect of applying the standard will be recognized at the date of initial application. The Company is progressing through our implementation plan and is continuing to evaluate the impact of the standard on our processes, accounting systems, controls and financial disclosures. The Company is not able to determine at this time if the adoption of this guidance will have a material impact on the Company’s combined financial statements. In February 2016, the FASB issued ASU 2016-02, “Leases (Topic 842)” (“ASU 2016-02”) to increase transparency and comparability among organizations by recognizing rights and obligations resulting from leases as lease assets and lease liabilities on the balance sheet and disclosing key information about leasing arrangements. The update requires lessees to recognize for all leases with a term of 12 months or more at the commencement date: (a) a lease liability or a lessee’s obligation to make lease payments arising from a lease, measured on a discounted basis; and (b) a right-of-use asset or a lessee’s right to use or control the use of a specified asset for the lease term. Under the update, lessor accounting remains largely unchanged. The update requires a modified retrospective transition approach for leases existing at, or entered into after, the beginning of the earliest comparative period presented in the financial statements and do not require any transition accounting for leases that expire before the earliest comparative period presented. The update is effective retrospectively for annual periods beginning after December 15, 2019, and interim periods beginning after December 15, 2020, with early adoption permitted. We are not able to determine at this time if the adoption of this guidance will have a material impact on our combined financial statements. In March 2016, the FASB issued ASU 2016-04, “Recognition of Breakage for Certain Prepaid Stored-Value Products (a consensus of the FASB Emerging Issues Task Force).” ASU 2016-04 requires entities that sell certain prepaid stored-value products redeemable for goods, services or cash at third-party merchants to derecognize liabilities related to those products for breakage (i.e., the value that is ultimately not redeemed by the consumer). This guidance is effective for annual periods beginning after December 15, 2018. Early adoption is permitted. Entities can use either a full retrospective approach, meaning they would apply the guidance to all periods presented, or a modified retrospective approach, meaning they would apply it only to the most current period presented with a cumulative-effect adjustment to retained earnings as of the beginning of the period of adoption. We are currently evaluating the methods and impact of adopting this new guidance on our combined financial statements. In June 2016, the FASB issued ASU 2016-13, “Financial Instruments-Credit Losses (Topic 326).” This ASU amends the Board’s guidance on the impairment of financial instruments. The ASU adds to GAAP an impairment model (known as the current expected credit losses model) that is based on an expected losses model rather than an incurred losses model. Under the new guidance, an entity recognizes as an allowance our estimate of expected credit losses. The ASU is also intended to reduce the complexity of GAAP by decreasing the number of impairment models that entities use to account for debt instruments. The update is effective for fiscal years beginning after December 15, 2020. We are currently assessing the future impact the adoption of this guidance will have on our combined financial statements. In August 2016, the FASB issued ASU 2016-15, “Statement of Cash Flows (Topic 230): Classification of Certain Cash Receipts and Cash Payments.” This ASU addresses eight specific cash flow issues with the objective of reducing the existing diversity in practice in how certain cash receipts and cash payments are presented and classified in the statement of cash flows under existing guidance. The update is effective for annual periods beginning after December 15, 2018. The amendments should be applied using a retrospective transition method to each period presented. We do not anticipate the adoption of this guidance will have a material impact on our combined financial statements. In October 2016, the FASB issued ASU 2016-16, “Income Taxes (Topic 740): Intra-Entity Transfers of Assets Other Than Inventory” (“ASU 2016-16”). This ASU was issued as part of the Board’s initiative to reduce complexity in accounting standards. This ASU eliminates an exception in ASC 740, which prohibits the immediate recognition of income tax consequences of intra-entity asset transfers other than inventory. Under ASU 2016-16, entities will be required to recognize the immediate current and deferred income tax effects of intra-entity asset transfers, which often involve a subsidiary of a company transferring intellectual property to another subsidiary. The new guidance will be effective for annual periods beginning after December 15, 2018. This ASU’s amendments should be applied on a modified retrospective basis, recognizing the effects in retained earnings as of the beginning of the year of adoption. We do not anticipate the adoption of this guidance will have a material impact on our combined financial statements. In November 2016, the FASB issued ASU 2016-18, “Statement of Cash Flows (Topic 230): Restricted Cash.” This ASU requires that a statement of cash flows explains the change during the period in the total of cash, cash equivalents, and amounts generally described as restricted cash or restricted cash equivalents. Therefore, amounts generally described as restricted cash and restricted cash equivalents should be included with cash and cash equivalents when reconciling the beginning-of-period and end-of-period total amounts shown on the statement of cash flows. The update is effective for annual periods beginning after December 15, 2018. We do not anticipate the adoption of this guidance will have a material impact on our combined financial statements. In January 2017, the FASB issued ASU 2017-01, “Business Combinations (Topic 805): Clarifying the Definition of a Business.” This ASU assists entities with evaluating whether transactions should be accounted for as acquisitions (or disposals) of assets or businesses by clarifying the definition of a business. The definition of a business affects many areas of accounting including acquisition, disposals, goodwill and consolidation. The update is effective for annual periods beginning after December 31, 2018. The amendments in this update should be applied prospectively on or after the effective date. We do not anticipate the adoption of this guidance will have a material impact on our combined financial statements. In January 2017, the FASB issued ASU 2017-04, “Intangibles - Goodwill and Other (Topic 350): Simplifying the Test for Goodwill Impairment” (“ASU 2017-04”). This ASU simplifies the subsequent measurement of goodwill by eliminating Step 2 from the goodwill impairment test. Previously, in computing the implied fair value of goodwill under Step 2, an entity had to perform procedures to determine the fair value at the impairment testing date of our assets and liabilities following the procedure that would be required in determining the fair value of assets acquired and liabilities assumed in a business combination. Instead, under ASU 2017-04, an entity should perform our annual, or interim, goodwill impairment test by comparing the fair value of a reporting unit with our carrying amount. An entity should recognize an impairment charge for the amount by which the carrying amount exceeds the reporting unit’s fair value; however, the loss recognized should not exceed the total amount of goodwill allocated to the reporting unit. The new guidance is effective for an entity’s annual or any interim goodwill impairment tests in fiscal years beginning after December 15, 2019 and early adoption is permitted for interim or annual goodwill impairment tests performed on testing dates after January 1, 2017. The Company is currently assessing the future impact the adoption of this guidance will have on our combined financial statements. Inflation and Economic Conditions We do not believe that inflation has had a material adverse effect on our revenues or results of operations. However, public demand for activities, including cruises, is influenced by general economic conditions, including inflation. Periods of economic softness could have a material adverse effect on the cruise industry and hospitality industry upon which we are dependent. Such a slowdown has adversely affected our results of operations and financial condition in certain prior years. Recurrence of the more severe aspects of the recent adverse economic conditions, as well as periods of fuel price increases, could have a material adverse effect on our results of operations and financial condition during the period of such recurrence. Weakness in the U.S. dollar compared to the U.K. pound sterling and the Euro also could have a material adverse effect on our results of operations and financial condition. U.S. Tax Reform On December 22, 2017, the U.S. enacted significant changes to tax law following the passage and signing of TCJA. The Company has completed the analysis of the tax accounting implications of the TCJA during the year ended December 31, 2018 in accordance with the terms of SEC Staff Bulletin 118. The Company did not record any adjustments in the year ended December 31, 2018 to provisional amounts that were material to our combined financial statements. Quantitative and Qualitative Disclosures of Market Risks Our future income, cash flows and fair values relevant to financial instruments are dependent upon prevalent market interest rates. Market risk refers to the risk of loss from adverse changes in market prices and interest rates. Concentration of credit risk. Financial instruments that potentially subject us to significant concentrations of credit risk consist principally of cash and cash equivalents and accounts receivable. We maintain cash and cash equivalents with high quality financial institutions. As of December 31, 2018, 2017 and 2016, we had three cruise companies that represented greater than 10% of accounts receivable. We do not normally require collateral or other security to support normal credit sales. We control credit risk through credit approvals, credit limits, and monitoring procedures. Accounts receivable are stated at amounts due from customers, net of an allowance for doubtful accounts. We record an allowance for doubtful accounts with respect to accounts receivable using historical collection experience, and generally, an account receivable balance is written off once it is determined to be uncollectible. We review the historical collection experience and consider other facts and circumstances and adjust the calculation to record an allowance for doubtful accounts as appropriate. If our current collection trends were to differ significantly from historic collection experience, we would make a corresponding adjustment to the allowance. As of December 31, 2018 and 2017, the allowance for doubtful accounts was $0.6 million and $0.5 million, respectively. Bad debt expense is included within administrative operating expenses in the combined statements of income and is immaterial of the years ended December 31, 2018, 2017 and 2016. Interest rate risk. We are subject to interest rate risk in connection with borrowing based on a variable interest rate. Derivative financial instruments, such as interest rate swap agreements and interest rate cap agreements, may be used for the purpose of managing fluctuating interest rate exposures that exist from our variable rate debt obligations that are expected to remain outstanding. Interest rate changes do not affect the market value of such debt, but could impact the amount of our interest payments, and accordingly, our future earnings and cash flows, assuming other factors are held constant. Foreign currency risk. The fluctuation in currency exchange rates is not a significant risk for us, as most of our revenues are earned and expenses are incurred in U.S. Dollars. CAUTIONARY STATEMENT REGARDING FORWARD-LOOKING STATEMENTS From time to time, including in this report and other disclosures, we may issue “forward-looking” statements within the meaning of Section 27A of the Securities Act of 1933, as amended, and Section 21E of the Securities Exchange Act of 1934, as amended (the “Exchange Act”). These forward-looking statements reflect our current views about future events and are subject to known and unknown risks, uncertainties and other factors which may cause our actual results to differ materially from those expressed or implied by such forward-looking statements. We attempt, whenever possible, to identify these statements by using words like “will,” “may,” “could,” “should,” “would,” “believe,” “expect,” “anticipate,” “forecast,” “future,” “intend,” “plan,” “estimate” and similar expressions of future intent or the negative of such terms. Such forward-looking statements include statements regarding: • the demand for the Company’s services together with the possibility that the Company may be adversely affected by other economic, business, and/or competitive factors or changes in the business environment in which the Company operates; • changes in consumer preferences or the market for the Company’s services; changes in applicable laws or regulations; • the availability of competition for opportunities for expansion of the Company’s business; difficulties of managing growth profitably; • the loss of one or more members of the Company’s management team; • changes in the market for the products we offer for sale; • other risks and uncertainties included from time to time in the Company’s reports (including all amendments to those reports) filed with the U.S. Securities and Exchange Commission; • other risks and uncertainties indicated in this Annual Report on Form 10-K, including those set forth under the section entitled “Risk Factors”; and • other statements preceded by, followed by or that include the words “estimate,” “plan,” “project,” “forecast,” “intend,” “expect,” “anticipate,” “believe,” “seek,” “target” or similar expressions. These forward-looking statements are based on information available as of the date of this report and current expectations, forecasts and assumptions, and involve a number of judgments, risks and uncertainties. Accordingly, forward-looking statements should not be relied upon as representing our views as of any subsequent date. We do not undertake any obligation to update forward-looking statements to reflect events or circumstances after the date they were made, whether as a result of new information, future events or otherwise, except as may be required under applicable securities laws. As a result of a number of known and unknown risks and uncertainties, our actual results or performance may be materially different from those expressed or implied by these forward-looking statements. For a discussion of the risks involved in our business and investing in our common shares, see the section entitled “Risk Factors.” Should one or more of these risks or uncertainties materialize, or should any of the underlying assumptions prove incorrect, actual results may vary in material respects from those expressed or implied by these forward-looking statements. You should not place undue reliance on these forward-looking statements.

<s>[INST] The following discussion and analysis of our audited financial condition and results of operations should be read in conjunction with the information presented in “Selected Historical Financial Information” and our combined financial statements and the notes thereto included elsewhere in this report. In addition to historical information, the following discussion contains forwardlooking statements, such as statements regarding our expectation for future performance, liquidity and capital resources, that involve risks, uncertainties and assumptions that could cause actual results to differ materially from those contained in or implied by any forwardlooking statements. Factors that could cause such differences include those identified below and those described in the sections entitled “Cautionary Note Regarding ForwardLooking Statements” and “Risk Factors.” We assume no obligation to update any of these forwardlooking statements. The information for the years ended December 31, 2018, 2017 and 2016 are derived from OSW Predecessor’s audited combined financial statements and the notes thereto included elsewhere in this report. Any reference to “OneSpaWorld” refers to OneSpaWorld Holdings Limited and our consolidated subsidiaries on a forwardlooking basis or, as the context requires, to the historical results of OSW Predecessor. Any reference to “OSW Predecessor” refers to the entities comprising the “OneSpaWorld” business prior to the consummation of the Business Combination. Overview We are the preeminent global operator of health and wellness centers onboard cruise ships and a leading operator of health and wellness centers at destination resorts worldwide. Our highlytrained and experienced staff offer guests a comprehensive suite of premium health, fitness, beauty and wellness services and products onboard 163 cruise ships and at 67 destination resorts globally as of December 31, 2018. With over 80% market share in the highly attractive outsourced maritime health and wellness market, we are the market leader at approximately 10x the size of our closest maritime competitor. Over the last 50 years, we have built our leading market position on our depth of staff expertise, broad and innovative service and product offerings, expansive global recruitment, training and logistics platform as well as decadeslong relationships with cruise and destination resort partners. Throughout our history, our mission has been simplehelping guests look and feel their best during and after their stay. At our core, we are a global services company. We serve a critical role for our cruise line and destination resort partners, operating a highly complex and increasingly important aspect of our cruise line and destination resort partners’ overall guest experience. Decades of investment and knowhow have allowed us to construct an unmatched global infrastructure to manage the complexity of our operations, which in 2018 included nearly 8,000 annual voyages with visits to over 1,100 ports of call around the world. We have consistently expanded our onboard offerings with innovative and leadingedge service and product introductions, and developed the powerful backend recruiting, training and logistics platforms to manage our operational complexity, maintain our industryleading quality standards, and maximize revenue per center. The combination of our renowned recruiting and training platform, deep labor pool, global logistics and supply chain infrastructure and proven revenue management capabilities represents a significant competitive advantage that we believe is not economically feasible to replicate. Matters Affecting Comparability Supply Agreement We purchase beauty products for resale from an entity (the “Supplier Entity”) that was, during the periods presented, a whollyowned subsidiary of Steiner Leisure. OSW Predecessor and the Supplier Entity entered into an agreement, effective as of January 1, 2017 (subsequently amended in 2018), which established the prices at which beauty products will be purchased by us from the Supplier Entity for a term of 10 years (the “Supply Agreement”). The Supply Agreement has had a positive impact on our business as it has reduced the cost of products for retail goods and has lowered the cost of products used in services. The prices of beauty products purchased by OSW Predecessor from the Supplier Entity prior to 2017 were not comparable to those set forth under the Supply Agreement and applicable to future periods. As a result, our operations and financial condition in periods prior to January 1, 2017 differ materially from those ended after [/INST] Positive. </s>

ONESPAWORLD HOLDINGS Ltd

2020-03-30

2019-12-31

ITEM 7. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS General The following discussion and analysis of our audited financial condition and results of operations should be read in conjunction with the information presented in “Selected Historical Financial Information” and our combined financial statements and the notes thereto included elsewhere in this report. In addition to historical information, the following discussion contains forward-looking statements, such as statements regarding our expectation for future performance, liquidity and capital resources, that involve risks, uncertainties and assumptions that could cause actual results to differ materially from those contained in or implied by any forward-looking statements. Factors that could cause such differences include those identified below and those described in the sections entitled “Cautionary Statement Regarding Forward-Looking Statements” and “Risk Factors.” We assume no obligation to update any of these forward-looking statements. The information for the periods ended March 20, 2019 to December 31, 2019 (Successor) and January 1, 2019 to March 19, 2019 (Predecessor) and for the years ended December 31, 2018 and 2017 are derived from OSW Predecessor’s audited combined financial statements and the notes thereto included elsewhere in this report. Any reference to “OneSpaWorld” refers to OneSpaWorld Holdings Limited and our consolidated subsidiaries on a forward-looking basis or, as the context requires, to the historical results of OSW Predecessor. Any reference to “OSW Predecessor” refers to the entities comprising the “OneSpaWorld” business prior to the consummation of the Business Combination. Overview We are the pre-eminent global operator of health and wellness centers onboard cruise ships and a leading operator of health and wellness centers at destination resorts worldwide. Our highly-trained and experienced staff offer guests a comprehensive suite of premium health, fitness, beauty and wellness services and products onboard 170 cruise ships and at 69 destination resorts globally as of December 31, 2019. With over 90% market share in the outsourced maritime health and wellness market, we are the market leader at approximately 10x the size of our closest maritime competitor. Over the last 50 years, we have built our leading market position on our depth of staff expertise, broad and innovative service and product offerings, expansive global recruitment, training and logistics platform as well as decades-long relationships with cruise and destination resort partners. Throughout our history, our mission has been simple-helping guests look and feel their best during and after their stay. At our core, we are a global services company. We serve a critical role for our cruise line and destination resort partners, operating a highly complex and increasingly important aspect of our cruise line and destination resort partners’ overall guest experience. Decades of investment and know-how have allowed us to construct an unmatched global infrastructure to manage the complexity of our operations, which in 2019 included nearly 8,600 annual voyages with visits to over 1,200 ports of call around the world. We have consistently expanded our onboard offerings with innovative and leading-edge service and product introductions, and developed the powerful back-end recruiting, training and logistics platforms to manage our operational complexity, maintain our industry-leading quality standards, and maximize revenue per center. The combination of our renowned recruiting and training platform, deep labor pool, global logistics and supply chain infrastructure, and proven revenue management capabilities represents a significant competitive advantage that we believe is not economically feasible to replicate. A significant portion of our revenues are generated from our cruise ship operations. Historically, we have been able to renew almost all of our cruise line agreements that expired or were scheduled to expire. Recently, we signed an agreement with Celebrity Cruises as the exclusive operator of health and wellness centers on Celebrity’s entire fleet, increasing the Celebrity vessels on which we operated in 2020 by nine, extended our current agreement with Norwegian Cruise Lines through 2024, won a contract with the new lifestyle brand Virgin Voyages to operate the spa and wellness offerings onboard the first three Virgin vessels, planned to launch in 2020, 2021 and 2022, and entered into an amended agreement with P&O Cruises to extend our operations on P&O’s vessels for the next five years. As discussed above, the coronavirus outbreak is currently impacting global economic conditions, the Health & Wellness industry, and other industries in which we do business. Temporary closures of businesses have been ordered and individuals’ ability to travel has been curtailed through mandated travel restrictions and may be further limited through additional voluntary or mandated closures of travel-related businesses. These actions have expanded significantly in the past few weeks and are expected to continue. The coronavirus outbreak has had a significant effect on our business and is expected to continue to have a significant effect on our results of operations and financial condition during the remainder of fiscal 2020, although the full financial impact on our business cannot be reasonably estimated at this time. Matters Affecting Comparability Supply Agreement We purchase beauty products for resale from an entity (the “Supplier Entity”) that was, during the periods presented, a wholly-owned subsidiary of Steiner Leisure. OSW Predecessor and the Supplier Entity entered into an agreement, effective as of January 1, 2017 (subsequently amended in 2018), which established the prices at which beauty products will be purchased by us from the Supplier Entity for a term of 10 years (the “Supply Agreement”). The Supply Agreement has had a positive impact on our business as it has reduced the cost of products for retail goods and has lowered the cost of products used in services. The Supply Agreement was effective as of January 1, 2017, however, existing inventories of products purchased prior to the effectiveness of the Supply Agreement were not fully depleted until the end of the third quarter of 2017. Beginning October 1, 2017, the cost of products used in services and cost of products reflect the actual pricing under the Supply Agreement because, at that time, all inventory on hand was purchased under the terms of the Supply Agreement. On March 19, 2019, we consummated the previously announced Business Combination pursuant to the Transaction Agreement. “OSW Predecessor” is comprised of the net assets and operations of (i) the following wholly-owned subsidiaries of Steiner Leisure: OneSpaWorld LLC, Steiner Spa Asia Limited, Steiner Spa Limited, and Steiner Marks Limited, (ii) the following respective indirect subsidiaries of Steiner Leisure: Mandara PSLV, LLC, Mandara Spa (Hawaii), LLC, Florida Luxury Spa Group, LLC, Steiner Transocean U.S., Inc., Steiner Spa Resorts (Nevada), Inc., Steiner Spa Resorts (Connecticut), Inc., Steiner Resort Spas (California), Inc., OneSpaWorld Resort Spas (North Carolina), Inc. (formerly known as Steiner Resort Spas (North Carolina), Inc.), OSW SoHo LLC, OSW Distribution LLC, World of Wellness Training Limited (formerly known as Steiner Training Limited), STO Italy S.r.l., One Spa World LLC, Mandara Spa Services LLC, OneSpaWorld Limited, OneSpaWorld (Bahamas) Limited (formerly known as Steiner Transocean Limited), OneSpaWorld Medispa LLC, OneSpaWorld Medispa Limited, OneSpaWorld Medispa (Bahamas) Limited (formerly known as STO Medispa Limited), Mandara Spa (Cruise I), LLC, Mandara Spa (Cruise II), LLC, Steiner Transocean (II) Limited (subsequently dissolved), The Onboard Spa by Steiner (Shanghai) Co., Ltd., Mandara Spa LLC, Mandara Spa Puerto Rico, Inc., Mandara Spa (Guam), L.L.C., Mandara Spa (Bahamas) Limited, Mandara Spa Aruba N.V., Mandara Spa Polynesia Sarl, Mandara Spa Asia Limited, PT Mandara Spa Indonesia, Spa Services Asia Limited, Mandara Spa Palau, Mandara Spa (Malaysia) Sdn. Bhd., Mandara Spa Ventures International Sdn. Bhd., Spa Partners (South Asia) Limited, Mandara Spa (Maldives) PVT LTD, and Mandara Spa (Fiji) Limited, (iii) Medispa Limited, a majority-owned subsidiary of Steiner Leisure, and (iv) the timetospa.com website owned by Elemis USA, Inc. (formerly known as Steiner Beauty Products, Inc.), subsequently transferred to OneSpaWorld. At the closing of the Business Combination, OneSpaWorld became the ultimate parent company of Haymaker and OSW Predecessor. Unless the context otherwise requires, “we,” “us,” “our” and the “Company” refer to OneSpaWorld Holdings Limited and its subsidiaries. timetospa.com Business Model As a result of our separation from Steiner Leisure, we ceased operating timetospa.com as a standalone e-commerce business with focused marketing efforts and paid search advertising effective as of December 31, 2017. timetospa.com is now a post-cruise sales tool where guests may continue their wellness journey after disembarking. Revenue and net income in the year ended December 31, 2017 are not directly comparable to revenue and net income in the year ended December 31, 2018 due to this change in the timetospa.com business model. Key Performance Indicators In assessing the performance of our business, we consider several key performance indicators used by management. These key indicators include: • Ship Count. The number of ships, both on average during the period and at period end, on which we operate health and wellness centers. This is a key metric that impacts revenue and profitability. • Average Weekly Revenue Per Ship. A key indicator of productivity per ship. Revenue per ship can be affected by the various sizes of health and wellness centers and categories of ships on which we serve. • Average Revenue Per Shipboard Staff Per Day. We utilize this performance metric to assist in determining the productivity of our onboard staff, which we believe is a critical element of our operations. • Destination Resort Count. The number of destination resorts, both on average during the period and at period end, on which we operate the health and wellness centers. This is a key metric that impacts revenue and profitability. • Average Weekly Revenue Per Destination Resort Health and Wellness Center. A key indicator of productivity per destination resort health and wellness center. Revenue per destination resort health and wellness center in a period can be affected by the mix of North American and Asian centers for such period because North American centers are typically larger and produce substantially more revenues per center than Asian centers. Additionally, average weekly revenue can also be negatively impacted by renovations of our destination resort health and wellness centers. For the year ended December 31, 2019, we have combined the results of the successor entity, OneSpaWorld Holdings Limited, for the period from March 20, 2019 to December 31, 2019 with the results of OSW Predecessor for the period from January 1, 2019 to March 19, 2019 (the “2019 Combined Period”) in the following table which sets forth the above key performance indicators for the periods presented: Key Financial Definitions Revenues. Revenues consist primarily of sales of services and sales of products to cruise ship passengers and destination resort guests. The following is a brief description of the components of our revenues: • Service revenues. Service revenues consist primarily of sales of health and wellness services, including a full range of massage treatments, facial treatments, nutritional/weight management consultations, teeth whitening, mindfulness services and medi-spa services to cruise ship passengers and destination resort guests. We bill our services at rates which inherently include an immaterial charge for products used in the rendering of such services, if applicable. • Product revenues. Product revenues consist primarily of sales of health and wellness products, such as facial skincare, body care, orthotics and detox supplements to cruise ship passengers, destination resort guests and timetospa.com customers. Cost of services. Cost of services consists primarily of an allocable portion of payments to cruise lines (which are derived as a percentage of service revenues or a minimum annual rent or a combination of both), an allocable portion of wages paid to shipboard employees, an allocable portion of staff-related shipboard expenses, costs related to recruitment and training of shipboard employees, wages paid directly to destination resort employees, payments to destination resort venue owners, the allocable cost of products consumed in the rendering of a service and health and wellness center depreciation. Cost of services has historically been highly variable; increases and decreases in cost of services are primarily attributable to a corresponding increase or decrease in service revenues. Cost of services has tended to remain consistent as a percentage of service revenues. Cost of products. Cost of products consists primarily of the cost of products sold through our various methods of distribution, an allocable portion of wages paid to shipboard employees and an allocable portion of payments to cruise lines and destination resort partners (which are derived as a percentage of product revenues or a minimum annual rent or a combination of both). Cost of products has historically been highly variable, increases and decreases in cost of products are primarily attributable to a corresponding increase or decrease in product revenues. Cost of products has tended to remain consistent as a percentage of product revenues. Administrative. Administrative expenses are comprised of expenses associated with corporate and administrative functions that support our business, including fees for professional services, insurance, headquarters rent and other general corporate expenses. We expect administrative expenses to increase due to additional legal, accounting, insurance and other expenses related to becoming a public company. Salary and payroll taxes. Salary and payroll taxes are comprised of employee expenses associated with corporate and administrative functions that support our business, including fees for employee salaries, bonuses, payroll taxes, pension/401(k) and other employee costs. Amortization of intangible assets. Amortization of intangible assets are comprised of the amortization of intangible assets with definite useful lives (e.g. retail concession agreements, destination resort agreements, licensing agreements) and amortization expenses associated with the 2015 and 2019 Transactions. Other income (expense), net. Other income (expense) consists of royalty income, interest income, interest expense and minority interest expense. Provision for income taxes. Provision for income taxes includes current and deferred federal income tax expenses, as well as state and local income taxes. See “-Critical Accounting Policies-Income Taxes” included elsewhere in this Annual Report on Form 10-K. Net income. Net income consists of income from operations less other income (expense) and provision for income taxes. Revenue Drivers and Business Trends Our revenues and financial performance are impacted by a multitude of factors, including, but not limited to: • The number of ships and destination resorts in which we operate health and wellness centers. Revenue is impacted by net new ship growth, ships out of service, unanticipated dry-docks, ships prevented from sailing due to outbreaks of illnesses, such as the recent coronavirus outbreak, and the number of destination resort health and wellness centers operating in each period. • The size and offerings of new health and wellness centers. We have focused our attention on the innovation and provision of higher value added and price point services such as medi-spa and advanced facial techniques, which require treatment rooms equipped with specific equipment and staff trained to perform these services. As our cruise line partners continue to invest in new ships with enhanced health and wellness centers that allow for more advanced treatment rooms and larger staff sizes, we are able to increase the availability of these services, driving an overall shift towards a more attractive service mix. • Expansion of value-added services and products across modalities in existing health and wellness centers. We continue to expand our higher value added and price point offerings in existing health and wellness centers, including introducing premium medi-spa services, resulting in higher guest spending. • The mix of ship count across contemporary, premium, luxury and budget categories. Revenue generated per shipboard health and wellness center differs across contemporary, premium, luxury and budget ship categories due to the size of the health and wellness centers, services offered, guest demographics and guest spending patterns. • The mix of cruise geography and itinerary. Revenue generated per shipboard health and wellness center is influenced by each cruise itinerary including the number of sea versus port days, which impacts center utilization, as well as the geographic sailing region which may impact offerings of services and products to best address guest preferences. • Collaboration with cruise line partners, including targeted marketing and promotion initiatives, as well as implementation of proprietary technologies to increase center utilization via pre-booking and pre-payment. We are now directly marketing and distributing promotions to onboard passengers as a result of enhanced collaboration with select cruise line partners. We have also begun to implement proprietary pre-booking and pre-payment technology platforms that interface with our cruise line partners’ pre-cruise planning systems. These areas of increased collaboration with cruise line partners are resulting in higher revenue generation across our health and wellness centers. • The impact of weather. Our health and wellness centers onboard cruise ships and in select destination resorts may be negatively affected by hurricanes. The negative impact of hurricanes is highest during peak hurricane season from August to October. The effect of each of these factors on our revenues and financial performance varies from period to period. Results of Operations The following tables present operations for two periods, Predecessor and Successor, which relate to the periods preceding and the periods succeeding the Business Combination, respectively. References to the “Successor 2019 Period” in the discussion below refer to the period from March 20, 2019 to December 31, 2019. References to the “Predecessor 2019 Period” in the discussion below refers to the period from January 1, 2019 to March 19, 2019. Revenues. Revenues for the Successor 2019 Period, Predecessor 2019 Period and for the year ended December 31, 2018 were $443.8 million, $118.5 million and $540.8 million, respectively. The increase was driven by seven incremental net new shipboard health and wellness centers added to the fleet, a continued trend towards larger and enhanced shipboard health and wellness centers, as well as increased guest spending on higher-priced services, product innovation and improved collaboration with partners, such as the continued rollout of new direct marketing initiatives onboard. This growth was partially offset by the negative impacts of ships temporarily taken out of service: • Service revenues Service Revenues for the Successor 2019 Period, Predecessor 2019 Period and the year ended December 31, 2018 were $339.8 million, $91.3 million and $410.9 million, respectively. • Product revenues. Product revenues for the Successor 2019 Period, Predecessor 2019 Period and year ended December 31, 2018 were $104.0 million, $27.2 million and $129.9 million, respectively. The productivity of shipboard health and wellness centers increased slightly for the 2019 combined period compared to 2018, as evidenced by an increase in both average weekly revenues and a small increase in revenues per shipboard staff per day. Average weekly revenues increased by 1.9% to $61,561 in 2019, from $60,421 in 2018, and revenues per shipboard staff per day increased by 0.2% over the same time period. We had an average of 2,964 shipboard staff members in service in 2019 compared to an average of 2,852 shipboard staff members in service in 2018. The productivity of destination resort health and wellness centers, measured by average weekly revenues, decreased 12.9% to $12,128 in 2019, from $13,927 in 2018. The decrease in productivity was driven by the closure of two large health and wellness centers in North America. Cost of services. Cost of services as a percentage of service revenue for the Successor 2019 Period, Predecessor 2019 Period, and for the year ended December 31, 2018 were 86.2%, 84.2% and 85.8%, respectively. Cost of products. Cost of products as a percentage of product revenue for the Successor 2019 Period, Predecessor 2019 Period and for the year ended December 31, 2018 were 86.9%, 88.2% and 85.3%, respectively. Successor 2019 Period includes purchase price adjustments concerning the inventory valuations resulting in higher costs, a portion of which are non-cash. Administrative. Administrative expenses for the Successor 2019 Period, Predecessor 2019 Period and for the year ended December 31, 2018 were $14.0 million, $2.5 million and $9.9 million, respectively. The Successor 2019 Period had expenses incurred in connection with the Business Combination and costs associated with being a public company. Salary and payroll taxes. Salary and payroll taxes for the Successor 2019 Period, Predecessor 2019 Period and for the year ended December 31, 2018 were $32.3 million, $29.3 million and $15.6 million, respectively. The Successor 2019 Period includes stock-based compensation of $20.4 million related to stock options that fully vested upon grant to certain directors and executives. The Predecessor 2019 Period had change in control payments of $26.6 million pursuant to employment agreements entered into in 2016 that were earned upon consummation of the Business Combination for services rendered prior to the Business Combination. Amortization of intangible assets. Amortization of intangible assets for the Successor 2019 Period, Predecessor 2019 Period and year ended December 31, 2018 were $13.5 million, $0.8 million and $3.5 million, respectively. Amortization expense in the 2019 Successor Period reflects the new basis of intangible assets identified in the Business Combination. Other income (expense), net. Other income (expense) for the Successor 2019 Period, Predecessor 2019 Period and year ended December 31, 2018 were $(13.5) million, $(9.7) million and $(33.7) million, respectively. The Predecessor 2019 Period included a loss on extinguishment of debt of $3.4 million associated with the payoff of the pre-existing debt by the Parent of the Company’s predecessor. Provision for income taxes. Provision for income taxes for the Successor 2019 Period, Predecessor 2019 Period, and year ended December 31, 2018 were $(0.1) million, $0.1 million and $1.0 million, respectively. Net income. Net (loss) income for the Successor 2019 Period, Predecessor 2019 Period and year ended December 31, 2018 were $(12.2) million, $(24.8) million and $13.7 million, respectively. The Successor 2019 Period had expenses related to stock-based compensation of $20.4 million. The Predecessor 2019 Period had change in control payments of $26.6 million earned upon consummation of the Business Combination. Comparison of Results for the Years Ended December 31, 2018 (audited) and December 31, 2017 (audited) Revenues. Revenues increased approximately 6.7%, or $34.1 million, to $540.8 million in 2018, from $506.7 million in 2017. The increase was driven by six incremental net new shipboard health and wellness centers added to the fleet, 14 incremental net new destination resort health and wellness centers opened, a continued trend towards larger and enhanced shipboard health and wellness centers as well as increased guest spending on higher-priced services, product innovation and improved collaboration with partners such as the continued rollout of new direct marketing initiatives onboard. The revenue increase was offset by one-time changes in the business model for the timetospa.com website. For the year ended December 31, 2018, the 20 incremental net new health and wellness centers contributed $20.1 million, the increase in average price of services and products sold contributed $15.3 million and the increase in the volume of services sold at existing health and wellness centers contributed $1.0 million in increased revenue, respectively, offset by a decrease of $2.2 million due to the change in the timetospa.com website business model. The revenue growth over this time period was relatively proportional between service and product revenues: • Service revenues. Service revenues increased approximately 7.1%, or $27.2 million, to $410.9 million in 2018, from $383.7 million in 2017. • Product revenues. Product revenues increased approximately 5.6%, or $6.9 million, to $129.9 million in 2018, from $123.0 million in 2017. The productivity of shipboard health and wellness centers increased for 2018 compared to 2017 as evidenced by an increase in both average weekly revenues and revenues per shipboard staff per day. Average weekly revenues increased by 6.0% to $60,421 in 2018, from $56,999 in 2017, and revenues per shipboard staff per day increased by 6.3% over the same time period. We had an average of 2,852 shipboard staff members in service in 2018 compared to an average of 2,809 shipboard staff members in service in 2017. The productivity of destination resort health and wellness centers, measured by average weekly revenues, decreased 12.9% to $13,927 in 2018, from $16,400 in 2017. The decrease in productivity was primarily driven by one large destination resort health and wellness center being under renovation as well as the addition of smaller health and wellness centers in Asia that generate lower revenue and the closure of a large health and wellness center in Las Vegas. Cost of services. Cost of services increased $20.0 million in 2018 compared to 2017. The increase was primarily attributable to an increase in service revenues which accounted for an increase of $23.6 million, offset by the effect of reduced costs under the Supply Agreement which decreased cost of services by $4.2 million. Cost of services as a percentage of service revenues decreased to 85.8% in 2018, from 86.6% in 2017. The decrease was primarily attributable to the effect of the Supply Agreement. Cost of products. Cost of products increased $2.8 million in 2018 compared to 2017. The increase was primarily attributable to an increase in product revenues which accounted for an increase of $6.1 million and an increase in payments to cruise and destination resort partners of $3.0 million, offset by the effect of the Supply Agreement which decreased cost of products by $5.2 million. Cost of products as a percentage of product revenues decreased to 85.3% in 2018, from 87.8% in 2017. The decrease was attributable to the effect of reduced costs under the Supply Agreement. Administrative. Administrative expenses increased $0.7 million in 2018 compared to 2017. The increase in administrative expenses was driven primarily by expenses incurred in connection with the Business Combination. Salary and payroll taxes. Salary and payroll taxes increased $0.3 million in 2018 compared to 2017. The increase was primarily related to additional merit-based compensation. Amortization of intangible assets. Amortization of intangible assets remained flat at $3.5 million in 2018 and 2017. Other income (expense), net. Other income (expense), net decreased $33.9 million in 2018 compared to 2017. This decrease was primarily attributable to an increase in interest expense related to internal restructuring, which resulted in debt previously held at the parent level being assigned to us in anticipation of the Business Combination. Provision for income taxes. Provision for income taxes decreased $4.2 million in 2018 compared to 2017. This decrease was primarily due to a favorable impact of the Act which resulted in a lower U.S. federal tax rate effective January 1, 2018. Cash taxes as a percentage of income before provision for income taxes for the years ended December 31, 2018 and 2017 were 4.9% and 1.2%, respectively. Net income. Net income was $13.7 million in 2018 compared to net income of $33.2 million in 2017. This decrease in net income was due to all of the factors described above. Liquidity and Capital Resources Overview We have historically funded our operations with cash flow from operations, except with respect to certain expenses and operating costs that had been paid prior to the Business Combination by Steiner Leisure on our behalf, and, when needed, with borrowings under our credit facility. Steiner Leisure has paid on our behalf expenses associated with the allocation of Parent corporate overhead and costs associated with the purchase of products from related parties and forgiven by Steiner Leisure. Historical operating cash flows exclude OSW Predecessor’s expenses and operating costs paid by Steiner Leisure on our behalf. Consequently, our combined historical cash flows may not be indicative of cash flows had we been a separate stand-alone entity, or of our future cash flows. Our principal uses for liquidity have been distributions to Steiner Leisure prior to the Business Combination, debt service and working capital, and most recently, the acquisition of the medi-spa joint venture. On December 31, 2019, the Company had a 60% controlling interest and a third party had a 40% noncontrolling interest in Medispa Limited. On February 14, 2020, the Company purchased the 40% noncontrolling interest for $12.3 million in a combination of cash and 98,753 shares of the Company’s common stock. The regional and global outbreak of the coronavirus has negatively impacted our revenue, including our current cash flow in the first quarter of fiscal 2020. As of the date of this report, the extent to which the coronavirus will impact our liquidity and capital resources will depend on future developments, which are highly uncertain and cannot be predicted at this time. Cash Flows The following table shows summary cash flow information for the periods from March 20, 2019 to December 31, 2019 (Successor), January 1, 2019 to March 19, 2019 (Predecessor) and the years ended December 31, 2018 and 2017 (Predecessor)(audited). (1) Allocation of Parent Corporate Overhead was paid by Steiner Leisure on our behalf. The amounts related to the allocation of Parent corporate overhead and costs associated with the purchase of products from related parties and forgiven by Steiner Leisure were considered non-cash contributions and enabled us to make increased cash distributions to Steiner Leisure, which are classified in financing cash outflows. Comparison of Results for the Period from March 20, 2019 to December 31, 2019 (Successor), January 1, 2019 to March 19, 2019 (Predecessor) and the Year Ended December 31, 2019 (Predecessor) (audited) Operating activities. Our net cash (used in) provided by operating activities for the Successor 2019 Period, Predecessor 2019 Period and for the year ended December 31, 2018 were $(3.2) million, $3.7 million and $32.4 million, respectively. In the Successor 2019 Period, the Company incurred stock-based compensation payments of $20.5 million related to stock options to certain directors and executives. In the Predecessor 2019 Period, the Company incurred change of control payments of $26.6 million payable upon consummation of the Business Combination. Investing activities. Investing activities for the Successor 2019 period, Predecessor 2019 period and for the year ended December 31, 2018 were $679.4 million, $0.5 million and $5.0 million, respectively. In the Successor 2019 Period, cash payments of $676.5 million were made to consummate the Business Combination. Financing activities. Financing activities for the Successor 2019 period, Predecessor 2019 period and for the year ended December 31, 2018 were $694.8 million, $(4.5) million and $(20.6) million, respectively. In the Successor 2019 Period, financing activities of $122.5 million, $349.4 million and $245.9 million, related to proceeds from the issuance of common shares, Haymaker cash contributions, and proceeds related to the term loan and revolver facilities, net of repayments, respectively, were undertaken in connection with the Business Combination. Comparison of Results for the Years Ended December 31, 2018 (audited) and December 31, 2017 (audited) Operating activities. Our net cash provided by operating activities decreased $37.7 million to $32.4 million in 2018, from $70.1 million in 2017. This decrease was due primarily to an unfavorable change in operating assets and liabilities, as well as a lower net income. The unfavorable change in operating assets and liabilities was largely driven by a change in the payment terms, the effect of reduced costs under the Supply Agreement and the depletion of existing inventories of products purchased prior to the effectiveness of the Supply Agreement of $9.4 million in 2017. The unfavorable change in net income was primarily due to interest expense of $34.1 million in 2018 related to an internal restructuring, which resulted in debt previously held at the parent level being assigned to us in anticipation of the Business Combination. Investing activities. Our net cash used by investing activities increased $2.3 million to $5.0 million in 2018, from $2.7 million in 2017. This increase was largely driven by the renovation of a destination resort health and wellness center. Financing activities. Our net cash used by financing activities decreased $44.9 million to $20.6 million in 2018, from $65.5 million in 2017. This decrease was largely due to a decrease in distributions to Steiner Leisure and its affiliates. Seasonality A significant portion of our revenues are generated onboard cruise ships. Certain cruise lines, and, as a result, we have experienced varying degrees of seasonality as the demand for cruises is stronger in the Northern Hemisphere during the summer months and during holidays. Accordingly, the third quarter and holiday periods generally result in the highest revenue yields for us. Further, cruises and destination resorts have been negatively affected by the frequency and intensity of hurricanes. The negative impact of hurricanes in the Northern Hemisphere is highest during peak hurricane season from August to October. Off-Balance Sheet Arrangements Other than the operating lease arrangements described below, we have no off-balance sheet arrangements that have or are reasonably likely to have a current or future material effect on our financial condition, changes in financial condition, income or expenses, results of operations, liquidity, capital expenditures or capital resources. Contractual Obligations The following table summarizes certain of our obligations as of December 31, 2019 and the estimated timing and effect that such obligations are expected to have on liquidity and cash flows in future periods (in thousands): (1) Cruise Line Agreements. A large portion of our revenues are generated on cruise ships. We have entered into agreements of varying terms with the cruise lines under which services and products are paid for by cruise passengers. These agreements provide for us to pay the cruise line commissions for use of their shipboard facilities, as well as fees for staff shipboard meals and accommodations. These commissions are based on a percentage of revenue, a minimum annual amount, or a combination of both. Some of the minimum commissions are calculated as a flat dollar amount, while others are based upon minimum passenger per diems for passengers actually embarked on each cruise of the respective vessel. Staff shipboard meals and accommodations are charged by the cruise lines on a per staff per day basis. We recognize all expenses related to cruise line commissions, minimum arrears payment, and staff shipboard meals and accommodations, generally, as they are incurred and include such expenses in cost of revenues in the accompanying combined statements of operations. For cruises in process at period end, an accrual is made to record such expenses in a manner that approximates a pro-rata basis. In addition, staff-related expenses such as shipboard employee commissions are recognized in the same manner. (2) Operating Leases. We lease office and warehouse space, as well as office equipment and automobiles, under operating leases. We also make certain payments to the owners of the destination resorts where destination resort health and wellness centers are located. Destination resort health and wellness centers generally require rent based on a percentage of revenues. In addition, as part of the rental arrangements for some of the destination resort health and wellness centers, we are required to pay a minimum annual rental regardless of whether such amount would be required to be paid under the percentage rent arrangement. Substantially all of these arrangements include renewal options ranging from three to five years. Rental expense incurred under operating leases for the years ended December 31, 2019, 2018 and 2017 were $9.5 million, $9.5 million and $8.8 million, respectively. (3) The amounts presented represent minimum annual commitments under our cruise line agreements and operating lease obligations and do not take into account cancelled voyages. Certain minimum annual commitments, if any, are not currently determinable for fiscal years other than 2020. Critical Accounting Policies Our consolidated and combined financial statements have been prepared in accordance with accounting principles generally accepted in the United States (“GAAP”). We have identified the policies outlined below as critical to our business operations and an understanding of our results of operations and that require the most difficult, subjective and complex judgments. This discussion is not intended to be a comprehensive description of all accounting policies. In many cases, the accounting treatment of a particular transaction is specifically dictated by accounting principles generally accepted in the United States, with no need for management’s judgment in their application. The impact on our business operations and any associated risks related to these policies is discussed under results of operations, below, where such policies affect our reported and expected financial results. For a detailed discussion on the application of these and other accounting policies, please see Note 2 in the Notes to the Consolidated and Combined Financial Statements. Note that our preparation of our combined financial statements included in this Annual Report on Form 10-K requires us to make estimates and assumptions that affect the reported amount of assets and liabilities, disclosure of contingent assets and liabilities at the date of our financial statements, and the reported amounts of revenue and expenses during the reporting period. There can be no assurance that actual results will be consistent with those estimates. General -Predecessor. Our combined financial statements include the accounts of the wholly-owned direct and indirect subsidiaries of Steiner Leisure listed in Note 1 and include the accounts of a company partially owned by OneSpaWorld Medispa (Bahamas) Limited, in which OneSpaWorld (Bahamas) Limited (100% owner of OneSpaWorld Medispa (Bahamas) Limited) has a controlling interest until February 14, 2020, at which time OneSpaWorld acquired full ownership of such company. The combined financial statements also include the accounts and results of operations associated with the timetospa.com website, owned by Elemis USA, Inc. until March 1, 2019. Our combined financial statements do not represent the financial position and results of operations of a legal entity but rather a combination of entities under our common control that have been “carved out” of Steiner Leisure’s consolidated financial statements and reflect significant assumptions and allocations. All significant intercompany transactions and balances have been eliminated in combination. Our combined financial statements include the assets, liabilities, revenues and expenses specifically related to our operations. We receive services and support from various functions performed by Steiner Leisure and costs associated with these functions have been allocated to us. These allocations are necessary to reflect all of the costs of doing business and include costs related to certain Steiner Leisure corporate functions, including, but not limited to, senior management, legal, human resources, finance, IT and other shared services that have been allocated to us based on direct usage or benefit where identifiable, with the remainder allocated on a pro rata basis determined by an estimate of the percentage of time Steiner Leisure employees devoted to us, as compared to total time available or by the headcount of employees at Steiner Leisure’s corporate headquarters that are fully dedicated to our entities in relation to the total employee headcount. These allocated costs are reflected in salary and payroll taxes and administrative expenses in the combined statements of operations. Management considers these allocations to be a reasonable reflection of the utilization of services by, or benefit provided to, us. However, the allocations may not be indicative of the actual expenses that would have been incurred had we operated as an independent, stand-alone entity. We believe the assumptions and allocations underlying the accompanying consolidated and combined financial statements and notes to the combined financial statements are reasonable, appropriate and consistently applied for the periods presented. We believe the combined financial statements reflect all costs of doing business. Cost of Revenues Cost of revenues includes: • Cost of services. Cost of services consists primarily of the cost of product consumed in the rendering of a service, an allocable portion of wages paid to shipboard employees, an allocable portion of payments to cruise lines (which are derived as a percentage of service revenues or a minimum annual rent or a combination of both), an allocable portion of staff-related shipboard expenses, costs related to recruitment and training of shipboard employees, wages paid directly to destination resort employees, payments to destination resort venue owners, and health and wellness facility depreciation. • Cost of products. Cost of products consists primarily of the cost of products sold through our various methods of distribution, an allocable portion of wages paid to shipboard employees, an allocable portion of payments to cruise lines and destination resort partners (which are derived as a percentage of product revenues or a minimum annual rent or a combination of both). Cost of revenues may be affected by, among other things, sales mix, production levels, exchange rates, changes in supplier prices and discounts, purchasing and manufacturing efficiencies, tariffs, duties, freight and inventory costs and increases in fuel costs. Certain cruise line and destination resort health and wellness center agreements provide for increases in the percentages of services and products revenues and/or, as the case may be, the amount of minimum annual payments over the terms of those agreements. These payments may also be increased under new agreements with cruise lines and destination resort health and wellness center owners that replace expiring agreements. Cost of products includes the cost of products sold through various methods of distribution. Operating expenses include administrative expenses, salaries, and payroll taxes. In addition, operating expenses include amortization of certain intangibles relating to acquisitions. Revenue Recognition. We recognize revenues when customers obtain control of goods and services promised by the Company. The amount of revenue recognized is based on the amount that reflects the consideration that is expected to be received in exchange for those respective goods and services. Amounts recognized are gross of commissions to cruise line or destination resort partners, which typically withhold commissions from customer payments. We have elected to present sales taxes on a net basis and, as such, sales taxes are excluded from revenue. Revenue is reported net of discounts and net of any estimated refund liability, which is determined based on historical experience. We also issue gift cards for future goods or services; revenue is recognized when they are redeemed; we also recognize revenue for breakage based on past experience for gift card amounts we expect to go unredeemed. Prior to adoption of ASC Topic 606, as discussed in Revenue Recognition section within Adoption of Accounting Pronouncements in Note 2. Summary of Significant accounting policies to our combined and consolidated financial statements, we recognized revenues earned as services are provided and as products are sold, following legacy accounting guidance under ASC Topic 605. Generally, this led to recognition that is consistent with our new policy. Under legacy guidance, we had also elected to recognize revenue on a net-of-tax basis, which is similar to our election under ASC Topic 606. For gift card breakage, the Company uses the redemption recognition method for recognizing breakage related to certain gift certificates for which it has sufficient historical information; this pattern is relatively consistent with our recognition pattern under ASC Topic 606. Share-Based Compensation. We recognize expense for our share-based compensation awards using a fair-value-based method. Share-based compensation expense is recognized over the requisite service period for awards that are based on a service period and not contingent upon any future performance. Income Taxes. Our U.S. entities, other than those that are domiciled in U.S. territories, file their U.S. tax return as part of a consolidated tax filing group, while our entities that are domiciled in U.S. territories file specific returns. In addition, our foreign entities file income tax returns in their respective countries of incorporation, where required. For the purposes of our combined financial statements included in this Annual Report on Form 10-K, we account for income taxes under the separate return method of accounting. This method requires the allocation of current and deferred taxes to us as if it were a separate taxpayer. Under this method, the resulting portion of current income taxes payable that is not actually owed to the tax authorities is written-off through equity. Taxes payable in the consolidated and combined balance sheets, as of December 31, 2019 and 2018 reflects current income tax amounts actually owed to the tax authorities, as of those dates, as well as the accrual for uncertain tax positions. The write-off of current income taxes payable not actually owed to the tax authorities is included in net Parent investment in the accompanying combined balance sheet as of December 31, 2018. Deferred income taxes are recognized based upon the tax consequences of “temporary differences” by applying enacted statutory rates applicable to future years to differences between the financial statement carrying amounts and the tax bases of existing assets and liabilities. Deferred income tax provisions and benefits are based on the changes to the asset or liability from period to period. A valuation allowance is provided on deferred tax assets if it is determined that it is more likely than not that the deferred tax assets will not be realized. The majority of our income is generated outside of the United States. We believe a large percentage of our shipboard service income is foreign-source income, not effectively connected to a business we conduct in the United States and, therefore, not subject to U.S. income taxation. We recognize interest and penalties within the provision for income taxes in the combined statements of income. To the extent interest and penalties are not assessed with respect to uncertain tax positions, amounts accrued will be reduced and reflected as a reduction of the overall income tax provision. We recognize liabilities for uncertain tax positions based on a two-step process. The first step is to evaluate the tax position for recognition by determining if the weight of available evidence indicates it is more likely than not that the position will be sustained on audit, including resolution of related appeals or litigation processes, if any. The second step is to measure the tax benefit as the largest amount of benefit, determined on a cumulative probability basis, which is more than 50% likely of being realized upon ultimate settlement. Business Combination. We are required to recognize the assets acquired, liabilities assumed, contractual contingencies, noncontrolling interests and contingent consideration at their fair value as of the acquisition date. The purchase price allocation process requires management to make significant estimates and assumptions with respect to intangible assets, all of which ultimately affect the fair value of goodwill established as of the acquisition date. Goodwill acquired in business combinations is assigned to the reporting unit(s) expected to benefit from the combination as of the acquisition date and is then subsequently tested for impairment at least annually. Goodwill and Indefinite-Lived Intangible Assets. Goodwill represents the excess of cost over the fair value of net tangible and identifiable intangible assets acquired. The Company has two operating segments: (1) Maritime and (2) Destination Resorts. The Maritime and Destination Resorts operating segments each have associated goodwill, and each has been determined to be a reporting unit. Goodwill and other intangible assets with indefinite useful lives are not amortized, but rather, are tested for impairment at least annually. We review goodwill for impairment at the reporting unit level annually or, when events or circumstances dictate, more frequently. The impairment review for goodwill consists of a qualitative assessment of whether it is more-likely-than-not that a reporting unit’s fair value is less than its carrying amount, and if necessary, a two-step goodwill impairment test. Factors to consider when performing the qualitative assessment primarily include general economic conditions and changes in forecasted operating results. If the qualitative assessment demonstrates that it is more-likely-than-not that the estimated fair value of the reporting unit exceeds its carrying value, it is not necessary to perform the two-step goodwill impairment test. We may elect to bypass the qualitative assessment and proceed directly to step one, for any reporting unit, in any period. The Company can resume the qualitative assessment for any reporting unit in any subsequent period. When performing the two-step goodwill impairment test, the fair value of the reporting unit is determined and compared to the carrying value of the net assets allocated to the reporting unit. If the fair value of the reporting unit exceeds its carrying value, no further analysis or write-down of goodwill is required. If the fair value of the reporting unit is less than the carrying value of its net assets, the implied fair value of the reporting unit is allocated to all its underlying assets and liabilities, including both recognized and unrecognized tangible and intangible assets, based on their fair value. If necessary, goodwill is then written down to its implied fair value. Long-Lived Assets. We review long-lived assets for impairment whenever events or changes in circumstances indicate, based on estimated future cash flows, that the carrying amount of these assets may not be fully recoverable. Recoverability of assets to be held and used is measured by a comparison of the carrying amount of an asset (asset group) to future undiscounted cash flows expected to be generated by the asset (asset group). An asset group is the lowest level of assets and liabilities for which identifiable cash flows are largely independent of the cash flows of other assets and liabilities. When estimating future cash flows, the Company considers: • only the future cash flows that are directly associated with and that are expected to arise as a direct result of the use and eventual disposition of the asset group; • potential events and changes in circumstance affecting key estimates and assumptions; and • the existing service potential of the asset (asset group) at the date tested. If an asset (asset group) is considered to be impaired, the impairment to be recognized is measured by the amount by which the carrying amount of the asset (asset group) exceeds our fair value. When determining the fair value of the asset (asset group), we consider the highest and best use of the assets from a market-participant perspective. The fair value measurement is generally determined through the use of independent third-party appraisals or an expected present value technique, both of which may include a discounted cash flow approach, which reflects assumptions of what market participants would utilize to price the asset (asset group). Assets to be disposed of are reported at the lower of the carrying amount or fair value less costs to sell. Assets to be abandoned, or from which no further benefit is expected, are written down to zero at the time that the determination is made and the assets are removed entirely from service. Recently Issued Accounting Pronouncements With the exception of those discussed below, there have been no recent accounting pronouncements or changes in accounting pronouncements during the year ended December 31, 2019 that are of significance, or potential significance, to us based on our current operations. The following summary of recent accounting pronouncements is not intended to be an exhaustive description of the respective pronouncement. In February 2016, the FASB issued ASU 2016-02, “Leases (Topic 842)” (“ASU 2016-02”) to increase transparency and comparability among organizations by recognizing rights and obligations resulting from leases as lease assets and lease liabilities on the balance sheet and disclosing key information about leasing arrangements. The update requires lessees to recognize for all leases with a term of 12 months or more at the commencement date: (a) a lease liability or a lessee’s obligation to make lease payments arising from a lease, measured on a discounted basis; and (b) a right-of-use asset or a lessee’s right to use or control the use of a specified asset for the lease term. Under the update, lessor accounting remains largely unchanged. The update requires a modified retrospective transition approach for leases existing at or entered into after the beginning of the earliest comparative period presented in the financial statements and do not require any transition accounting for leases that expire before the earliest comparative period presented. The update is effective retrospectively for annual periods beginning after December 15, 2019, and interim periods beginning after December 15, 2020, with early adoption permitted. We intend to elect the optional transition method, which allows entities to initially apply the standard at the adoption date and recognize a cumulative-effect adjustment to the opening balance of retained earnings in the period of adoption. The Company continues to evaluate the effect that the update will have on the Company’s consolidated financial statement. The Company expects the update will have a material effect on our consolidated balance sheets due to the recognition of operating lease assets and operating lease liabilities primarily related to the destination resort agreements and office space which will result in a balance sheet presentation that is not comparable to the prior period in the first year of adoption. Upon adoption, we expect that there will be no cumulative-effect adjustment of initially applying the guidance to our opening balance of retained earnings. We do not expect this guidance to have a material impact to our consolidated statements of operations, consolidated statements of cash flows and our debt-covenant compliance under our current agreements on an ongoing basis. In August 2018, the FASB issued ASU No. 2018-15, Intangibles - Goodwill and Other - Internal Use Software (Topic 350-40): Customer’s Accounting for Implementation Costs Incurred in a Cloud Computing Arrangement That Is a Service Contract, which amends ASC 350-40 to address a customer’s accounting for implementation costs incurred in a cloud computing arrangement (CCA) that is a service contract. ASU 2018-15 aligns the accounting for costs incurred to implement a CCA that is a service arrangement with the guidance on capitalizing costs associated with developing or obtaining internal-use software. The standard is effective for fiscal years beginning after December 15, 2019, with early adoption permitted. Entities are permitted to apply either a retrospective or prospective approach to adopt the guidance. We are currently evaluating the impact of the adoption of this update on our consolidated financial position, results of operations, and cash flows. In June 2016, the FASB issued ASU 2016-13, “Financial Instruments-Credit Losses (Topic 326).” This ASU amends the Board’s guidance on the impairment of financial instruments. The ASU adds to GAAP an impairment model (known as the current expected credit losses model) that is based on an expected losses model rather than an incurred losses model. Under the new guidance, an entity recognizes as an allowance its estimate of expected credit losses. The ASU is also intended to reduce the complexity of GAAP by decreasing the number of impairment models that entities use to account for debt instruments. The update is effective for fiscal years beginning after December 15, 2020. The Company is currently assessing the impact the adoption of this guidance will have on its consolidated financial statements. In January 2017, the FASB issued ASU 2017-04, “Intangibles - Goodwill and Other (Topic 350): Simplifying the Test for Goodwill Impairment” (“ASU 2017-04”). This ASU simplifies the subsequent measurement of goodwill by eliminating Step 2 from the goodwill impairment test. Previously, in computing the implied fair value of goodwill under Step 2, an entity had to perform procedures to determine the fair value at the impairment testing date of its assets and liabilities following the procedure that would be required in determining the fair value of assets acquired and liabilities assumed in a business combination. Instead, under ASU 2017-04, an entity should perform its annual, or interim, goodwill impairment test by comparing the fair value of a reporting unit with its carrying amount. An entity should recognize an impairment charge for the amount by which the carrying amount exceeds the reporting unit’s fair value; however, the loss recognized should not exceed the total amount of goodwill allocated to the reporting unit. The new guidance is effective for an entity’s annual or any interim goodwill impairment tests in fiscal years beginning after December 15, 2019 and early adoption is permitted for interim or annual goodwill impairment tests performed on testing dates after January 1, 2017. The Company will evaluate, upon adoption of this guidance, the impact of this guidance on the Company’s financial statements. Inflation and Economic Conditions We do not believe that inflation has had a material adverse effect on our revenues or results of operations. However, public demand for activities, including cruises, is influenced by general economic conditions, including inflation, global health epidemics/pandemics and customer preferences. Periods of economic softness could have a material adverse effect on the cruise industry and hospitality industry upon which we are dependent. Such a slowdown could adversely affect our results of operations and financial condition. The recent coronavirus outbreak has negatively impacted our results of operations and financial condition during the first quarter of 2020, the full effect of which impact is currently unknown. Recurrence of the more severe aspects of the recent adverse economic conditions, including further escalation of the coronavirus outbreak, as well as periods of fuel price increases, could have a material adverse effect on our results of operations and financial condition during the period of such recurrence. Weakness in the U.S. dollar compared to the U.K. pound sterling and the Euro also could have a material adverse effect on our results of operations and financial condition. U.S. Tax Reform On December 22, 2017, the U.S. enacted significant changes to tax law following the passage and signing of TCJA. The Company completed the analysis of the tax accounting implications of the TCJA during the year ended December 31, 2018 in accordance with the terms of SEC Staff Bulletin 118. The Company did not record any adjustments in the year ended December 31, 2018 to provisional amounts that were material to our combined financial statements.

<s>[INST] The following discussion and analysis of our audited financial condition and results of operations should be read in conjunction with the information presented in “Selected Historical Financial Information” and our combined financial statements and the notes thereto included elsewhere in this report. In addition to historical information, the following discussion contains forwardlooking statements, such as statements regarding our expectation for future performance, liquidity and capital resources, that involve risks, uncertainties and assumptions that could cause actual results to differ materially from those contained in or implied by any forwardlooking statements. Factors that could cause such differences include those identified below and those described in the sections entitled “Cautionary Statement Regarding ForwardLooking Statements” and “Risk Factors.” We assume no obligation to update any of these forwardlooking statements. The information for the periods ended March 20, 2019 to December 31, 2019 (Successor) and January 1, 2019 to March 19, 2019 (Predecessor) and for the years ended December 31, 2018 and 2017 are derived from OSW Predecessor’s audited combined financial statements and the notes thereto included elsewhere in this report. Any reference to “OneSpaWorld” refers to OneSpaWorld Holdings Limited and our consolidated subsidiaries on a forwardlooking basis or, as the context requires, to the historical results of OSW Predecessor. Any reference to “OSW Predecessor” refers to the entities comprising the “OneSpaWorld” business prior to the consummation of the Business Combination. Overview We are the preeminent global operator of health and wellness centers onboard cruise ships and a leading operator of health and wellness centers at destination resorts worldwide. Our highlytrained and experienced staff offer guests a comprehensive suite of premium health, fitness, beauty and wellness services and products onboard 170 cruise ships and at 69 destination resorts globally as of December 31, 2019. With over 90% market share in the outsourced maritime health and wellness market, we are the market leader at approximately 10x the size of our closest maritime competitor. Over the last 50 years, we have built our leading market position on our depth of staff expertise, broad and innovative service and product offerings, expansive global recruitment, training and logistics platform as well as decadeslong relationships with cruise and destination resort partners. Throughout our history, our mission has been simplehelping guests look and feel their best during and after their stay. At our core, we are a global services company. We serve a critical role for our cruise line and destination resort partners, operating a highly complex and increasingly important aspect of our cruise line and destination resort partners’ overall guest experience. Decades of investment and knowhow have allowed us to construct an unmatched global infrastructure to manage the complexity of our operations, which in 2019 included nearly 8,600 annual voyages with visits to over 1,200 ports of call around the world. We have consistently expanded our onboard offerings with innovative and leadingedge service and product introductions, and developed the powerful backend recruiting, training and logistics platforms to manage our operational complexity, maintain our industryleading quality standards, and maximize revenue per center. The combination of our renowned recruiting and training platform, deep labor pool, global logistics and supply chain infrastructure, and proven revenue management capabilities represents a significant competitive advantage that we believe is not economically feasible to replicate. A significant portion of our revenues are generated from our cruise ship operations. Historically, we have been able to renew almost all of our cruise line agreements that expired or were scheduled to expire. Recently, we signed an agreement with Celebrity Cruises as the exclusive operator of health and wellness centers on Celebrity’s entire fleet, increasing the Celebrity vessels on which we operated in 2020 by nine, extended our current agreement with Norwegian Cruise Lines through 2024, won a contract with the new lifestyle brand Virgin Voyages to operate the spa and wellness offerings onboard the first three Virgin vessels, planned to launch in 2020, 2021 and 2022, and entered into an amended agreement with P&O Cruises to extend our operations on P&O’s [/INST] Negative. </s>

Spirit of Texas Bancshares, Inc.

2019-03-15

2018-12-31

Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations The following discussion and analysis of our financial condition and results of operations should be read in conjunction with “Selected Historical Consolidated Financial Data” and our consolidated financial statements and the accompanying notes included elsewhere in this Form 10-K. This discussion and analysis contains forward-looking statements that are subject to certain risks and uncertainties and are based on certain assumptions that we believe are reasonable but may prove to be inaccurate. Certain risks, uncertainties and other factors, including those set forth under “Cautionary Note Regarding Forward-Looking Statements,” “Risk Factors” and elsewhere in this Form 10-K, may cause actual results to differ materially from those projected results discussed in the forward-looking statements appearing in this discussion and analysis. Except as required by law, we assume no obligation to update any of these forward-looking statements. Overview We are a Texas corporation and a registered bank holding company located in the Houston metropolitan area with headquarters in Conroe, Texas. We offer a broad range of commercial and retail banking services through our wholly-owned bank subsidiary, Spirit of Texas Bank SSB. We operate through 23 full-service branches located primarily in the Houston and Dallas/Fort Worth metropolitan areas. As of December 31, 2018, we had total assets of $1.47 billion, loans held for investment of $1.09 billion, total deposits of $1.18 billion and total stockholders’ equity of $198.8 million. As a bank holding company, we generate most of our revenues from interest income on loans, gains on sale of the guaranteed portion of SBA loans, customer service and loan fees, brokerage fees derived from secondary mortgage originations and interest income from investments in securities. We incur interest expense on deposits and other borrowed funds and noninterest expenses, such as salaries and employee benefits and occupancy expenses. Our goal is to maximize income generated from interest earning assets, while also minimizing interest expense associated with our funding base to widen net interest spread and drive net interest margin expansion. Net interest margin is a ratio calculated as net interest income divided by average interest-earning assets. Net interest income is the difference between interest income on interest-earning assets, such as loans and securities, and interest expense on interest-bearing liabilities, such as deposits and borrowings that are used to fund those assets. Net interest spread is the difference between rates earned on interest-earning assets and rates paid on interest-bearing liabilities. Changes in market interest rates and the interest rates we earn on interest-earning assets or pay on interest-bearing liabilities, as well as the volume and types of interest-earning assets, interest-bearing and noninterest-bearing liabilities and stockholders’ equity, are usually the largest drivers of periodic changes in net interest spread, net interest margin and net interest income. Fluctuations in market interest rates are driven by many factors, including governmental monetary policies, inflation, deflation, macroeconomic developments, changes in unemployment, the money supply, political and international conditions and conditions in domestic and foreign financial markets. Periodic changes in the volume and types of loans in our loan portfolio are affected by, among other factors, economic and competitive conditions in Texas, as well as developments affecting the real estate, technology, financial services, insurance, transportation, manufacturing and energy sectors within our target markets and throughout Texas. Acquisition of Comanche On November 14, 2018, Spirit of Texas Bancshares, Inc. (the “Company” or “Spirit”) completed its acquisition of Comanche National Corporation and its subsidiary, The Comanche National Bank (together, “Comanche”). This transaction resulted in 8 additional branches in the North Texas region. The Company issued 2,142,811 shares of its common stock as well as a net cash payment to Comanche shareholders of $12.2 million. For more information about the acquisition, see “Note 2. Business Combinations” located in

<s>[INST] Overview We are a Texas corporation and a registered bank holding company located in the Houston metropolitan area with headquarters in Conroe, Texas. We offer a broad range of commercial and retail banking services through our whollyowned bank subsidiary, Spirit of Texas Bank SSB. We operate through 23 fullservice branches located primarily in the Houston and Dallas/Fort Worth metropolitan areas. As of December 31, 2018, we had total assets of $1.47 billion, loans held for investment of $1.09 billion, total deposits of $1.18 billion and total stockholders’ equity of $198.8 million. As a bank holding company, we generate most of our revenues from interest income on loans, gains on sale of the guaranteed portion of SBA loans, customer service and loan fees, brokerage fees derived from secondary mortgage originations and interest income from investments in securities. We incur interest expense on deposits and other borrowed funds and noninterest expenses, such as salaries and employee benefits and occupancy expenses. Our goal is to maximize income generated from interest earning assets, while also minimizing interest expense associated with our funding base to widen net interest spread and drive net interest margin expansion. Net interest margin is a ratio calculated as net interest income divided by average interestearning assets. Net interest income is the difference between interest income on interestearning assets, such as loans and securities, and interest expense on interestbearing liabilities, such as deposits and borrowings that are used to fund those assets. Net interest spread is the difference between rates earned on interestearning assets and rates paid on interestbearing liabilities. Changes in market interest rates and the interest rates we earn on interestearning assets or pay on interestbearing liabilities, as well as the volume and types of interestearning assets, interestbearing and noninterestbearing liabilities and stockholders’ equity, are usually the largest drivers of periodic changes in net interest spread, net interest margin and net interest income. Fluctuations in market interest rates are driven by many factors, including governmental monetary policies, inflation, deflation, macroeconomic developments, changes in unemployment, the money supply, political and international conditions and conditions in domestic and foreign financial markets. Periodic changes in the volume and types of loans in our loan portfolio are affected by, among other factors, economic and competitive conditions in Texas, as well as developments affecting the real estate, technology, financial services, insurance, transportation, manufacturing and energy sectors within our target markets and throughout Texas. Acquisition of Comanche On November 14, 2018, Spirit of Texas Bancshares, Inc. (the “Company” or “Spirit”) completed its acquisition of Comanche National Corporation and its subsidiary, The Comanche National Bank (together, “Comanche”). This transaction resulted in 8 additional branches in the North Texas region. The Company issued 2,142,811 shares of its common stock as well as a net cash payment to Comanche shareholders of $12.2 million. For more information about the acquisition, see “Note 2. Business Combinations” located in [/INST] Negative. </s>

Spirit of Texas Bancshares, Inc.

2020-03-16

2019-12-31

Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations The following discussion and analysis of our financial condition and results of operations should be read in conjunction with “Selected Historical Consolidated Financial Data” and our consolidated financial statements and the accompanying notes included elsewhere in this Annual Report on Form 10-K. This discussion and analysis contains forward-looking statements that are subject to certain risks and uncertainties and are based on certain assumptions that we believe are reasonable but may prove to be inaccurate. Certain risks, uncertainties and other factors, including those set forth under “Cautionary Note Regarding Forward-Looking Statements,” “Risk Factors” and elsewhere in this Annual Report on Form 10-K, may cause actual results to differ materially from those projected results discussed in the forward-looking statements appearing in this discussion and analysis. Except as required by law, we assume no obligation to update any of these forward-looking statements. Overview We are a Texas corporation and a registered bank holding company located in the Houston metropolitan area with headquarters in Conroe, Texas. We offer a broad range of commercial and retail banking services through our wholly-owned bank subsidiary, Spirit of Texas Bank SSB. We operate through 35 full-service branches and two LPO’s located primarily in the Houston, Dallas/Fort Worth, Bryan/College Station, San Antonio-New Braunfels, Corpus Christi and Tyler metropolitan areas metropolitan areas. As of December 31, 2019, we had total assets of $2.38 billion, loans held for investment of $1.77 billion, total deposits of $1.93 billion and total stockholders’ equity of $345.7 million. As a bank holding company, we generate most of our revenues from interest income on loans, gains on sale of the guaranteed portion of SBA loans, customer service and loan fees, brokerage fees derived from secondary mortgage originations and interest income from investments in securities. We incur interest expense on deposits and other borrowed funds and noninterest expenses, such as salaries and employee benefits and occupancy expenses. Our goal is to maximize income generated from interest earning assets, while also minimizing interest expense associated with our funding base to widen net interest spread and drive net interest margin expansion. Net interest margin is a ratio calculated as net interest income divided by average interest-earning assets. Net interest income is the difference between interest income on interest-earning assets, such as loans and securities, and interest expense on interest-bearing liabilities, such as deposits and borrowings that are used to fund those assets. Net interest spread is the difference between rates earned on interest-earning assets and rates paid on interest-bearing liabilities. Changes in market interest rates and the interest rates we earn on interest-earning assets or pay on interest-bearing liabilities, as well as the volume and types of interest-earning assets, interest-bearing and noninterest-bearing liabilities and stockholders’ equity, are usually the largest drivers of periodic changes in net interest spread, net interest margin and net interest income. Fluctuations in market interest rates are driven by many factors, including governmental monetary policies, inflation, deflation, macroeconomic developments, changes in unemployment, the money supply, political and international conditions and conditions in domestic and foreign financial markets. Periodic changes in the volume and types of loans in our loan portfolio are affected by, among other factors, economic and competitive conditions in Texas, as well as developments affecting the real estate, technology, financial services, insurance, transportation, manufacturing and energy sectors within our target markets and throughout Texas. Acquisition of Beeville On April 2, 2019, the Company completed its acquisition of First Beeville Financial Corporation and its subsidiary, The First National Bank of Beeville. This transaction resulted in three additional branches and two LPO’s in the South Texas region. The Company issued 1,579,191 shares of its common stock as well as a net cash payment to Beeville shareholders of $32.4 million. For more information about the acquisition, see “Note 3. Business Combinations” located in

<s>[INST] Overview We are a Texas corporation and a registered bank holding company located in the Houston metropolitan area with headquarters in Conroe, Texas. We offer a broad range of commercial and retail banking services through our whollyowned bank subsidiary, Spirit of Texas Bank SSB. We operate through 35 fullservice branches and two LPO’s located primarily in the Houston, Dallas/Fort Worth, Bryan/College Station, San AntonioNew Braunfels, Corpus Christi and Tyler metropolitan areas metropolitan areas. As of December 31, 2019, we had total assets of $2.38 billion, loans held for investment of $1.77 billion, total deposits of $1.93 billion and total stockholders’ equity of $345.7 million. As a bank holding company, we generate most of our revenues from interest income on loans, gains on sale of the guaranteed portion of SBA loans, customer service and loan fees, brokerage fees derived from secondary mortgage originations and interest income from investments in securities. We incur interest expense on deposits and other borrowed funds and noninterest expenses, such as salaries and employee benefits and occupancy expenses. Our goal is to maximize income generated from interest earning assets, while also minimizing interest expense associated with our funding base to widen net interest spread and drive net interest margin expansion. Net interest margin is a ratio calculated as net interest income divided by average interestearning assets. Net interest income is the difference between interest income on interestearning assets, such as loans and securities, and interest expense on interestbearing liabilities, such as deposits and borrowings that are used to fund those assets. Net interest spread is the difference between rates earned on interestearning assets and rates paid on interestbearing liabilities. Changes in market interest rates and the interest rates we earn on interestearning assets or pay on interestbearing liabilities, as well as the volume and types of interestearning assets, interestbearing and noninterestbearing liabilities and stockholders’ equity, are usually the largest drivers of periodic changes in net interest spread, net interest margin and net interest income. Fluctuations in market interest rates are driven by many factors, including governmental monetary policies, inflation, deflation, macroeconomic developments, changes in unemployment, the money supply, political and international conditions and conditions in domestic and foreign financial markets. Periodic changes in the volume and types of loans in our loan portfolio are affected by, among other factors, economic and competitive conditions in Texas, as well as developments affecting the real estate, technology, financial services, insurance, transportation, manufacturing and energy sectors within our target markets and throughout Texas. Acquisition of Beeville On April 2, 2019, the Company completed its acquisition of First Beeville Financial Corporation and its subsidiary, The First National Bank of Beeville. This transaction resulted in three additional branches and two LPO’s in the South Texas region. The Company issued 1,579,191 shares of its common stock as well as a net cash payment to Beeville shareholders of $32.4 million. For more information about the acquisition, see “Note 3. Business Combinations” located in [/INST] Negative. </s>

Forum Merger II Corp

2019-03-26

2018-12-31

Item 7. Management’s Discussion And Analysis of Financial Condition And Results of Operations Special Note Regarding Forward-Looking Statements All statements other than statements of historical fact included in this Form 10-K including, without limitation, statements under “Management’s Discussion and Analysis of Financial Condition and Results of Operations” regarding the Company’s financial position, business strategy and the plans and objectives of management for future operations, are forward-looking statements. When used in this Form 10-K, words such as “anticipate,” “believe,” “estimate,” “expect,” “intend” and similar expressions, as they relate to us or the Company’s management, identify forward-looking statements. Such forward-looking statements are based on the beliefs of management, as well as assumptions made by, and information currently available to, the Company’s management. Actual results could differ materially from those contemplated by the forward-looking statements as a result of certain factors detailed in our filings with the SEC. The following discussion and analysis of our financial condition and results of operations should be read in conjunction with the financial statements and the notes thereto contained elsewhere in this Report. Certain information contained in the discussion and analysis set forth below includes forward-looking statements that involve risks and uncertainties. Overview We are a blank check company incorporated on May 4, 2018 as a Delaware corporation and formed for the purpose of effecting a merger, capital stock exchange, asset acquisition, stock purchase, reorganization or similar business combination with one or more businesses (a “business combination”). We intend to effectuate our business combination using cash from the proceeds of our initial public offering and the sale of the private placement units that occurred simultaneously with the completion of our initial public offering, our capital stock, debt or a combination of cash, stock and debt. The issuance of additional shares of our stock in a business combination: ● may significantly dilute the equity interest of investors, which dilution would increase if the anti-dilution provisions in the Class B common stock resulted in the issuance of Class A shares on a greater than one-to-one basis upon conversion of the Class B common stock; ● may subordinate the rights of holders of our common stock if preferred stock is issued with rights senior to those afforded our common stock; ● could cause a change in control if a substantial number of shares of our common stock is issued, which may affect, among other things, our ability to use our net operating loss carry forwards, if any, and could result in the resignation or removal of our present officers and directors; ● may have the effect of delaying or preventing a change of control of us by diluting the stock ownership or voting rights of a person seeking to obtain control of us; and ● may adversely affect prevailing market prices for our Class A common stock and/or warrants. Similarly, if we issue debt securities or otherwise incur significant indebtedness, it could result in: ● default and foreclosure on our assets if our operating revenues after business combination are insufficient to repay our debt obligations; ● acceleration of our obligations to repay the indebtedness even if we make all principal and interest payments when due if we breach certain covenants that require the maintenance of certain financial ratios or reserves without a waiver or renegotiation of that covenant; ● our immediate payment of all principal and accrued interest, if any, if the debt security is payable on demand; ● our inability to obtain necessary additional financing if the debt security contains covenants restricting our ability to obtain such financing while the debt security is outstanding; ● our inability to pay dividends on our common stock; ● using a substantial portion of our cash flow to pay principal and interest on our debt, which will reduce the funds available for dividends on our common stock if declared, our ability to pay expenses, make capital expenditures and acquisitions, and fund other general corporate purposes; ● limitations on our flexibility in planning for and reacting to changes in our business and in the industry in which we operate; ● increased vulnerability to adverse changes in general economic, industry and competitive conditions and adverse changes in government regulation; ● limitations on our ability to borrow additional amounts for expenses, capital expenditures, acquisitions, debt service requirements, and execution of our strategy; and ● other purposes and other disadvantages compared to our competitors who have less debt. We expect to continue to incur significant costs in the pursuit of our acquisition plans. We cannot assure you that our plans to complete a business combination will be successful. Results of Operations We have neither engaged in any operations nor generated any revenues to date. Our only activities from inception to December 31, 2018 were organizational activities, those necessary to prepare for the initial public offering, and identifying a target company for a business combination. We do not expect to generate any operating revenues until after the completion of our business combination. We generate non-operating income in the form of interest income on marketable securities. We incur expenses as a result of being a public company (for legal, financial reporting, accounting and auditing compliance), as well as for due diligence expenses in connection with completing a business combination. For the period from May 4, 2018 (inception) through December 31, 2018, we had net income of $1,077,153, which consists of interest income on marketable securities held in the trust account of $1,447,296 and an unrealized gain on marketable securities held in our trust account of $301,126, offset by operating costs of $384,938, and a provision for income taxes of $286,331. Liquidity and Capital Resources On August 7, 2018, we consummated the initial public offering of 20,000,000 units at a price of $10.00 per unit, generating gross proceeds of $200,000,000. Simultaneously with the closing of the initial public offering, we consummated the sale of 655,000 private placement units to the sponsor and underwriters at a price of $10.00 per unit, generating gross proceeds of $6,550,000. Following the initial public offering and the sale of the private placement units, a total of $200,000,000 was placed in the trust account and we had $2,027,199 of cash held outside of the trust account, after payment of costs related to the initial public offering, and available for working capital purposes. We incurred $11,532,114 in transaction costs, including $4,000,000 of underwriting fees, $7,000,000 of deferred underwriting fees and $532,114 of other costs. For the period from May 4, 2018 (inception) through December 31, 2018, cash used in operating activities was $280,791, consisting primarily of net income of $1,077,153, offset by interest earned on marketable securities held in the trust account $1,447,296 and an unrealized gain on marketable securities held in our trust account of $301,126 and a deferred tax provision of $63,236. Changes in operating assets and liabilities provided $327,242 of cash from operating activities. We intend to use substantially all of the funds held in the trust account (excluding deferred underwriting fees) to complete our business combination. To the extent that our capital stock or debt is used, in whole or in part, as consideration to complete our business combination, the remaining proceeds held in the trust account will be used as working capital to finance the operations of the target business or businesses, make other acquisitions and pursue our growth strategies. As of December 31, 2018, we had cash of $1,762,095 held outside the trust account. We intend to use the funds held outside the trust account primarily to identify and evaluate target businesses, perform business due diligence on prospective target businesses, travel to and from the offices, plants or similar locations of prospective target businesses or their representatives or owners, review corporate documents and material agreements of prospective target businesses, and structure, negotiate and complete a business combination. In order to fund working capital deficiencies or finance transaction costs in connection with a business combination, the Sponsor or an affiliate of the Sponsor or certain of our officers and directors may, but are not obligated to, loan us funds as may be required. If we complete a business combination, we would repay such loaned amounts. In the event that a business combination does not close, we may use a portion of the working capital held outside the trust account to repay such loaned amounts but no proceeds from our trust account would be used for such repayment. Up to $1,200,000 of such working capital loans may be convertible into private placement units at a price of $10.00 per unit at the option of the lender. We do not believe we will need to raise additional funds in order to meet the expenditures required for operating our business a year from the date that the financial statements are issued. However, if our estimates of the costs of identifying a target business, undertaking in-depth due diligence and negotiating a business combination are less than the actual amount necessary to do so, we may have insufficient funds available to operate our business prior to our business combination. Moreover, we may need to obtain additional financing either to complete our business combination or because we become obligated to redeem a significant number of public shares upon completion of our business combination, in which case we may issue additional securities or incur debt in connection with such business combination. In addition, we intend to target businesses larger than we could acquire with the net proceeds of our initial public offering and the sale of the private placement units, and may as a result be required to seek additional financing to complete such proposed initial business combination. Subject to compliance with applicable securities laws, we would only complete such financing simultaneously with the completion of our business combination. If we are unable to complete our initial business combination because we do not have sufficient funds available to us, we will be forced to cease operations and liquidate the trust account. In addition, following our business combination, if cash on hand is insufficient, we may need to obtain additional financing in order to meet our obligations. Off-balance sheet financing arrangements We have no obligations, assets or liabilities, which would be considered off-balance sheet arrangements as of December 31, 2018. We do not participate in transactions that create relationships with unconsolidated entities or financial partnerships, often referred to as variable interest entities, which would have been established for the purpose of facilitating off-balance sheet arrangements. We have not entered into any off-balance sheet financing arrangements, established any special purpose entities, guaranteed any debt or commitments of other entities, or purchased any non-financial assets. Contractual obligations We do not have any long-term debt, capital lease obligations, operating lease obligations, purchase obligations or long-term liabilities, other than an agreement to pay an affiliate of the sponsor a monthly fee of $15,000 for office space, utilities and administrative support to the Company. We began incurring these fees on August 7, 2018 and will continue to incur these fees monthly until the earlier of the completion of the business combination and the Company’s liquidation. Critical Accounting Policies The preparation of financial statements and related disclosures in conformity with accounting principles generally accepted in the United States of America requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities, disclosure of contingent assets and liabilities at the date of the financial statements, and income and expenses during the periods reported. Actual results could materially differ from those estimates. We have identified the following critical accounting policy: Common stock subject to possible redemption We account for common stock subject to possible redemption in accordance with the guidance in Accounting Standards Codification (“ASC”) Topic 480 “Distinguishing Liabilities from Equity.” Common stock subject to mandatory redemption is classified as a liability instrument and is measured at fair value. Conditionally redeemable common stock (including common stock that features redemption rights that are either within the control of the holder or subject to redemption upon the occurrence of uncertain events not solely within the Company’s control) is classified as temporary equity. At all other times, common stock is classified as stockholders’ equity. Our common stock features certain redemption rights that are considered to be outside of our control and subject to occurrence of uncertain future events. Accordingly, common stock subject to possible redemption is presented at redemption value as temporary equity, outside of the stockholders’ equity section of our balance sheet. Recent accounting pronouncements Management does not believe that any recently issued, but not yet effective, accounting standards, if currently adopted, would have a material effect on our financial statements.

<s>[INST] All statements other than statements of historical fact included in this Form 10K including, without limitation, statements under “Management’s Discussion and Analysis of Financial Condition and Results of Operations” regarding the Company’s financial position, business strategy and the plans and objectives of management for future operations, are forwardlooking statements. When used in this Form 10K, words such as “anticipate,” “believe,” “estimate,” “expect,” “intend” and similar expressions, as they relate to us or the Company’s management, identify forwardlooking statements. Such forwardlooking statements are based on the beliefs of management, as well as assumptions made by, and information currently available to, the Company’s management. Actual results could differ materially from those contemplated by the forwardlooking statements as a result of certain factors detailed in our filings with the SEC. The following discussion and analysis of our financial condition and results of operations should be read in conjunction with the financial statements and the notes thereto contained elsewhere in this Report. Certain information contained in the discussion and analysis set forth below includes forwardlooking statements that involve risks and uncertainties. Overview We are a blank check company incorporated on May 4, 2018 as a Delaware corporation and formed for the purpose of effecting a merger, capital stock exchange, asset acquisition, stock purchase, reorganization or similar business combination with one or more businesses (a “business combination”). We intend to effectuate our business combination using cash from the proceeds of our initial public offering and the sale of the private placement units that occurred simultaneously with the completion of our initial public offering, our capital stock, debt or a combination of cash, stock and debt. The issuance of additional shares of our stock in a business combination: may significantly dilute the equity interest of investors, which dilution would increase if the antidilution provisions in the Class B common stock resulted in the issuance of Class A shares on a greater than onetoone basis upon conversion of the Class B common stock; may subordinate the rights of holders of our common stock if preferred stock is issued with rights senior to those afforded our common stock; could cause a change in control if a substantial number of shares of our common stock is issued, which may affect, among other things, our ability to use our net operating loss carry forwards, if any, and could result in the resignation or removal of our present officers and directors; may have the effect of delaying or preventing a change of control of us by diluting the stock ownership or voting rights of a person seeking to obtain control of us; and may adversely affect prevailing market prices for our Class A common stock and/or warrants. Similarly, if we issue debt securities or otherwise incur significant indebtedness, it could result in: default and foreclosure on our assets if our operating revenues after business combination are insufficient to repay our debt obligations; acceleration of our obligations to repay the indebtedness even if we make all principal and interest payments when due if we breach certain covenants that require the maintenance of certain financial ratios or reserves without a waiver or renegotiation of that covenant; our immediate payment of all principal and accrued interest, if any, if the debt security is payable on demand; our inability to obtain necessary additional financing if the debt security contains covenants restricting our ability to obtain such financing while the debt security is outstanding; our inability to pay dividends on our common stock; using a substantial portion of our cash flow to pay principal and interest on our debt, which will reduce the funds available for dividends on our common stock if declared, our ability to pay expenses, make capital expenditures and acquisitions, and fund other general corporate purposes; limitations on our flexibility in planning for and reacting to changes in our business and in the industry in which we operate; increased vulnerability to adverse changes in general economic, industry and competitive conditions and adverse changes in government regulation; limitations on our ability to borrow additional amounts for expenses, capital expenditures, acquisitions, debt service requirements, and execution of our strategy; and other purposes and other disadvantages compared to our competitors who have less debt. We expect to continue to incur significant costs in the pursuit of our acquisition plans. We cannot assure you that our plans to complete a business combination will be successful. Results [/INST] Negative. </s>

Forum Merger II Corp

2020-03-11

2019-12-31

Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations Special Note Regarding Forward-Looking Statements All statements other than statements of historical fact included in this Form 10-K including, without limitation, statements under “Management’s Discussion and Analysis of Financial Condition and Results of Operations” regarding the Company’s financial position, business strategy and the plans and objectives of management for future operations, are forward-looking statements. When used in this Form 10-K, words such as “anticipate,” “believe,” “estimate,” “expect,” “intend” and similar expressions, as they relate to us or the Company’s management, identify forward-looking statements. Such forward-looking statements are based on the beliefs of management, as well as assumptions made by, and information currently available to, the Company’s management. Actual results could differ materially from those contemplated by the forward-looking statements as a result of certain factors detailed in our filings with the SEC. The following discussion and analysis of our financial condition and results of operations should be read in conjunction with the financial statements and the notes thereto contained elsewhere in this Report. Certain information contained in the discussion and analysis set forth below includes forward-looking statements that involve risks and uncertainties. Overview We are a blank check company incorporated on May 4, 2018 as a Delaware corporation and formed for the purpose of effecting a merger, capital stock exchange, asset acquisition, stock purchase, reorganization or similar business combination with one or more businesses. We intend to effectuate our business combination using cash from the proceeds of our initial public offering and the sale of the private placement units that occurred simultaneously with the completion of our initial public offering, our capital stock, debt or a combination of cash, stock and debt. The issuance of additional shares of our stock in a business combination: ● may significantly dilute the equity interest of investors, which dilution would increase if the anti-dilution provisions in the Class B common stock resulted in the issuance of Class A shares on a greater than one-to-one basis upon conversion of the Class B common stock; ● may subordinate the rights of holders of our common stock if preferred stock is issued with rights senior to those afforded our common stock; ● could cause a change in control if a substantial number of shares of our common stock are issued, which may affect, among other things, our ability to use our net operating loss carry forwards, if any, and could result in the resignation or removal of our present officers and directors; ● may have the effect of delaying or preventing a change of control of us by diluting the stock ownership or voting rights of a person seeking to obtain control of us; and ● may adversely affect prevailing market prices for our Class A common stock and/or warrants. Similarly, if we issue debt securities or otherwise incur significant indebtedness, it could result in: ● default and foreclosure on our assets if our operating revenues after a business combination are insufficient to repay our debt obligations; ● acceleration of our obligations to repay the indebtedness even if we make all principal and interest payments when due if we breach certain covenants that require the maintenance of certain financial ratios or reserves without a waiver or renegotiation of that covenant; ● our immediate payment of all principal and accrued interest, if any, if the debt security is payable on demand; ● our inability to obtain necessary additional financing if the debt security contains covenants restricting our ability to obtain such financing while the debt security is outstanding; ● our inability to pay dividends on our common stock; ● using a substantial portion of our cash flow to pay principal and interest on our debt, which will reduce the funds available for dividends on our common stock if declared, our ability to pay expenses, make capital expenditures and acquisitions, and fund other general corporate purposes; ● limitations on our flexibility in planning for and reacting to changes in our business and in the industry in which we operate; ● increased vulnerability to adverse changes in general economic, industry and competitive conditions and adverse changes in government regulation; ● limitations on our ability to borrow additional amounts for expenses, capital expenditures, acquisitions, debt service requirements, and execution of our strategy; and ● other disadvantages compared to our competitors who have less debt. We expect to continue to incur significant costs in the pursuit of our acquisition plans. We cannot assure you that our plans to complete a business combination will be successful. Recent Developments On February 7, 2020, our stockholders approved an amendment to our amended and restated certificate of incorporation to extend the period of time for which we are required to consummate a Business Combination to June 10, 2020. The number of shares of common stock presented for redemption in connection with the extension was 4,589. We paid cash in the aggregate amount of $47,175, or approximately $10.28 per share, to redeeming stockholders. We agreed to deposit $0.033 for each public share outstanding that was not redeemed for each of the four consecutive monthly periods of the extension, assuming the Company takes the full time through June 10, 2020 to complete a business combination. In February and March 2020, we deposited $0.033 for each public outstanding that was not converted, or an aggregate of $1,319,697 into the trust account. In addition, our stockholders voted to elect Neil Goldberg, Richard Katzman and Steven Berns to serve as Class I directors on our board or directors until the 2021 annual meeting of stockholders or until their respective successors are elected and qualified. On February 10, 2020, we issued an unsecured promissory note to the Sponsor in the aggregate amount of $2,639,394 in order to fund the extension payments. The note is non-interest bearing and payable upon the consummation of a business combination. Results of Operations We have neither engaged in any operations nor generated any revenues to date. Our only activities through December 31, 2019 were organizational activities, including those necessary to prepare for the initial public offering and identifying a target company for a business combination. We do not expect to generate any operating revenues until after the completion of our business combination. We generate non-operating income in the form of interest income on marketable securities. We incur expenses as a result of being a public company (for legal, financial reporting, accounting and auditing compliance), as well as for due diligence expenses in connection with completing a business combination. For the year ended December 31, 2019, we had net income of $2,350,168, which consisted of interest income on marketable securities held in the trust account of $4,289,906 and an unrealized gain on marketable securities held in our trust account of $18,040, offset by operating costs of $1,105,323 and a provision for income taxes of $852,455. For the period from May 4, 2018 (inception) through December 31, 2018, we had net income of $1,077,153, which consists of interest income on marketable securities held in the trust account of $1,447,296 and an unrealized gain on marketable securities held in our trust account of $301,126, offset by formation and operating costs of $384,938, and a provision for income taxes of $286,331. Liquidity and Capital Resources On August 7, 2018, we consummated the initial public offering of 20,000,000 units at a price of $10.00 per unit, generating gross proceeds of $200,000,000. Simultaneously with the closing of the initial public offering, we consummated the sale of 655,000 private placement units to the Sponsor and underwriters at a price of $10.00 per unit, generating gross proceeds of $6,550,000. Following the initial public offering and the sale of the private placement units, a total of $200,000,000 was placed in the trust account. We incurred $11,532,114 in transaction costs, including $4,000,000 of underwriting fees, $7,000,000 of deferred underwriting fees and $532,114 of other costs. For the year ended December 31, 2019, cash used in operating activities was $1,216,491. Net income of $2,350,168 was offset by interest earned on marketable securities held in the trust account of $4,289,906, an unrealized gain on marketable securities held in our trust account of $18,040 and a deferred tax benefit of $58,665. Changes in operating assets and liabilities provided $799,952 of cash from operating activities. For the period from May 4, 2018 (inception) through December 31, 2018, cash used in operating activities was $280,791, consisting primarily of net income of $1,077,153, offset by interest earned on marketable securities held in the trust account $1,447,296 and an unrealized gain on marketable securities held in our trust account of $301,126 and a deferred tax provision of $63,236. Changes in operating assets and liabilities provided $327,242 of cash from operating activities. We intend to use substantially all of the funds held in the trust account (excluding deferred underwriting fees) to complete our business combination. To the extent that our capital stock or debt is used, in whole or in part, as consideration to complete our business combination, the remaining proceeds held in the trust account will be used as working capital to finance the operations of the target business or businesses, make other acquisitions and pursue our growth strategies. As of December 31, 2019, we had cash of $1,287,406 held outside the trust account. We intend to use the funds held outside the trust account primarily to identify and evaluate target businesses, perform business due diligence on prospective target businesses, travel to and from the offices, plants or similar locations of prospective target businesses or their representatives or owners, review corporate documents and material agreements of prospective target businesses, and structure, negotiate and complete a business combination. In order to fund working capital deficiencies or finance transaction costs in connection with a business combination, the Sponsor or an affiliate of the Sponsor or certain of our officers and directors may, but are not obligated to, loan us funds as may be required. If we complete a business combination, we would repay such loaned amounts. In the event that a business combination does not close, we may use a portion of the working capital held outside the trust account to repay such loaned amounts but no proceeds from our trust account would be used for such repayment. Up to $1,200,000 of such working capital loans may be convertible into private placement units at a price of $10.00 per unit at the option of the lender. We do not believe we will need to raise additional funds in order to meet the expenditures required for operating our business through June 10, 2020. However, if our estimates of the costs of identifying a target business, undertaking in-depth due diligence and negotiating a business combination are less than the actual amount necessary to do so, we may have insufficient funds available to operate our business prior to our business combination. Moreover, we may need to obtain additional financing either to complete our business combination or because we become obligated to redeem a significant number of public shares upon completion of our business combination, in which case we may issue additional securities or incur debt in connection with such business combination. In addition, we intend to target businesses larger than we could acquire with the net proceeds of our initial public offering and the sale of the private placement units and may as a result be required to seek additional financing to complete such proposed initial business combination. Subject to compliance with applicable securities laws, we would only complete such financing simultaneously with the completion of our business combination. If we are unable to complete our initial business combination because we do not have sufficient funds available to us, we will be forced to cease operations and liquidate the trust account. In addition, following our business combination, if cash on hand is insufficient, we may need to obtain additional financing in order to meet our obligations. Off-balance sheet financing arrangements We have no obligations, assets or liabilities, which would be considered off-balance sheet arrangements as of December 31, 2019. We do not participate in transactions that create relationships with unconsolidated entities or financial partnerships, often referred to as variable interest entities, which would have been established for the purpose of facilitating off-balance sheet arrangements. We have not entered into any off-balance sheet financing arrangements, established any special purpose entities, guaranteed any debt or commitments of other entities, or purchased any non-financial assets. Contractual obligations We do not have any long-term debt, capital lease obligations, operating lease obligations, purchase obligations or long-term liabilities, other than an agreement to pay an affiliate of the Sponsor a monthly fee of $15,000 for office space, utilities and administrative support to the Company. We began incurring these fees on August 7, 2018 and will continue to incur these fees monthly until the earlier of the completion of the business combination and the Company’s liquidation. In addition, we have an agreement to pay the underwriters a deferred underwriting fee of $0.35 per Unit, or $7,000,000 in the aggregate. The deferred fee will be forfeited by the underwriters solely in the event that the Company fails to complete a business combination, subject to the terms of the underwriting agreement. Critical Accounting Policies The preparation of financial statements and related disclosures in conformity with accounting principles generally accepted in the United States of America requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities, disclosure of contingent assets and liabilities at the date of the financial statements, and income and expenses during the periods reported. Actual results could materially differ from those estimates. We have identified the following critical accounting policies: Common stock subject to possible redemption We account for our common stock subject to possible redemption in accordance with the guidance in Accounting Standards Codification (“ASC”) Topic 480 “Distinguishing Liabilities from Equity.” Common stock subject to mandatory redemption is classified as a liability instrument and is measured at fair value. Conditionally redeemable common stock (including common stock that features redemption rights that are either within the control of the holder or subject to redemption upon the occurrence of uncertain events not solely within our control) is classified as temporary equity. At all other times, common stock is classified as stockholders’ equity. Our common stock features certain redemption rights that are considered to be outside of our control and subject to occurrence of uncertain future events. Accordingly, common stock subject to possible redemption is presented at redemption value as temporary equity, outside of the stockholders’ equity section of our balance sheets. Net loss per common share We apply the two-class method in calculating earnings per share. Shares of common stock subject to possible redemption which are not currently redeemable and are not redeemable at fair value, have been excluded from the calculation of basic net loss per share since such shares, if redeemed, only participate in their pro rata share of the trust account earnings. Our net income is adjusted for the portion of income that is attributable to common stock subject to possible redemption, as these shares only participate in the earnings of the trust account and not our income or losses. Recent accounting pronouncements Management does not believe that any recently issued, but not yet effective, accounting standards, if currently adopted, would have a material effect on our financial statements.

<s>[INST] All statements other than statements of historical fact included in this Form 10K including, without limitation, statements under “Management’s Discussion and Analysis of Financial Condition and Results of Operations” regarding the Company’s financial position, business strategy and the plans and objectives of management for future operations, are forwardlooking statements. When used in this Form 10K, words such as “anticipate,” “believe,” “estimate,” “expect,” “intend” and similar expressions, as they relate to us or the Company’s management, identify forwardlooking statements. Such forwardlooking statements are based on the beliefs of management, as well as assumptions made by, and information currently available to, the Company’s management. Actual results could differ materially from those contemplated by the forwardlooking statements as a result of certain factors detailed in our filings with the SEC. The following discussion and analysis of our financial condition and results of operations should be read in conjunction with the financial statements and the notes thereto contained elsewhere in this Report. Certain information contained in the discussion and analysis set forth below includes forwardlooking statements that involve risks and uncertainties. Overview We are a blank check company incorporated on May 4, 2018 as a Delaware corporation and formed for the purpose of effecting a merger, capital stock exchange, asset acquisition, stock purchase, reorganization or similar business combination with one or more businesses. We intend to effectuate our business combination using cash from the proceeds of our initial public offering and the sale of the private placement units that occurred simultaneously with the completion of our initial public offering, our capital stock, debt or a combination of cash, stock and debt. The issuance of additional shares of our stock in a business combination: may significantly dilute the equity interest of investors, which dilution would increase if the antidilution provisions in the Class B common stock resulted in the issuance of Class A shares on a greater than onetoone basis upon conversion of the Class B common stock; may subordinate the rights of holders of our common stock if preferred stock is issued with rights senior to those afforded our common stock; could cause a change in control if a substantial number of shares of our common stock are issued, which may affect, among other things, our ability to use our net operating loss carry forwards, if any, and could result in the resignation or removal of our present officers and directors; may have the effect of delaying or preventing a change of control of us by diluting the stock ownership or voting rights of a person seeking to obtain control of us; and may adversely affect prevailing market prices for our Class A common stock and/or warrants. Similarly, if we issue debt securities or otherwise incur significant indebtedness, it could result in: default and foreclosure on our assets if our operating revenues after a business combination are insufficient to repay our debt obligations; acceleration of our obligations to repay the indebtedness even if we make all principal and interest payments when due if we breach certain covenants that require the maintenance of certain financial ratios or reserves without a waiver or renegotiation of that covenant; our immediate payment of all principal and accrued interest, if any, if the debt security is payable on demand; our inability to obtain necessary additional financing if the debt security contains covenants restricting our ability to obtain such financing while the debt security is outstanding; our inability to pay dividends on our common stock; using a substantial portion of our cash flow to pay principal and interest on our debt, which will reduce the funds available for dividends on our common stock if declared, our ability to pay expenses, make capital expenditures and acquisitions, and fund other general corporate purposes; limitations on our flexibility in planning for and reacting to changes in our business and in the industry in which we operate; increased vulnerability to adverse changes in general economic, industry and competitive conditions and adverse changes in government regulation; limitations on our ability to borrow additional amounts for expenses, capital expenditures, acquisitions, debt service requirements, and execution of our strategy; and other disadvantages compared to our competitors who have less debt. We expect to continue to incur significant costs in the pursuit of our acquisition plans. We cannot assure you that our plans to complete a business combination will be successful. Recent Developments On February 7, [/INST] Positive. </s>

Upwork Inc.

2019-03-07

2018-12-31

Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations. You should read the following discussion and analysis of our financial condition and results of operations together with the sections titled “Business,” “Risk Factors,” and “Selected Consolidated Financial Data,” and the consolidated financial statements and related notes included elsewhere in this Annual Report. This discussion contains forward-looking statements based upon current expectations that involve risks and uncertainties. Our actual results may differ materially from those anticipated in these forward-looking statements as a result of various factors, including those discussed in the sections titled “Special Note Regarding Forward-Looking Statements” and “Risk Factors” and in other parts of this Annual Report. Overview Business We operate the largest online marketplace that enables businesses to find and work with highly-skilled freelancers, as measured by GSV. GSV represents the total amount that clients spend on both our marketplace offerings and our managed services offering as well as additional fees we charge to users for other services. Freelancers are an increasingly sought-after, critical, and expanding segment of the global workforce. We define freelancers as users of our platform that advertise and provide services to clients through our platform, and we define clients as users of our platform that work with freelancers through our platform. The freelancers on our platform include independent professionals and agencies of varying sizes. The clients on our platform range in size from small businesses to Fortune 500 companies. During the year ended December 31, 2018, our platform enabled $1.8 billion of GSV in over 180 countries. For purposes of determining countries where we enable GSV, we include both the countries in which the clients that paid for the applicable services are located, as well as the countries in which the freelancers that provided those services are located. In October 2018, we completed our IPO, in which we issued and sold an aggregate of 7,840,908 shares of our common stock, including 1,022,727 shares pursuant to the exercise of the underwriters’ option to purchase additional shares. The shares were sold to the underwriters at the IPO price of $15.00 per share less an underwriting discount of $1.05 per share. We received aggregate net proceeds of $109.4 million from the IPO after deducting underwriting discounts and commissions but before deducting offering expenses payable by us. We generate a majority of our revenue from fees charged to freelancers. We also generate revenue through fees charged to clients for transacting payments through our platform, as well as foreign currency exchange fees, Upwork Payroll service fees, and fees for premium offerings. In addition, we provide a managed services offering where we engage freelancers to complete projects, directly invoice the client, and assume responsibility for work performed by the freelancers. We generated revenue of $253.4 million in 2018, $202.6 million in 2017, and $164.4 million in 2016, representing year-over-year increases of 25% in 2018 and 23% in 2017. Financial Highlights for 2018 In 2018, our platform enabled $1.8 billion of GSV, representing an increase of 28% over the prior year, and our total revenue was $253.4 million, representing an increase of 25% over the prior year. Our marketplace revenue was $223.9 million, representing an increase of 26% over the prior year. We continue to make significant investments to grow our business, including in sales and marketing, research and development, operations, and personnel and, as a result, we generated a net loss of $19.9 million in 2018 compared to a net loss of $4.1 million in 2017. Our adjusted EBITDA was $3.8 million in 2018, a decline of 52% from 2017. Adjusted EBITDA is a financial measure that is not prepared in accordance with, and is not an alternative to, financial measures prepared in accordance with U.S. GAAP. See the section titled “Selected Consolidated Financial Data-Non-GAAP Financial Measures” for a definition of adjusted EBITDA and information regarding our use of adjusted EBITDA and a reconciliation of net loss to adjusted EBITDA. As a global platform that connects freelancers and clients regardless of their location, our GSV originates from around the world. Of the $1.8 billion of GSV enabled on our platform in 2018, approximately 23% was generated from U.S. freelancers, our largest freelancer geography, as measured by GSV, in both 2018 and 2017, while freelancers in India and the Philippines remained our next largest freelancer geographies in both years. Of the $1.4 billion of GSV enabled on our platform in 2017, approximately 19%, was generated from freelancers in the United States. Approximately 66% of our GSV in 2018 was generated from U.S. clients, compared to approximately 67% of GSV in 2017, with clients in no other country representing more than 10% of our GSV in either year. We believe U.S. clients will continue to drive growth by engaging freelancers globally, particularly freelancers in the United States where there are various efficiencies associated with same-country engagements, such as cultural and contractual norms, time zones, and language. Key Financial and Operational Metrics We monitor the following key financial and operational metrics to evaluate our business, measure our performance, identify trends affecting our business, formulate business plans, and make strategic decisions (in thousands, except percentages): (1) Adjusted EBITDA is not prepared in accordance with, and is not an alternative to, financial measures prepared in accordance with U.S. GAAP. See “Selected Consolidated Financial Data-Non-GAAP Financial Measures” for a definition of adjusted EBITDA and for information regarding our use of adjusted EBITDA and a reconciliation of adjusted EBITDA to net loss, the most directly comparable financial measure prepared under U.S. GAAP. We believe these key financial and operational metrics are useful to evaluate period-over-period comparisons of our business and in understanding our operating results. The number of core clients in any given period drives both GSV, which represents the amount of business transacted through our platform, and client spend retention. Client spend retention impacts the growth rate of GSV. We believe our marketplace revenue, which represents a majority of our revenue, will grow as GSV grows, although they could grow at different rates. For a discussion of limitations in the measurement of core clients, GSV, and client spend retention, see “Risk Factors-We track certain performance metrics with internal tools and do not independently verify such metrics. Certain of our performance metrics are subject to inherent challenges in measurement, and real or perceived inaccuracies in such metrics may harm our reputation and negatively affect our business.” Core Clients We define a core client as a client that has spent in the aggregate at least $5,000 since it began using our platform and also had spend-activity on our platform during the twelve months preceding the date of measurement. This includes the total amount spent by the client on both the Elance and oDesk platforms for the periods prior to the consolidation of the two platforms as described above under “Business-Corporate Information.” We believe $5,000 is an important spend milestone as it indicates that the client is actively using our platform. Historically, these core clients have been more likely to continue using our platform. We believe that the number of core clients is a key indicator of our growth and the overall health of our business because core clients are a primary driver of GSV, and, therefore, marketplace revenue. Gross Services Volume GSV includes both client spend and additional fees charged for other services. Client spend-the total amount that clients spend on both our marketplace offerings and our managed services offering-is the primary component of GSV. GSV also includes additional fees charged to both clients and freelancers for other services, such as freelancer withdrawals and foreign currency exchange. GSV is an important metric because it represents the amount of business transacted through our platform. Growth in the number of core clients and increased client spend retention are the primary drivers of GSV growth. In addition, our marketplace revenue is primarily comprised of the service fees paid by freelancers as a percentage of the total amount freelancers charge clients for services accessed through our platform. Therefore, marketplace revenue is correlated to GSV, and we believe that our marketplace revenue will grow as GSV grows, although they could grow at different rates. We expect our GSV to fluctuate between periods due to a number of factors, including the volume and characteristics of projects that are posted by clients on our platform, such as size, duration, pricing, and other factors. Client Spend Retention We calculate client spend retention by dividing our recurring client spend by our base client spend. We define base client spend as the aggregate client spend from all clients during the four quarters ended one year prior to the date of measurement. We define our recurring client spend as the aggregate client spend during the four quarters ended on the date of measurement from the same clients included in our measure of base client spend. Our business is recurring in nature even though clients are not contractually required to spend on a recurring basis. We believe that client spend retention is a key indicator of the value of our platform and the overall health of our business because it impacts the growth rate of GSV, and, therefore, marketplace revenue. The growth in our marketplace is driven primarily by long-term and recurring use by freelancers and clients, which leads to increased revenue visibility for us. While continued use of our platform by freelancers is a factor that impacts our ability to attract and retain clients, our platform currently has a significant surplus of freelancers in relation to the number of clients actively engaging freelancers. As a result of this surplus of freelancers relative to clients, we primarily focus our efforts on retaining client spend and acquiring new clients as opposed to acquiring new freelancers and retaining existing freelancers. Moreover, we generate revenue when clients engage and pay freelancers and therefore our key metrics and operating results are directly impacted by client spend. On the other hand, the number of freelancers retained between periods is merely one of many factors that may impact client spend in a particular period and is not a primary driver of our key metrics and operating results. For these reasons, we do not calculate or track freelancer retention metrics in order to manage our business. Marketplace Revenue Marketplace revenue, which represents the majority of our revenue, consists of revenue derived from our Upwork Standard and Upwork Enterprise and other premium offerings. We generate marketplace revenue from both freelancers and clients. Our marketplace revenue is primarily comprised of the service fees paid by freelancers as a percentage of the total amount freelancers charge clients for services accessed through our platform, and to a lesser extent, payment processing and administration fees charged to clients. We also generate marketplace revenue for other services, such as foreign currency exchange fees, Upwork Payroll service fees, and fees for premium offerings. Marketplace revenue is an important metric because it is the primary driver of our business model, and we believe it provides greater comparability to other online marketplaces. The growth rate of marketplace revenue fluctuates in relation to the growth rate of GSV. Therefore, marketplace revenue is correlated to GSV, and we believe that our marketplace revenue will grow as GSV grows, although they could grow at different rates. Adjusted EBITDA We define adjusted EBITDA as net loss adjusted for stock-based compensation expense, depreciation and amortization, interest expense, other (income) expense, net, provision for (benefit from) income tax, the change in fair value of our Tides Foundation common stock warrant (see Note 8 of the notes to our consolidated financial statements included elsewhere in this Annual Report), and, if applicable, other non-cash transactions. Adjusted EBITDA is not prepared in accordance with, and is not an alternative to, financial measures prepared in accordance with U.S. GAAP. See the section titled “Selected Consolidated Financial Data-Non-GAAP Financial Measures” for information on our use of adjusted EBITDA and a reconciliation of net loss to adjusted EBITDA. Components of Our Results of Operations Revenue Marketplace Revenue. Marketplace revenue is generated from our Upwork Standard and Upwork Enterprise and other premium offerings. Under our Upwork Standard and Upwork Enterprise offerings, we generate revenue from both freelancers and clients. Marketplace revenue, which represents the majority of our total revenue, is primarily comprised of the service fees paid by freelancers as a percentage of the total amount that freelancers charge clients for services accessed through our platform and, to a lesser extent, payment processing and administration fees paid by clients. Our Upwork Standard offering provides clients with access to freelance talent with verified work history on our platform and client feedback, the ability to instantly match with the right freelancers, and built-in collaboration features. For our Upwork Standard offering, we have a tiered freelancer service fee schedule based on cumulative lifetime billings by the freelancer to each client. Freelancers on our Upwork Standard offering typically pay us 20% of the first $500, 10% for the next $9,500, and then 5% for any amount over $10,000 they bill to each client through our platform. We also generate revenue from freelancers through withdrawal and other fees, which are currently immaterial. In addition, we generate marketplace revenue from our Upwork Standard offering by charging clients a payment processing and administration fee. Clients using our Upwork Standard offering pay either 2.75% of their client spend or a flat fee of $25 per month for unlimited payment transactions with qualifying payment methods. We also generate revenue from foreign currency exchange fees from clients, which are currently immaterial. Our Upwork Enterprise offering and other premium offerings, which are designed for larger clients, include access to additional product features, premium access to top talent, professional services, custom reporting, and invoicing on a monthly basis. For our Upwork Enterprise offering, we charge clients a monthly or annual subscription fee and a service fee calculated as a percentage of the client’s spend on freelancer services, in addition to the service fees paid by freelancers. Additionally, Upwork Enterprise clients can also subscribe to a compliance offering that includes worker classification services for an additional fee. Upwork Enterprise clients may also choose to use our platform to engage freelancers that were not sourced through our platform for a lower fee percentage. One of our premium offerings, Upwork Payroll, is available to clients when freelancers are classified as employees for engagements on our online marketplace. The client enters into an Upwork Payroll agreement with us, and we separately contract with unrelated third-party staffing providers who provide employment services to such clients. Revenue from Upwork Payroll is currently immaterial. Managed Services Revenue. Through our managed services offering, we are responsible for providing services and engaging freelancers directly or as employees of third-party staffing providers to perform services for clients on our behalf. The freelancers delivering managed services include independent professionals and agencies of varying sizes. Under U.S. GAAP, we are deemed to be the principal in these managed services arrangements, and therefore, recognize the entire GSV of managed services projects as managed services revenue, as compared to recognizing only the percentage of the client spend that we receive, as we do with our marketplace offerings. Cost of Revenue and Gross Profit Cost of Revenue. Cost of revenue consists primarily of the cost of payment processing fees, amounts paid to freelancers to deliver services for clients under our managed services offering, personnel-related costs for our services and support personnel, third-party hosting fees for our use of AWS and the amortization expense associated with acquired intangibles and capitalized internal-use software and platform development. We define personnel-related costs as salaries, bonuses, benefits, travel and entertainment, and stock-based compensation costs for employees and the costs related to other service providers we engage. We expect cost of revenue to increase in absolute dollars in future periods due to higher payment processing fees, third-party hosting fees, and personnel-related costs in order to support growth on our platform. Amounts paid to freelancers to deliver services under our managed services offering are tied to the volume of managed services used by our clients. The level and timing of all of these items could fluctuate and affect our cost of revenue in the future. Gross Profit and Gross Margin. Our gross profit and gross margin may fluctuate from period-to-period. Such fluctuations may be influenced by our revenue, the mix of payment methods that our clients choose, the timing and amount of investments to expand hosting capacity, our continued investments in our services and support teams, the timing and amount of services freelancers deliver for clients under our managed services offering, and the amortization expense associated with acquired intangibles and capitalized internal-use software and platform development cost. In addition, gross margin will be impacted by fluctuations in our revenue mix between marketplace revenue and our managed services revenue. Operating Expenses Research and Development. Research and development expense primarily consists of personnel-related costs and third-party hosting costs related to development. Research and development costs are expensed as incurred, except to the extent that such costs are associated with internal-use software and platform development that qualifies for capitalization. We believe continued investments in research and development are important to attain our strategic objectives and expect research and development expense to increase in absolute dollars for the foreseeable future, although this expense, expressed as a percentage of total revenue, may vary from period to period. Sales and Marketing. Sales and marketing expense consists primarily of expenses related to personnel-related costs, including sales commissions, which we expense as they are incurred, and advertising and marketing activities. We continue to invest in our sales and marketing capabilities and expect this expense to increase in absolute dollars in future periods, although this expense expressed as a percentage of total revenue may vary from period-to-period. General and Administrative. General and administrative expense consists primarily of personnel-related costs for our executive, finance, legal, human resources, and operations functions. General and administrative expense also includes outside consulting, legal, and accounting services, and insurance. We also include the change in fair market value of our outstanding Tides Foundation common stock warrant within this line item. For further information regarding this charitable donation, see Note 8 of the notes to our consolidated financial statements included elsewhere in this Annual Report. We expect to continue to invest in corporate infrastructure and incur additional expenses associated with operating as a public company, including increased legal and accounting costs, investor relations costs, higher insurance premiums, and compliance costs. As a result, we expect general and administrative expense to increase in absolute dollars in future periods, although this expense, expressed as a percentage of total revenue, may vary from period to period. Provision for Transaction Losses. Provision for transaction losses consists primarily of losses resulting from fraud and bad debt expense associated with our trade and client receivables balance and transaction losses associated with chargebacks. Provisions for these items represent estimates of losses based on our actual historical incurred losses and other factors. As a result, we expect provision for transaction losses to increase in absolute dollars in future periods although this expense expressed as a percentage of total revenue may vary from period-to-period. Interest Expense Interest expense consists of interest on our outstanding borrowings. Other Expense, Net Other expense, net consists primarily of gains and losses from foreign currency exchange transactions, interest income that we earn from our money market funds, and expenses resulting from the revaluation of our convertible preferred stock warrant liability. Our convertible preferred stock warrant liability was converted to additional paid-in capital upon the completion of our IPO, which occurred in October 2018. Income Tax Benefit (Provision) We account for income taxes in accordance with the liability method. Under the liability method, deferred assets and liabilities are recognized based upon anticipated future tax consequences attributable to differences between financial statement carrying amounts of assets and liabilities and their respective tax bases. The provision for income taxes is comprised of the current tax liability and the change in deferred tax assets and liabilities. We establish a valuation allowance to the extent that it is more likely than not that deferred tax assets will not be recoverable against future taxable income. Deferred tax assets and liabilities are measured using the enacted tax rates that will be in effect for the years in which those tax assets are expected to be realized or settled. We regularly assess the likelihood that deferred tax assets will be realized from recoverable income taxes or recovered from future taxable income based on the realization criteria set forth in the relevant authoritative guidance. To the extent that we believe any amounts are less likely than not to be realized, we record a valuation allowance to reduce our deferred tax assets. The realization of deferred tax assets is dependent upon future earnings, if any, the timing and amount of which are uncertain. Accordingly, the net deferred tax assets have been fully offset by a valuation allowance. If we subsequently realize deferred tax assets that were previously determined to be unrealizable, the respective valuation allowance would be reversed, resulting in an adjustment to earnings in the period such determination is made. In addition, the calculation of tax liabilities involves dealing with uncertainties in the application of complex tax regulations. We recognize potential liabilities based on an estimate of whether, and the extent to which, additional taxes will be due. We account for uncertain tax positions in accordance with the relevant guidance, which prescribes a recognition threshold and measurement approach for uncertain tax positions taken or expected to be taken in our income tax return, and also provides guidance on recognition, classification, interest and penalties, accounting in interim periods, disclosure, and transition. The guidance utilizes a two-step approach for evaluation of uncertain tax positions. The first step is to determine if the weight of available evidence indicates a tax position is more likely than not to be sustained upon audit. The second step is to measure the tax benefit as the largest amount, which is more likely than not to be realized on ultimate settlement. A liability is reported for unrecognized tax benefits resulting from uncertain tax positions taken or expected to be taken in a tax return. Any interest and penalties related to unrecognized tax benefits are recorded as income tax expense. Results of Operations The following table sets forth our consolidated results of operations for the years ended December 31, 2018, 2017 and 2016 (in thousands): Comparison of the Years Ended December 31, 2018 and 2017 Revenue Total revenue was $253.4 million in 2018, an increase of $50.8 million, or 25%, compared to 2017. Marketplace revenue represented 88% of total revenue for 2018, an increase of $45.8 million, or 26%, compared to 2017. Marketplace revenue increased primarily due to an increase in GSV. GSV grew by 28% in 2018 compared to 2017, primarily driven by a 22% increase in the number of core clients, and higher client spend retention, which increased to 108% for 2018 from 99% for 2017. We believe these increases were primarily due to investments in sales and marketing to acquire new clients and drive brand awareness and research and development to build new product features. Freelancer service fees generated $149.9 million and $120.9 million of marketplace revenue in 2018 and 2017, respectively. Client payment processing and administration fees generated $35.5 million and $27.9 million of marketplace revenue in 2018 and 2017, respectively. Managed services revenue represented 12% of total revenue in both 2018 and 2017. Managed services revenue increased $5.0 million, or 20%, in 2018 compared to 2017, primarily due to an increase in the amount of freelancer services engaged by a client through our managed services offering. Managed services revenue is growing, as expected, at a slower rate than our marketplace revenue, and we anticipate this trend to continue. Cost of Revenue and Gross Margin Cost of revenue increased by $16.0 million, or 24%, in 2018 compared to 2017. The increase was primarily due to the increase in other components of cost of revenue, which included increases of $6.2 million in payment processing fees due to an increase in client spend on our platform, $2.4 million in third-party hosting costs directly related to increased usage of AWS, $1.1 million related to increased personnel-related costs, $1.0 million in costs directly associated with expanding our customer support team due to increased activity on our platform, and $0.8 million attributed to normal operating costs that increased due to the increase in revenue. Costs of freelancer services to deliver managed services increased by $4.5 million, or 23%, in 2018 compared to 2017, primarily due to a corresponding increase of $5.0 million in managed services revenue in 2018 as compared to 2017. In general, the cost of freelancer services to deliver managed services is directly correlated to our managed services revenue. Research and Development Research and development expense increased by $9.9 million, or 22%, in 2018 compared to 2017. The increase was primarily due to an increase in personnel-related costs of $10.9 million, an increase of $1.1 million in amortization of licensed software, an increase of $0.8 million in facilities-related and other costs, and an increase of $0.3 million in third-party hosting costs, partially offset by $3.1 million of additional internal-use software and platform development costs capitalized in 2018 and lower costs incurred from outside professional services of approximately $0.1 million. Sales and Marketing Sales and marketing expense increased by $19.9 million, or 38%, in 2018, as compared to 2017. This increase was primarily due to increases of $10.0 million in personnel-related costs to build out our enterprise sales team, including sales commissions that we expense as incurred, $7.7 million in marketing and advertising costs associated with online and offline marketing programs to drive brand awareness and attract new users, $1.8 million of facilities-related costs for our sales office, and $0.4 million related to travel and other miscellaneous costs. General and Administrative General and administrative expense increased by $12.0 million, or 32%, in 2018 compared to 2017. This increase was primarily due to increases of $7.1 million in personnel-related costs, which included adding additional personnel primarily within our finance and accounting organization and higher stock-based compensation, $1.8 million in professional expenses related to us preparing to become a public company, $1.4 million in facilities-related and other costs, $1.1 million in software licenses, $0.4 million in non-income taxes, and $0.2 million related to the revaluation of the shares that are expected to vest and become exercisable under our Tides Foundation common stock warrant. Provision for Transaction Losses Provision for transaction losses increased by $1.6 million, or 37% in 2018 compared to 2017. The increase was due to growth in GSV and related trade and client receivables, partially offset by reductions resulting from increased efforts to reduce fraudulent activity on the platform. Interest Expense and Other Expense, Net Interest expense increased $1.1 million in 2018 as compared to 2017. This increase was due to a higher amount of outstanding borrowings in 2018. See Note 6 of the notes to our consolidated financial statements included elsewhere in this Annual Report. Other expense, net increased $6.1 million in 2018 compared to 2017, primarily due to the revaluation of our convertible preferred stock warrant liability. The value of the convertible preferred stock warrant liability increased significantly due to the completion of our IPO and the final IPO offering price being significantly higher than the historical estimated fair value used to revalue the convertible preferred stock warrant liability. The expenses related to the convertible preferred stock warrant liability will not recur in future periods. Comparison of the Years Ended December 31, 2017 and 2016 Revenue Total revenue increased by $38.1 million, or 23%, to $202.6 million in 2017 as compared to 2016. Marketplace revenue represented 88% of total revenue in 2017, an increase of $39.6 million, or 29%, in 2017 as compared to 2016. Marketplace revenue increased primarily due to an increase in GSV. GSV grew by 20%, primarily driven by a 13% increase in the number of core clients, and higher client spend retention, which increased from 85% for the year ended December 31, 2016 to 99% for the year ended December 31, 2017. Additionally, the number of projects increased 13%, from over 1.6 million in 2016 to over 1.8 million in 2017. We believe these increases were primarily due to investments in marketing to acquire new clients and drive brand awareness and research and development to build new product features. Marketplace revenue also grew, to a lesser extent, due to the Upwork Standard pricing model change implemented in the second quarter of 2016. We changed our Upwork Standard pricing model late in the second quarter of 2016 to implement a tiered freelancer service fee based on cumulative lifetime billings by the freelancer to each client. Previously, we had typically charged freelancers a flat 10% fee. The goal of the pricing change was to encourage longer-term relationships between freelancers and clients on our platform, allowing us to attract more projects, and to align client incentives with our incentives to use lower cost payment methods. Additionally, late in the second quarter of 2016, we introduced a client payment processing and administration fee that generated $12.6 million of marketplace revenue in 2016 and $27.9 million of marketplace revenue in 2017. Managed services revenue represented 12% of total revenue in 2017 as compared to 16% in 2016. The decrease of $1.5 million, or 6%, was primarily due to a decline in the amount of freelancer services used by a client using our managed services offering. Cost of Revenue and Gross Margin Cost of revenue increased by $2.9 million, or 5%, in 2017 as compared to 2016. This increase was primarily due to increases of $3.6 million in payment processing fees as a result of an increase in client spend on our platform, $0.9 million in third-party hosting costs as a result of our transition to AWS and increased transaction volume on our platform, and $2.9 million in personnel-related costs from an increase in personnel to support our growth, partially offset by a decrease of $2.6 million in amortization of intangibles that related to developed technology and $0.5 million in amortization that related to capitalized internal-use software and platform development. Costs of freelancer services to deliver managed services decreased by $1.1 million, or 5%, due to a decline in the amount of freelancer services used by a client using our managed services offering. In general, the cost of freelancer services to deliver managed services is directly correlated to our managed services revenue. Total gross margin improved from 62% in 2016 to 68% in 2017 primarily driven by the introduction of the payment processing and administration fee to clients in June 2016. Research and Development Research and development expense increased by $7.7 million, or 20%, in 2017 as compared to 2016 and was consistent as a percentage of total revenue at 23%. The increase was primarily due to an increase in personnel-related costs, driven by development of new products and features. Sales and Marketing Sales and marketing expense increased by $15.6 million, or 42%, in 2017 compared to 2016. This increase was primarily due to increases of $8.5 million in personnel-related costs to build out our enterprise sales team, including sales commissions that we expense as incurred, and $6.2 million in marketing and advertising costs associated with online and offline marketing programs to drive brand awareness and attract new users. General and Administrative General and administrative expense increased $1.9 million, or 5%, in 2017 as compared to 2016. This increase was primarily due to increases of $2.8 million of personnel-related costs and $0.5 million in audit and accounting-related costs in preparation to become a public company, partially offset by a $1.1 million legal settlement resulting from a trademark dispute accrued in 2016. Provision for Transaction Losses Provision for transaction losses decreased $1.3 million, or 23%, in 2017 as compared to 2016. This decrease was primarily due to improvements in managing transaction losses and chargebacks for fraud on our platform and bad debt expense associated with our trade and client receivables as we improved on collections from enterprise clients. Interest Expense and Other Expense, Net Interest expense increased $0.1 million, or 12%, in 2017 as compared to 2016. This increase was due to a higher amount of outstanding borrowings in 2017 as compared to 2016. Other expense, net decreased $0.8 million, or 93%, in 2017 compared to 2016. This decrease was primarily due to a decrease of $0.5 million in net losses from foreign currency transactions and a decrease of $0.3 million in prepayment fees paid to a lender. kQuarterly Results of Operations The following tables summarize our selected unaudited quarterly consolidated statements of operations data for each of the eight quarters in the period ended December 31, 2018. The information for each of these quarters has been prepared on a basis consistent with our audited financial statements included elsewhere in this Annual Report and, in the opinion of management, includes all adjustments of a normal, recurring nature that are necessary for the fair statement of the results of operations for these periods in accordance with U.S. GAAP. The data should be read in conjunction with our audited financial statements and notes thereto included elsewhere in this Annual Report. Our historical quarterly results are not necessarily indicative of the results that may be expected for a full year or in any future period. The following table sets forth our unaudited quarterly consolidated results of operations data for each of the periods indicated as a percentage of total revenue: Liquidity and Capital Resources Prior to our IPO, we financed our operations and capital expenditures primarily through sales of convertible preferred stock, bank borrowings, and utilization of cash generated from operations in the periods in which we generated cash flows from operations. In October 2018, we completed our IPO, in which we issued and sold an aggregate of 7,840,908 shares of our common stock, including 1,022,727 shares pursuant to the exercise of the underwriters’ option to purchase additional shares. The shares were sold at the IPO price of $15.00 per share, less an underwriting discount of $1.05 per share. We received aggregate net proceeds of $109.4 million from the IPO after deducting underwriting discounts and commissions but before deducing offering expenses payable by us. We used approximately $10.0 million of net proceeds from the IPO to repay indebtedness under the Loan Agreement. As of December 31, 2018, we had $129.1 million in cash and cash equivalents. We believe our existing cash and cash equivalents, cash flow from operations (in periods in which we generate cash flow from operations), and amounts available for borrowing under the Loan Agreement will be sufficient to meet our working capital requirements for at least the next twelve months. To the extent existing cash and cash equivalents, cash from operations, and amounts available for borrowing under the Loan Agreement are insufficient to fund our working capital requirements, or should we require additional cash for other purposes, we will need to raise additional funds. In the future, we may attempt to raise additional capital through the sale of equity securities or through equity-linked or debt financing arrangements. If we raise additional funds by issuing equity or equity-linked securities, the ownership and economic interests of our existing stockholders will be diluted. If we raise additional financing by the incurrence of additional indebtedness, we will be subject to additional debt service requirements and could also be subject to additional restrictive covenants, such as limitations on our ability to incur additional debt, and other operating restrictions that could adversely impact our ability to conduct our business. Any future indebtedness we incur may result in terms that could also be unfavorable to our equity investors. There can be no assurances that we will be able to raise additional capital on terms we deem acceptable, or at all. The inability to raise additional capital as and when required would have an adverse effect, which could be material, on our results of operations, financial condition and ability to achieve our business objectives. Escrow Funding Requirements We offer escrow services to users of our platform. As such, we are licensed as an internet escrow agent and are therefore required to hold our users’ escrowed cash and in-transit cash in trust as an asset and record a corresponding liability for escrow funds held on behalf of freelancers and clients on our balance sheet. Escrow regulations require us to fund the trust with our operating cash to cover shortages due to the timing of cash receipts from clients for completed hourly billings. Freelancers submit their billings for hourly contracts to their clients on a weekly basis every Sunday and the aggregate amount of such billings is added to escrow funds payable to freelancers on the same day. As of Sunday each week, we have not yet collected funds for hourly billings from clients as these funds are in transit. Therefore, in order to satisfy escrow funding requirements, every Sunday we fund the shortage of cash in trust with our own operating cash and typically collect this cash shortage from clients within the next several days. As a result, we expect our total cash and cash flows from operating activities to be impacted when a quarter ends on a Sunday, as occurred on December 31, 2017 and September 30, 2018, and will occur on March 31, 2019 and June 30, 2019. As of December 31, 2018 and 2017, funds held in escrow, including funds in transit, were $98.2 million and $87.2 million, respectively. We used $0.3 million and $13.4 million of our cash on December 31, 2018 and 2017, respectively, to temporarily fund that one week of hourly billings. To the extent we have not yet collected funds for hourly billings from clients which are in-transit due to timing differences in receipt of cash from clients and payments of cash to freelancers, we may, from time to time, utilize the revolving line of credit under our Loan Agreement to satisfy escrow funding requirements. Term and Revolving Loans In September 2017, we entered into the Loan Agreement, which was amended in November 2017 and September 2018. The aggregate amount of the facility is up to $49.0 million, consisting of an outstanding $15.0 million term loan (the “First Term Loan”), an outstanding $9.0 million term loan (the “Second Term Loan” and, together with the First Term Loan, the “Term Loans”) and a revolving line of credit which permits borrowings of up to $25.0 million subject to customary conditions. Among other things, we may only borrow funds under the revolving line of credit if, after giving effect thereto, our total borrowings under the line of credit do not exceed a specified percentage of eligible trade and client accounts receivable. The First Term Loan, Second Term Loan, and revolving line of credit mature in March 2022, September 2022, and September 2020, respectively. All borrowings under the Loan Agreement bear interest at floating rates and our borrowing costs are therefore affected by changes in market interest rates. Specifically, the First Term Loan bears interest at the prime rate plus 0.25% per annum and has a repayment term of 18 months of interest-only payments ending in March 2019 followed by equal monthly installments of principal plus interest until the maturity in March 2022. The Second Term Loan bears interest at the prime rate plus 0.25% per annum and has a repayment term of 17 months of interest-only payments ending in March 2019, followed by equal monthly installments of principal plus interest until the maturity in September 2022. The revolving line of credit bears interest at the prime rate with accrued interest due monthly. When we entered into the Loan Agreement in September 2017, we borrowed the entire $15.0 million First Term Loan and used the proceeds to repay an outstanding $14.0 million loan. In November 2017, we borrowed $19.0 million (consisting of the full $9.0 million Second Term Loan and $10.0 million of borrowings under the revolving line of credit), which we used to repurchase shares of our capital stock from a then-existing stockholder. As of December 31, 2018, we had $24.0 million outstanding pursuant to the Term Loans and no borrowings outstanding under the revolving line of credit. We used approximately $10.0 million of net proceeds from the IPO to repay indebtedness under the Loan Agreement. Our obligations under the Loan Agreement are secured by first priority liens on substantially all of our assets excluding our intellectual property (but including proceeds therefrom) and the funds and assets held by our subsidiary Upwork Escrow. The Loan Agreement prohibits us from pledging our intellectual property. The Loan Agreement contains affirmative covenants, including financial covenants that, among other things, require us to maintain a ratio of adjusted current assets to current liabilities of not less than 1.3 and to achieve certain minimum levels of EBITDA. The Loan Agreement also includes a restrictions on dividend payments, other than dividends payable solely in common stock. The Loan Agreement also contains certain non-financial covenants. We were in compliance with the covenants under the Loan Agreement as of December 31, 2018. Cash Flows The following table summarizes our cash flows for the years ended December 31, 2018, 2017 and 2016 (in thousands): (1) We used $0.3 million and $13.4 million on December 31, 2018 and 2017, respectively, to temporarily fund the trust account associated with our escrow services. See the section titled “-Liquidity and Capital Resources-Escrow Funding Requirements.” Operating Activities Our largest source of operating cash is revenue generated from our platform. Our primary uses of cash from operating activities are for personnel-related expenditures, marketing activities, including advertising, and third-party hosting costs. In addition, because we are licensed as an internet escrow agent, our total cash and cash provided by (used in) operating activities may be impacted by the timing of the end of our fiscal quarter as discussed in the section titled “-Liquidity and Capital Resources-Escrow Funding Requirements.” Net cash provided by operating activities during 2018 was $13.7 million, which resulted from a net loss of $19.9 million, offset by non-cash charges of $10.4 million for stock-based compensation, $4.9 million for depreciation and amortization, $6.1 million and $0.2 million related to the change in fair values of our redeemable convertible preferred stock warrant liability and the Tides Foundation common stock warrant, respectively, $5.1 million for provision for transaction losses, $0.2 million for amortization of debt issuance costs and loss on disposal of fixed assets, and net cash inflows of $6.7 million from changes in operating assets and liabilities. The changes in operating assets and liabilities included cash inflows of $3.5 million resulting from a decrease in trade and client receivables due to the timing of collections year-over-year. Due to the fluctuations in revenue and the number of transactions on our platform, coupled with fluctuations of the timing of cash receipts from clients, our trade and client receivables will likely fluctuate in the future. Additionally, changes in accounts payable and accrued expenses and other liabilities generated cash inflows of $1.6 million and $2.9 million, respectively. These cash inflows were partially offset by $1.3 million related to cash spent on prepaid expenses and other assets. Net cash used in operating activities during 2017 was $4.0 million, which resulted from a net loss of $4.1 million and net cash outflows of $15.4 million from changes in operating assets and liabilities, primarily offset by non-cash charges of $6.8 million for stock-based compensation, $4.3 million for provision for transaction losses, and $4.2 million for depreciation and amortization. The net cash outflows from changes in operating assets and liabilities were primarily the result of increases of $8.9 million in trade and client receivables and $0.5 million in prepaid expenses and other assets and a decrease of $6.1 million in accrued expenses and other liabilities. The increase in trade and client receivables was primarily because the last calendar day of 2017 (i.e., December 31, 2017) fell on a Sunday, requiring us to fund the shortage of cash in the trust until we collect this from clients over the next few days, and an increase in our trade and client receivables for our Upwork Enterprise clients, that pay us on net terms. Due to the growth in revenue and the number of transactions on our platform, coupled with fluctuations of the timing of cash receipts from clients, our trade and client receivables may fluctuate in the future. The decrease in accrued expenses and other liabilities was primarily due to fluctuations in timing of cash payments. Net cash provided by operating activities during 2016 was $3.1 million, which resulted from non-cash charges of $8.5 million for depreciation and amortization, $7.3 million for stock-based compensation, and $5.6 million for provision for transaction losses, partially offset by a net loss of $16.2 million and net cash outflows of $2.1 million from changes in operating assets and liabilities. The net cash outflows from changes in operating assets and liabilities were primarily the result of increases of $8.3 million in trade and client receivables and $0.5 million in prepaid expenses and other assets and a decrease of $0.6 million in accounts payable, partially offset by increases of $7.1 million in accrued expenses and other liabilities and $0.2 million in deferred revenue. The increase in trade and client receivables and deferred revenue was primarily due to growth in revenue and the number of transactions on our platform as well as the timing of cash receipts from clients. The decrease in accounts payable and the increase in accrued expenses and other liabilities was primarily due to the timing of cash payments and increased activities to support overall business growth. Investing Activities Net cash used in investing activities during 2018 was $7.3 million, which resulted from capitalized internal-use software and platform development costs of $3.8 million, purchases of property and equipment of $3.0 million primarily for leasehold improvements and furniture, and an increase of $0.4 million in restricted cash related to cash reserve requirements under California escrow laws and regulations and additional cash held as collateral related to our office leases. Net cash used in investing activities during 2017 was $2.1 million, which resulted from purchases of property and equipment of $1.8 million and capitalized internal-use software and platform development costs of $0.5 million, partially offset by a decrease of $0.2 million in restricted cash related to cash collateral for letters of credit issued in conjunction with operating leases and foreign currency forward contracts. Net cash used in investing activities during 2016 was $0.5 million, which resulted from purchases of property and equipment of $0.9 million, partially offset by a decrease of $0.4 million in restricted cash related to the refund of a security deposit for new office space. Financing Activities Net cash provided by financing activities during 2018 was $101.1 million, which was primarily due to proceeds received from our IPO, net of underwriting discounts and commissions, of $109.4 million, and cash received from the exercise of stock options and common stock warrants of $8.2 million, partially offset by net repayments of debt of $10.0 million, payments of taxes related to net share settlements of $0.2 million, and the payment of costs related to our IPO of $6.2 million. Net cash provided by financing activities during 2017 was $0.4 million primarily due to proceeds from the exercise of stock options, proceeds from borrowings of $33.8 million, net of borrowing costs, under the Loan Agreement and $2.8 million from the exercise of stock options and a convertible preferred stock warrant, offset by the repayment of $17.0 million in borrowings under a prior loan and security agreement, and a repurchase by us of convertible preferred stock for $19.2 million. Net cash provided by financing activities during 2016 was $5.2 million primarily due to net proceeds from borrowings of $17.0 million under a prior loan and security agreement, partially offset by the repayment of $12.0 million in borrowings under an earlier loan and security agreement. Obligations and Other Commitments Our principal commitments consist of obligations under our non-cancellable operating leases for office space and the Loan Agreement. The following table summarizes our contractual obligations as of December 31, 2018 (in thousands): (1) Represents minimum operating lease payments under operating leases for office facilities, excluding potential lease renewals, net of tenant improvement allowances. In the ordinary course of business, we enter into contracts and agreements that contain a variety of representations and warranties and provide for indemnification. In addition, we have entered into indemnification agreements with our directors and executive officers and certain employees that require us, among other things, to indemnify them against certain liabilities that may arise by reason of their status or service as our directors, executive officers, or employees. The terms of such obligations may vary. To date, we have not paid any material claims or been required to defend any actions related to our indemnification obligations. As of December 31, 2018, we had accrued liabilities related to uncertain non-income tax positions based on management’s best estimate of its liability, which are reflected on our consolidated balance sheet. We could be subject to examination in various jurisdictions related to income and non-income tax matters. The resolution of these types of matters, giving recognition to the recorded reserve, could have an adverse impact on our business. Off-Balance Sheet Arrangements As of December 31, 2018, we did not have any relationships with other entities or financial partnerships such as entities often referred to as structured finance or special purpose entities that have been established for the purpose of facilitating off-balance sheet arrangements or other contractually narrow or limited purposes. Critical Accounting Policies and Estimates Our consolidated financial statements are prepared in accordance with U.S. GAAP. The preparation of the consolidated financial statements requires us to make estimates and assumptions that affect the reported amounts of assets, liabilities, revenue, expenses, and related disclosures. We evaluate our estimates and assumptions on an ongoing basis using historical experience and other factors and adjust those estimates and assumptions when facts and circumstances dictate. Actual results could materially differ from these estimates and assumptions. An accounting policy is deemed to be critical if it requires an accounting estimate to be made based on assumptions about matters that are highly uncertain at the time the estimate is made, if different estimates reasonably could have been used, or if changes in the estimate that are reasonably possible could materially impact the financial statements. We believe estimates and assumptions associated with the evaluation of revenue recognition criteria, including the determination of revenue reporting as gross versus net in our revenue arrangements, internal-use software and platform development costs, fair values of stock-based awards, and income taxes have the greatest potential impact on our consolidated financial statements. Therefore, we consider these to be our critical accounting policies and estimates. Revenue Recognition We primarily generate revenue from freelancers and clients from marketplace and managed services offerings. We recognize revenue in accordance with ASC 605, Revenue Recognition, and related authoritative guidance. Under ASC 605, revenue is recognized when the following criteria are met: (i) persuasive evidence of an arrangement exists; (ii) fees are fixed or determinable; (iii) the collection of the fees is reasonably assured; and (iv) services have been rendered. Revenue is recognized net of any taxes collected, which are subsequently remitted to governmental authorities. We report revenue in conformity with ASC 605-45, Revenue Recognition-Principal Agent Considerations. The determination of whether we are the principal or agent, and therefore whether to report revenue on a gross basis for the amount billed or on a net basis for the amount earned from each transaction, requires us to evaluate a number of indicators. We evaluate each separate unit of account for gross versus net as required. We also report revenue in conformity with ASC 605-50, Customer Payments and Incentives. The determination of whether we should characterize consideration paid to customers as costs or a reduction to revenue requires us to evaluate whether the consideration paid has an identifiable separable benefit to us and is at fair value. Marketplace Our marketplace revenue is derived from both our Upwork Standard offering and our Upwork Enterprise and other premium offerings. Upwork Standard We earn fees from freelancers under our Upwork Standard offering as follows: Service Fees. We provide freelancers access to our platform to perform specified services agreed between freelancers and clients (“freelancer services”). Freelancers charge clients on an hourly or a milestone basis for services accessed through our platform (“freelancer billings”). We charge freelancers a service fee as a percentage of freelancer billings using a tiered service fee model based on cumulative lifetime billings by the freelancer to each client. For service fees charged to freelancers, we recognize revenue on a net basis, as an agent, for providing access to our platform as we take no responsibility for the freelancer services, and therefore we are not considered the primary obligor for the freelancer services. Additionally, freelancers and clients negotiate and agree upon the scope and price for freelancer services directly with each other. We recognize the service fee as services are rendered. Withdrawal Fees. We generate revenue from withdrawal fees from freelancers when the freelancers withdraw funds from their cash balances held with us. We charge a flat withdrawal fee for each withdrawal transaction and recognize that fee as it is earned for each transaction. Membership Fees. We generate revenue from membership fees from freelancers. These fees are charged monthly and provide freelancers access to additional features on our platform. Membership fees are recognized over the period of the membership, which is generally monthly. Connects Fees. We generate revenue from connects fees from freelancers. These fees provide freelancers enhanced access to clients on our platform. These fees are recognized as services are rendered. We earn fees from clients under our Upwork Standard offering as follows: Client Payment Processing and Administration Fees. We generate revenue from clients for payment processing fees at the time the client is charged for the amounts due from the client. We charge a fee per transaction or a flat monthly payment processing fee. Per-transaction payment processing fees are recognized when the client is charged for the amount due and fees charged on a monthly basis are recognized over the month that payment processing services are provided. For client payment processing fees, we earn revenue on a gross basis as a principal and not net of the third-party payment processing costs incurred because we are considered the primary obligor for payment processing and administration services and have the latitude to set the price with clients separate and apart from the fees we pay our third-party payment processors. Foreign Currency Exchange Fees. We generate revenue from foreign currency exchange fees from clients by charging a fixed mark-up above quoted foreign currency exchange rates when we collect amounts denominated in foreign currency. Foreign currency exchange fees are recognized as they are earned for each payment transaction. Upwork Payroll Service Fees. We generate revenue from Upwork Payroll service fees from clients when their freelancers are classified as employees for engagements on our platform. The client enters into an Upwork Payroll agreement with us, and we separately contract with unrelated third-party staffing providers who provide employment services to such clients. In such arrangements, freelancers providing freelancer services to clients become employees of third-party staffing providers. For more detail, see Note 2 of the notes to our consolidated financial statements included elsewhere in this Annual Report. Upwork Enterprise and Other Premium Offerings We earn fees from freelancers under Upwork Enterprise and other premium offerings as follows: Service Fees. We provide freelancers access to our platform to perform freelancer services for clients. We charge freelancers a service fee as a percentage of freelancer billings. We earn service fees based on a fixed percentage fee. For service fees charged to freelancers, we recognize revenue on a net basis, as an agent, for providing access to our platform as we take no responsibility for the freelancer services, and therefore we are not considered the primary obligor for the freelancer services. Additionally, freelancers and clients negotiate and agree upon the scope and the price for freelancer services directly with each other. We recognize the service fee as services are rendered. We earn fees from clients under Upwork Enterprise and other premium offerings as follows: Client Service Fees. We offer clients access to our platform to source freelancers in exchange for a client service fee calculated as a percentage of freelancer billings. We recognize the client service fees as services are rendered by the freelancers. Enterprise Compliance Service Fees. We generate revenue from enterprise compliance service fees from clients under a compliance agreement with us to determine whether a freelancer should be classified as an employee or an independent contractor based on the scope of freelancer services agreed between the client and freelancer and other factors. We charge enterprise compliance service fees as a percentage of freelancer billings. We recognize revenue as services are rendered. Subscription Fees. We generate revenue from monthly or annual subscription fees from clients for subscription services that include additional service features, premium access to top talent, professional services, custom reporting, and invoicing. The revenue attribution is consistent with membership fees for our Upwork Standard offering. Revenue Sharing Arrangements For our Upwork Standard, Upwork Enterprise, and other premium offerings, we generate a revenue share as a percentage of the fees charged by certain financial institutions to the freelancers. We recognize revenue from these arrangements as they are earned, which is generally monthly based on the contractual terms. Managed Services Under a managed services arrangement, we are responsible for providing services and engaging freelancers directly or as employees of third-party staffing providers to perform the services for clients on our behalf. We recognize revenue on a gross basis for amounts charged to the client based on our determination that we are deemed to be the primary obligor as we take responsibility and risk for these services completed for the client. We determine pricing for these services and then identify and engage these freelancers or third-party staffing providers to fulfill the service obligation to the client. Revenue for these services is recognized as these services are rendered. See Note 2 of the notes to our consolidated financial statements included elsewhere in this Annual Report for a further description of our revenue recognition policies. Goodwill Goodwill represents the excess of the aggregate fair value of the consideration transferred over the fair value of the net tangible and identifiable assets acquired in 2014 as a result of the combination of Elance and oDesk described above under “Business-Corporate Information.” The total accounting purchase price of this combination was $147.4 million. Elance and oDesk each considered a number of factors when deciding whether to consummate the 2014 combination between the two companies. The business reasons for the combination, and the rationale for the purchase price, included creating greater scale and visibility of the combined company to gain increased market share by attracting new users, improving operational efficiencies, and benefits from cost synergies. Additional factors included our expectations regarding the ongoing changes in the labor market, including the impact of technology in reducing the prevailing inefficiencies in the labor market, which we believed would result in a greater market opportunity for the combined company than had the two companies remained independent. Our achievement of these anticipated benefits is reflected in our overall performance following the 2014 combination, particularly starting in 2017 after the initial integration initiatives involving the two companies, including the migration to a unified Upwork platform, had generally concluded. Specifically, we have invested in building a robust, unified platform with features and functionalities that we believe resulted in a larger, more liquid marketplace, including more access to jobs for freelancers and skills and expertise for clients, and provided us with significant cost efficiencies. We also believe the quality of our unified platform, Upwork, is reflected in our NPS, which exceeded 60 on average from both freelancers and clients throughout 2017 and 2018.2 Goodwill from this combination is not amortized but is assessed for impairment at least annually, or more frequently if events or changes in circumstances indicate the goodwill may be impaired. We conduct our annual assessment during the fourth quarter of each calendar year based on a single reporting unit structure. We have the option to first assess qualitative factors to determine whether the existence of events or circumstances leads to a determination that it is more likely than not that the fair value of the reporting unit is less than its carrying amount. If, after assessing the totality of events or circumstances, we determine it is not more likely than not that the fair value of the reporting unit is less than its carrying amount, then additional impairment testing is not required. However, if we conclude otherwise, then we are required to perform the first of a two-step impairment test. The first step involves comparing the estimated fair value of the reporting unit with its respective book value, including goodwill. If the estimated fair value exceeds book value, goodwill is considered not to be impaired and no additional steps are necessary. If, however, the fair value of the reporting unit is less than book value, then a second step is required that compares the carrying amount of the goodwill with its implied fair value. The estimate of implied fair value of goodwill may require valuations of certain internally-generated and unrecognized intangible and tangible net assets. If the carrying amount of goodwill exceeds the implied fair value of the goodwill, an impairment loss is recognized in an amount equal to the excess. _____________________ 2 NPS is a measure of client and freelancer satisfaction on a scale ranging from negative 100 to 100 based on the standard question: “On a scale of 0 to 10, with 10 being extremely likely, how likely are you to recommend Upwork to a friend or colleague?” NPS is based on users that respond to the survey question after closing a project and users who respond to the survey question once every 60 days. NPS is calculated by using the standard methodology of subtracting the percentage of users that respond that they are not likely to recommend us from the percentage of users that respond that they are extremely likely to recommend us. For 2018, we conducted our goodwill impairment testing by performing the first step of the two-step impairment model. The fair value was determined by us using quoted market prices of our common stock. We determined that the fair value of our reporting unit exceeded the net book value of our reporting unit, and as such, we concluded that there was no impairment of goodwill at the impairment testing date. For 2017, we conducted our goodwill impairment testing by assessing qualitative factors to determine whether it was more likely than not that the fair value of our reporting unit was less than its carrying amount. As part of this assessment, we considered factors, including but not limited to, the overall macroeconomic environment, specific industry and market conditions, cost factors, our overall financial performance against expectations, changes in strategy or the manner in which we use our assets, and changes in key management personnel. While we had a history of operating losses, our operating results improved in 2017 compared to 2016. No other indicators of impairment were identified during our assessment. Furthermore, we considered the most recent valuations of our common stock, which indicated that there was substantial excess of fair value over book value. Accordingly, we concluded there was no impairment to goodwill at the impairment testing date. For 2016, we conducted our goodwill impairment testing by performing the first step of the two-step impairment model. The fair value was determined by us with assistance from an independent third-party valuation firm by using a combination of income and market approaches. In estimating the fair value of our reporting unit, we compared current period results to relevant projections. Actual revenue results for such period were approximately 20% lower than the initial projections prepared at the time of the combination of Elance and oDesk. The difference between actual and projected results for such period was primarily due to the decision (made subsequent to the consummation of the Elance-oDesk combination) to enable clients, freelancers, and their projects to migrate from the legacy Elance platform to the unified Upwork platform, which resulted in a portion of the pre-existing Elance clients and freelancers electing not to migrate to the unified Upwork platform. Projections used in estimating the fair value of the reporting unit incorporated the effects of the migration as well as other current management expectations. The estimated fair value of our reporting unit was approximately three times greater than the book value at the impairment testing date and as such, we concluded there was no impairment to goodwill at the impairment testing date. Multiple-Element Arrangements Some of our offerings consist of multiple elements, which can include a mix of service fees along with other services, including subscription services, Upwork Payroll services, compliance services, and payment processing services. Where neither vendor-specific objective evidence nor third-party evidence of selling price exists, we are required to use our best estimate of selling price to allocate arrangement consideration on a relative basis to each element. At the inception of arrangements, which do not include subscription services, as there is no fixed consideration to be allocated, a relative fair value allocation is not required. In the instance the multiple-element arrangement includes subscription services, the only fixed consideration relates to the subscription services, which is a separate unit of accounting, and the fixed consideration is allocated only to the subscription services at inception as all other fees in the arrangement are contingent on certain activities being performed. Internal-Use Software and Platform Development Costs We capitalize certain internal-use software and platform development costs associated with creating and enhancing internal-use software related to our software platform and technology infrastructure. These costs include personnel and related employee benefits expenses for employees who are directly associated with and who devote time to software projects, and external direct costs of materials and services consumed in developing or obtaining the software. Software development costs that do not meet the criteria for capitalization are expensed as incurred and recorded in research and development expenses in our consolidated statements of operations. Software development activities generally consist of three stages: (i) the planning stage; (ii) the application and infrastructure development stage; and (iii) the post-implementation stage. Costs incurred in the planning and post-implementation stages of software development, including costs associated with the post configuration training and repairs and maintenance of the developed technologies, are expensed as incurred. We capitalize costs associated with software developed for internal use when both the preliminary project stage is completed and management has authorized further funding for the completion of the project. Costs incurred in the application and infrastructure development stages, including significant enhancements and upgrades, are capitalized. Capitalization ends once a project is substantially complete and the software and technologies are ready for their intended purpose. Internal-use software and platform development costs are amortized using a straight-line method over the estimated useful life of two years, commencing when the software is ready for its intended use. Amortization expense related to capitalized-internal use software is allocated to each functional expense based on headcount. Amortization expenses related to capitalized platform development costs are allocated to research and development expense. Stock-Based Compensation We measure and recognize compensation expense for all stock-based awards granted to service providers, including stock options, RSUs, purchase rights granted under our 2018 Employee Stock Purchase Plan (“2018 ESPP”) based on the estimated fair value of the award on the grant date. We calculate the estimated fair value of stock options and purchase rights granted under the 2018 ESPP on the date of grant using the Black-Scholes option-pricing model, which is impacted by the fair value of our common stock, as well as changes in assumptions regarding a number of highly complex and subjective variables. These variables include, but are not limited to, the expected dividend yield, the expected term of the awards, the risk-free interest rates and the expected common stock price volatility over the term of the option awards. Prior to our IPO, the estimated fair value of our common stock was determined by our board of directors, and had been based in part upon contemporaneous valuations performed at periodic intervals by unrelated third-party specialists. Because there had been no public market for our common stock, our board of directors considered this independent valuation and other factors, including, but not limited to, our actual operating and financial performance, the current status of the technical and commercial success of our operations, our financial condition, the stage of development and competition to establish the fair value of our common stock at the time of grant of stock options. Following our IPO, we use the quoted market price of our common stock as reported on The Nasdaq Global Select Market for the fair value of stock options and RSUs and purchase rights under our 2018 ESPP. We generally recognize the fair value of stock options and RSUs on a straight-line basis over the period during which a service provider is required to provide services in exchange for the award (generally the vesting period). The fair value of the performance based award granted to our Chief Executive Officer on July 1, 2018 is recognized using a graded vesting attribution method. Prior to the adoption of Accounting Standards Update No. 2016-09, or ASU 2016-09, on January 1, 2018, stock-based compensation expense was recognized only for those options expected to vest. We estimated forfeitures based on historical rates of forfeitures of stock options adjusted to reflect future changes in facts and circumstances, if any, and revised the estimated forfeiture rate if actual forfeitures differed from initial estimates. Subsequent to the adoption, we account for forfeitures as they occur. We recognize the fair value of purchase rights granted under the 2018 ESPP as an expense on a straight-line basis over the offering period and account for forfeitures as they occur. The estimated grant-date fair value of our stock options issued to service providers was calculated using the Black-Scholes option-pricing model, based on the following assumptions for the years ended December 31, 2018, 2017 and 2016: The estimated grant-date fair value of purchase rights granted under the 2018 ESPP was calculated using the Black-Scholes option-pricing model, based on the following assumptions for the year ended December 31, 2018: Dividend Yield. The expected dividend is zero as we have never declared dividends and have no current plans to do so in the foreseeable future. Expected Term. The expected term represents the period that our stock-based awards are expected to be outstanding. For awards containing only service conditions, we determine the expected term using the simplified method as we do not have sufficient historical information to develop reasonable expectations about future exercise patterns and post-vesting employment termination behavior. The simplified method deems the term to be the average of the time-to-vesting and the contractual life of the options. We use relevant data, including past exercise patterns, if available, to determine the expected term for performance-based awards. We estimate expected term using historical data on employee exercises and post-vesting employment termination behavior taking into account the contractual life of the award. Risk-Free Interest Rate. The risk-free interest rate is based on the U.S. Treasury yield curve in effect at the time of grant for zero-coupon U.S. Treasury notes with maturities approximately equal to the stock option’s expected term. Expected Volatility. We estimate the expected volatility from the average historical stock volatilities of several unrelated public companies within our industry that we consider to be comparable to our business over a period equivalent to the expected term of the stock option grants. We intend to continue to consistently apply this process using the same or similar companies to estimate the expected volatility until sufficient historical information regarding the volatility of the share price of our common stock becomes available. We also grant stock-based awards to non-employees. We believe that for stock options issued to non-employees, the fair value of the stock option is more reliably measurable than the fair value of the services rendered. Therefore, we estimate the fair value of non-employee stock options using a Black-Scholes valuation model with appropriate assumptions. The estimated fair value of non-employee stock options is re-measured over the vesting period, and the expense is recognized on a straight-line basis over the period during which the award vests. Income Taxes We utilize the asset and liability method under which deferred tax assets and liabilities arise from the temporary differences between the tax basis of an asset or liability and its reported amount in the consolidated financial statements, as well as from net operating loss and tax credit carryforwards. Deferred tax amounts are determined by using the tax rates expected to be in effect when the taxes will actually be paid or refunds received, as provided for under currently enacted tax law. A valuation allowance is established when necessary to reduce deferred tax assets to the amount expected to be realized. We regularly review our tax positions and benefits to be realized. We recognize tax liabilities based upon our estimate of whether, and the extent to which, additional taxes will be due when such estimates are more likely than not to be sustained. An uncertain income tax position will be recognized only if it is more likely than not to be sustained. We recognize interest and penalties related to income tax matters as income tax expense. Recent Accounting Pronouncements See Note 2 of the notes to our consolidated financial statements included elsewhere in this Annual Report for recently issued accounting pronouncements not yet adopted as of the date of this Annual Report.

<s>[INST] Overview Business We operate the largest online marketplace that enables businesses to find and work with highlyskilled freelancers, as measured by GSV. GSV represents the total amount that clients spend on both our marketplace offerings and our managed services offering as well as additional fees we charge to users for other services. Freelancers are an increasingly soughtafter, critical, and expanding segment of the global workforce. We define freelancers as users of our platform that advertise and provide services to clients through our platform, and we define clients as users of our platform that work with freelancers through our platform. The freelancers on our platform include independent professionals and agencies of varying sizes. The clients on our platform range in size from small businesses to Fortune 500 companies. During the year ended December 31, 2018, our platform enabled $1.8 billion of GSV in over 180 countries. For purposes of determining countries where we enable GSV, we include both the countries in which the clients that paid for the applicable services are located, as well as the countries in which the freelancers that provided those services are located. In October 2018, we completed our IPO, in which we issued and sold an aggregate of 7,840,908 shares of our common stock, including 1,022,727 shares pursuant to the exercise of the underwriters’ option to purchase additional shares. The shares were sold to the underwriters at the IPO price of $15.00 per share less an underwriting discount of $1.05 per share. We received aggregate net proceeds of $109.4 million from the IPO after deducting underwriting discounts and commissions but before deducting offering expenses payable by us. We generate a majority of our revenue from fees charged to freelancers. We also generate revenue through fees charged to clients for transacting payments through our platform, as well as foreign currency exchange fees, Upwork Payroll service fees, and fees for premium offerings. In addition, we provide a managed services offering where we engage freelancers to complete projects, directly invoice the client, and assume responsibility for work performed by the freelancers. We generated revenue of $253.4 million in 2018, $202.6 million in 2017, and $164.4 million in 2016, representing yearoveryear increases of 25% in 2018 and 23% in 2017. Financial Highlights for 2018 In 2018, our platform enabled $1.8 billion of GSV, representing an increase of 28% over the prior year, and our total revenue was $253.4 million, representing an increase of 25% over the prior year. Our marketplace revenue was $223.9 million, representing an increase of 26% over the prior year. We continue to make significant investments to grow our business, including in sales and marketing, research and development, operations, and personnel and, as a result, we generated a net loss of $19.9 million in 2018 compared to a net loss of $4.1 million in 2017. Our adjusted EBITDA was $3.8 million in 2018, a decline of 52% from 2017. Adjusted EBITDA is a financial measure that is not prepared in accordance with, and is not an alternative to, financial measures prepared in accordance with U.S. GAAP. See the section titled “Selected Consolidated Financial DataNonGAAP Financial Measures” for a definition of adjusted EBITDA and information regarding our use of adjusted EBITDA and a reconciliation of net loss to adjusted EBITDA. As a global platform that connects freelancers and clients regardless of their location, our GSV originates from around the world. Of the $1.8 billion of GSV enabled on our platform in 2018, approximately 23% was generated from U.S. freelancers, our largest freelancer geography, as measured by GSV, in both 2018 and 2017, while freelancers in India and the Philippines remained our next largest freelancer geograph [/INST] Negative. </s>

Upwork Inc.

2020-03-02

2019-12-31

Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations. You should read the following discussion and analysis of our financial condition and results of operations together with the sections titled “Business,” “Risk Factors,” and “Selected Consolidated Financial Data,” and the consolidated financial statements and related notes included elsewhere in this Annual Report. This discussion contains forward-looking statements based upon current expectations that involve risks and uncertainties, as well as assumptions that may never materialize or that may be proven incorrect. Our actual results may differ materially from those anticipated in these forward-looking statements as a result of various factors, including those discussed in the sections titled “Special Note Regarding Forward-Looking Statements” and “Risk Factors” and in other parts of this Annual Report. Overview Business We operate the largest online talent solution that enables businesses to find and work with highly-skilled independent professionals, as measured by GSV. GSV represents the total amount that clients spend on our marketplace offerings and our managed services offering as well as additional fees we charge to both clients and freelancers for other services. Freelancers are an increasingly sought-after, critical, and expanding segment of the global workforce. We define freelancers as users of our platform that advertise and provide services to clients through our platform, and we define clients as users of our platform that work with freelancers through our platform. The freelancers on our platform include independent professionals and agencies of varying sizes. The clients on our platform range in size from small businesses to Fortune 500 companies. Our platform enabled $2.1 billion of GSV in over 180 countries for the year ended December 31, 2019. For purposes of determining countries where we enable GSV, we include both the countries in which the clients that paid for the applicable services are located, as well as the countries in which the freelancers that provided those services are located. We generate a majority of our revenue from fees charged to freelancers. We also generate revenue through fees charged to clients for transacting payments through our platform and fees for premium offerings, foreign currency exchange fees, and Upwork Payroll service fees. In addition, we provide a managed services offering where we engage freelancers to complete projects, directly invoice the client, and assume responsibility for work performed. As noted above, on December 31, 2019, we adopted Topic 606 effective as of January 1, 2019 using the modified retrospective method. As a result, revenue results for the year ended December 31, 2019 are presented in accordance with this new revenue recognition standard while historical revenue results for reporting periods prior to 2019 are presented in conformity with amounts previously disclosed under the prior revenue recognition standard, Topic 605. We generated revenue of $300.6 million in 2019, $253.4 million in 2018, and $202.6 million in 2017, representing year-over-year increases of 19% in 2019 and 25% in 2018. Financial Highlights for 2019 In 2019, our platform enabled $2.1 billion of GSV, representing an increase of 19% over the prior year, and our total revenue was $300.6 million, representing an increase of 19% over the prior year. Our marketplace revenue was $268.3 million, representing an increase of 20% over the prior year. Long-term and recurring use of our platform by freelancers and clients are the primary drivers of growth in our marketplace and an increase in these types of use improve revenue visibility. For the year ended December 31, 2019, in addition to acquiring new clients, our total client spend retention was 102%, compared to 108% for the year ended December 31, 2018. For additional information related to how we calculate client spend retention and a discussion of period-over-period changes in this amount, see the section titled “-Key Financial and Operational Metrics” below. Additionally, we have made significant investments to grow our business, including investments in sales and marketing to acquire new clients and drive brand awareness, investments in research and development to build new product features and launch new offerings, and investments in operations and personnel, and we intend to continue to focus on these efforts. As a result, we generated a net loss of $16.7 million in 2019 compared to a net loss of $19.9 million in 2018. Our adjusted EBITDA was $7.4 million in 2019, an increase of 95% from 2018. Adjusted EBITDA is a financial measure that is not prepared in accordance with, and is not an alternative to, financial measures prepared in accordance with U.S. GAAP. See the section titled “Selected Consolidated Financial Data-Non-GAAP Financial Measures” for a definition of adjusted EBITDA and information regarding our use of adjusted EBITDA and a reconciliation of net loss to adjusted EBITDA. As a global platform that connects freelancers and clients regardless of their location, our GSV originates from around the world. Of the $2.1 billion of GSV enabled on our platform in 2019, approximately 27% was generated from U.S. freelancers, our largest freelancer geography, as measured by GSV, in each of 2019, 2018 and 2017, while freelancers in India and the Philippines remained our next largest freelancer geographies in all three years. Of the $1.8 billion and $1.4 billion of GSV enabled on our platform in 2018 and 2017, approximately 23% and 19%, respectively, was generated from freelancers in the United States. Approximately 68% of our GSV in 2019 was generated from U.S. clients, compared to approximately 66% and 67% of GSV in 2018 and 2017, respectively, with clients in no other country representing more than 10% of our GSV in any year. We believe U.S. clients will continue to drive growth by engaging freelancers globally, particularly freelancers in the United States where there are various efficiencies associated with same-country engagements, such as cultural and contractual norms, time zones, and language. Key Financial and Operational Metrics We monitor the following key financial and operational metrics to evaluate our business, measure our performance, identify trends affecting our business, formulate business plans, and make strategic decisions. On December 31, 2019, we adopted Topic 606 effective as of January 1, 2019 using the modified retrospective method. Financial results for the year ended December 31, 2019 are presented in accordance with this new revenue recognition standard. Historical financial results for reporting periods prior to 2019 are presented in conformity with amounts previously disclosed under the prior revenue recognition standard, Topic 605. Our key metrics were as follows as of or for the periods presented (in thousands, except percentages): (1)Adjusted EBITDA is not prepared in accordance with, and is not an alternative to, financial measures prepared in accordance with U.S. GAAP. See “Selected Consolidated Financial Data-Non-GAAP Financial Measures” for a definition of adjusted EBITDA and for information regarding our use of adjusted EBITDA and a reconciliation of adjusted EBITDA to net loss, the most directly comparable financial measure prepared under U.S. GAAP. As discussed below with respect to each key metric, we believe these key financial and operational metrics are useful to evaluate period-over-period comparisons of our business and in understanding our operating results, and management uses these metrics to track our performance. GSV represents the total amount that clients spend on our marketplace offerings and our managed services offering as well as additional fees we charge to both clients and freelancers for other services. We believe that GSV is an important metric, as it represents the overall amount of business transacted through our platform, which in turn is a key driver of our financial results. We believe our marketplace revenue, which represents a majority of our revenue, will grow as GSV grows, although they could grow at different rates. We evaluate the correlation between marketplace revenue and GSV by measuring marketplace take rate, which is calculated as marketplace revenue divided by marketplace GSV. We use the number of core clients to track the number of clients that we consider are actively using our platform, and this metric in any given period drives both GSV and client spend retention. Similarly, client spend retention impacts the growth rate of GSV. For information on how we define core clients and how we calculate client spend retention and marketplace take rate, see “-Core Clients,” “-Client Spend Retention,” and “-Marketplace Take Rate,” respectively, below. For a discussion of limitations in the measurement of our key financial and operational metrics, see “Risk Factors-We track certain performance metrics with internal tools and do not independently verify such metrics. Certain of our performance metrics are subject to inherent challenges in measurement, and real or perceived inaccuracies in such metrics may harm our reputation and negatively affect our business.” Core Clients We define a core client as a client that has spent in the aggregate at least $5,000 since it began using our platform and also had spend-activity on our platform during the 12 months preceding the date of measurement. This includes the total amount spent by the client on both the Elance and oDesk platforms for the periods prior to the consolidation of the two platforms as described above under "Business-Corporate Information." We believe that aggregate spend of at least $5,000 indicates that the client is actively using our platform. Historically, these core clients have been more likely to continue using our platform. We continue to see businesses of all sizes use our platform in a recurring way for larger, more complex projects, and we expect the number of core clients to continue to increase over time. Over the past two years, we have added an average of approximately 5,000 additional core clients per quarter. We believe we will continue to add approximately 4,000 to 5,000 core clients per quarter in the coming quarters, but the number of core clients could vary quarter by quarter. We believe that the number of core clients is a key indicator of our growth and the overall health of our business because core clients are a primary driver of GSV and, therefore, marketplace revenue. Gross Services Volume GSV includes both client spend and additional fees charged for other services. Client spend, which we define as the total amount that clients spend on both our marketplace offerings and our managed services offering, is the primary component of GSV. GSV also includes additional fees charged to both clients and freelancers for other services, such as freelancer membership fees, purchases of “Connects” (virtual tokens that allow freelancers to bid on projects on our platform), freelancer withdrawals, and foreign currency exchange. GSV is an important metric because it represents the amount of business transacted through our platform. Our marketplace revenue is primarily comprised of the service fees paid by freelancers as a percentage of the total amount freelancers charge clients for services accessed through our platform. Therefore, marketplace revenue is correlated to GSV, and we believe that our marketplace revenue will grow as GSV grows, although they could grow at different rates. For a discussion of how we measure and evaluate the correlation between marketplace revenue and GSV, refer to “-Marketplace Take Rate” below. Growth in the number of core clients and increased client spend retention are the primary drivers of GSV growth, and we expect the client spend retention trends discussed in "-Client Spend Retention," below, to affect the rate at which GSV grows. We expect our GSV to fluctuate between periods due to a number of factors, including the volume of projects that are posted by clients on our platform as well as the characteristics of those projects, such as size, duration, pricing, and other factors. Client Spend Retention We calculate client spend retention by dividing our recurring client spend by our base client spend. We define base client spend as the aggregate client spend from all clients during the four quarters ended one year prior to the date of measurement. We define our recurring client spend as the aggregate client spend during the four quarters ended on the date of measurement from the same clients included in our measure of base client spend. Our business is recurring in nature even though clients are not contractually required to spend on a recurring basis. We believe that client spend retention is a key indicator of the value of our platform and the overall health of our business because it impacts the growth rate of GSV, and, therefore, marketplace revenue. Long-term and recurring use by freelancers and clients are the primary drivers of growth in our marketplace and give us increased revenue visibility. While continued use of our platform by freelancers is a factor that impacts our ability to attract and retain clients, our platform currently has a significant surplus of freelancers in relation to the number of clients actively engaging freelancers. As a result of this surplus of freelancers relative to clients, we primarily focus our efforts on retaining client spend and acquiring new clients as opposed to acquiring new freelancers and retaining existing freelancers. Moreover, we generate revenue when clients engage and pay freelancers and therefore our key metrics and operating results are directly impacted by client spend. On the other hand, the number of freelancers retained between periods is merely one of many factors that may impact client spend in a particular period and is not a primary driver of our key metrics and operating results. For these reasons, we do not calculate or track freelancer retention metrics in order to manage our business. As of December 31, 2019, client spend retention was 102%, down from its peak of 108% as of December 31, 2018. We believe that this decline in client spend retention-from its historically highest levels in 2018 and the first quarter of 2019-follows from the acceleration in client spend retention that occurred subsequent to the launch in the second half of 2017 of our U.S.-to-U.S. domestic marketplace offering, which initiated a substantial increase in the average hourly earnings rate of freelancers. These hourly rates stabilized over the course of 2019, causing the reduction in retention rate. We believe this trend will continue in 2020, and we expect the long-term historical performance of this metric to range between 98% and 100%. Moreover, following the launch of our U.S.-to-U.S. domestic marketplace offering, an increasing proportion of U.S. clients are engaging solely U.S. freelancers. We are observing that U.S. clients that engage solely U.S. freelancers post higher-budget projects and pay higher rates initially but, to date, have exhibited lower client spend retention than the rest of our clients. As we acquire more mid-market, large enterprise and global account clients in current and future periods, we expect them to continue to make positive contributions to our client spend retention in future years. For these and other reasons, client spend retention will continue to vary from period to period due to client size and spending behavior. Marketplace Revenue Marketplace revenue, which represents the majority of our revenue, consists of revenue derived from our Upwork Basic, Plus, Business, and Enterprise offerings, and our other premium offerings. We generate marketplace revenue from both freelancers and clients. Our marketplace revenue is primarily comprised of the service fees paid by freelancers as a percentage of the total amount freelancers charge clients for services accessed through our platform, and to a lesser extent, payment processing and administration fees charged to clients. We also generate marketplace revenue from fees for premium offerings, freelancer membership fees, Connects purchases, and other services, such as foreign currency exchange fees and Upwork Payroll service fees. Marketplace revenue is an important metric because it is the primary driver of our business model, and we believe it provides greater comparability to other online marketplaces. The growth rate of marketplace revenue fluctuates in relation to the growth rate of GSV. Therefore, marketplace revenue is correlated to GSV, and we believe that our marketplace revenue will grow as GSV grows, although they could grow at different rates. We expect our marketplace revenue growth rates to continue to vary from period to period due to a variety of other factors such as the number of Mondays (i.e., the day we bill and recognize revenue for a substantial portion of our client fees each week), or the number of Sundays (i.e., the day we bill and recognize revenue for the majority of our freelancer service fees each week) in any given quarter; the lapping of significant launches of new products, pricing changes, and other monetization efforts; the performance of client spend retention; and the ability of the recent and continued investment in our enterprise sales team to accelerate the acquisition of, and achieve increased spend from, Upwork Enterprise and Business clients, and the timing of those results. As a result of these factors, we expect our marketplace revenue growth rate to be stronger in the first quarter of 2020 as compared to the first quarter of 2019 and then for our marketplace revenue growth rate to be relatively weaker in the second, third, and fourth quarters of 2020 as compared to the same periods in 2019. We also expect our sequential quarter-over-quarter marketplace revenue growth rates to be relatively consistent throughout all of 2020. Marketplace Take Rate Marketplace take rate measures the correlation between marketplace revenue and GSV and is calculated by dividing marketplace revenue by marketplace GSV. Marketplace take rate is an important metric because it is the key indicator of how well we monetize spend on our platform from our Upwork Basic, Plus, Business and Enterprise offerings, and other premium offerings. We expect our marketplace take rate to vary from period to period as marketplace revenue and GSV vary as a result of a variety of factors, such as the number of Mondays (i.e., the day we bill and recognize revenue for a substantial portion of our client fees each week), or the number of Sundays (i.e., the day we bill and recognize revenue for the majority of our freelancer service fees each week) in any given quarter; pricing changes; the ability of the recent and continued investment in our enterprise sales team to accelerate the acquisition of, and achieve increased spend from, our Upwork Enterprise and Business clients and the timing of those results; and ongoing efforts to improve processes on our platform, including, but not limited to project proposals and purchases of Connects. Adjusted EBITDA We define adjusted EBITDA as net loss adjusted for stock-based compensation expense, depreciation and amortization, interest expense, other (income) expense, net, provision for (benefit from) income tax, and, if applicable, other non-cash transactions. Adjusted EBITDA is not prepared in accordance with, and is not an alternative to, financial measures prepared in accordance with U.S. GAAP. See the section titled “Selected Consolidated Financial Data-Non-GAAP Financial Measures” for information on our use of adjusted EBITDA and a reconciliation of net loss to adjusted EBITDA. Components of Our Results of Operations Revenue On December 31, 2019, we adopted Topic 606 effective as of January 1, 2019 using the modified retrospective method. The core principle of Topic 606 is that an entity should recognize revenue for the transfer of goods or services equal to the amount that it expects to be entitled to receive for those goods or services. As a result of adoption, we recorded a revenue deferral of $11.8 million with a corresponding increase to accumulated deficit as of January 1, 2019. See “Note 2-Basis of Presentation and Summary of Significant Accounting Policies” and “Note 3-Revenue” of the notes to the consolidated financial statements included elsewhere in this Annual Report for further details. Marketplace Revenue. Marketplace revenue is generated from our Upwork Basic, Plus, Business, and Enterprise offerings, and other premium offerings. Under these marketplace offerings, we generate revenue from both freelancers and clients. Marketplace revenue, which represents the majority of our total revenue, is primarily comprised of the service fees paid by freelancers as a percentage of the total amount that freelancers charge clients for services accessed through our platform and, to a lesser extent, payment processing and administration fees paid by clients. Our Upwork Basic and Plus offerings provide clients with access to online talent with verified work history on our platform and client feedback, the ability to instantly match with the right freelancers, and built-in collaboration features. For freelancers working with clients that are on our Upwork Basic and Plus offerings, we have a tiered freelancer service fee schedule based on cumulative lifetime billings by the freelancer to each client. Freelancers typically pay us 20% of the first $500, 10% for the next $9,500, and then 5% for any amount over $10,000 they bill to each client through our platform. We recognize revenue on Sunday for the majority of our tiered freelancer service fees each week. We also generate revenue from freelancers through freelancer membership fees, Connects purchases, and withdrawal and other fees, each of which is currently immaterial. In addition, we generate marketplace revenue from our Upwork Basic and Plus offerings by charging clients a payment processing and administration fee. Clients using our Upwork Basic offering pay a fee equal to 3% of their client spend. We recognize revenue on Monday for a substantial portion of our client fees each week. Clients using our Upwork Plus offering pay a flat fee of about $50 per month for additional features and pay a fee equal to 3% of their client spend unless they pay via ACH (in which case, provided all eligibility criteria are met, the fee is waived). We also generate revenue from foreign currency exchange fees from clients, which is currently immaterial. Our Upwork Business and Enterprise offerings and other premium offerings, which are designed for larger clients, include access to additional product features, premium access to top talent, professional services, custom reporting, and flexible payment terms. For our Upwork Business and Enterprise offerings, we charge clients a monthly or annual subscription fee and a service fee calculated as a percentage of the client’s spend on freelancer services, in addition to the service fees paid by freelancers. Additionally, Upwork Enterprise clients can also subscribe to a compliance offering that includes worker classification services for an additional fee. Upwork Business and Enterprise clients may also choose to use our platform to engage freelancers that were not sourced through our platform for a lower fee percentage. One of our premium offerings, Upwork Payroll, is available to clients when freelancers are classified as employees for engagements on our online marketplace. The client enters into an Upwork Payroll agreement with us, and we separately contract with unrelated third-party staffing providers that provide employment services to such clients. Revenue from Upwork Payroll is currently immaterial. Managed Services Revenue. Through our managed services offering, we are responsible for providing services and engaging freelancers directly or as employees of third-party staffing providers to perform services for clients on our behalf. The freelancers providing services in connection with our managed services include independent professionals and agencies of varying sizes. Under U.S. GAAP, we are deemed to be the principal in these managed services arrangements and therefore recognize the entire GSV of managed services projects as managed services revenue, as compared to recognizing only the percentage of the client spend that we receive, as we do with our marketplace offerings. Cost of Revenue and Gross Profit Cost of Revenue. Cost of revenue consists primarily of the cost of payment processing fees, amounts paid to freelancers to deliver services for clients under our managed services offering, personnel-related costs for our services and support personnel, third-party hosting fees for our use of AWS and the amortization expense associated with acquired intangibles and capitalized internal-use software and platform development costs. We define personnel-related costs as salaries, bonuses, benefits, travel and entertainment, and stock-based compensation costs for employees and the costs related to other service providers we engage. We expect cost of revenue to increase in absolute dollars in future periods due to higher payment processing fees, third-party hosting fees, and personnel-related costs in order to support growth on our platform. We expect third-party hosting fees to temporarily increase for a period of time in 2020 as we migrate from the AWS data centers in California to the AWS data center in Oregon, as we will need to use both AWS facilities during the migration period. We plan to complete this migration in the first half of 2020 and believe this migration will ultimately reduce third-party hosting costs once completed. Amounts paid to freelancers in connection with our managed services offering are tied to the volume of managed services used by our clients. The level and timing of all of these items could fluctuate and affect our cost of revenue in the future. Gross Profit and Gross Margin. Our gross profit and gross margin may fluctuate from period-to-period. Such fluctuations may be influenced by our revenue, the mix of payment methods that our clients choose, the timing and amount of investments to expand hosting capacity, our continued investments in our services and support teams, the timing and amounts paid to freelancers in connection with our managed services offering, and the amortization expense associated with acquired intangibles and capitalized internal-use software and platform development costs. In addition, gross margin will be impacted by fluctuations in our revenue mix between marketplace revenue and our managed services revenue. For example, managed services revenue grew at a slower rate than our marketplace revenue in 2019 compared to 2018, and we anticipate this trend to continue, as we primarily focus on increasing client usage of and spend on our marketplace offerings. As a result of this trend, we expect improvements in gross margin to continue through 2020, although at a lower rate than we experienced in 2019 primarily due to the costs we will incur in the first half of 2020 as a result of our migration from the AWS data centers in California to the AWS data center in Oregon, Operating Expenses Research and Development. Research and development expense primarily consists of personnel-related costs and third-party hosting costs related to development. Research and development costs are expensed as incurred, except to the extent that such costs are associated with internal-use software and platform development that qualifies for capitalization. We believe continued investments in research and development are important to attain our strategic objectives and expect research and development expense to increase in absolute dollars for the foreseeable future, although this expense, expressed as a percentage of total revenue, may vary from period to period. Sales and Marketing. Sales and marketing expense consists primarily of expenses related to personnel-related costs, including sales commissions, which we expense as they are incurred, and advertising and marketing activities. We continue to invest in our sales and marketing capabilities and are focused on increasing our investment in our enterprise sales team in an effort to accelerate our acquisition of Upwork Enterprise and Business clients. We expect this expense to increase in absolute dollars in future periods, although this expense expressed as a percentage of total revenue may vary from period-to-period. General and Administrative. General and administrative expense consists primarily of personnel-related costs for our executive, finance, legal, human resources, corporate development, and operations functions; outside consulting, legal, and accounting services; and insurance. We expect to continue to invest in corporate infrastructure and to incur additional expenses associated with operating as a public company, including increased legal and accounting costs, investor relations costs, insurance premiums, and compliance costs, including costs to comply with the Sarbanes-Oxley Act, particularly since we no longer qualify as an “emerging growth company” as of December 31, 2019. As a result, we expect general and administrative expense to increase in absolute dollars in future periods, although this expense, expressed as a percentage of total revenue, may vary from period to period. Provision for Transaction Losses. Provision for transaction losses consists primarily of losses resulting from fraud and bad debt expense associated with our trade and client receivables balance and transaction losses associated with chargebacks. Provisions for these items represent estimates of losses based on our actual historical incurred losses and other factors. We expect provisions for transaction losses to increase proportionally as GSV grows. As a result, we expect provision for transaction losses to increase in absolute dollars in future periods, although expressed as a percentage of total revenue, this expense may vary from period to period. Interest Expense Interest expense consists of interest on our outstanding borrowings. Other (Income) Expense, Net Other (income) expense, net consists primarily of gains and losses from foreign currency exchange transactions, interest income that we earn from our deposits in money market funds and investments in marketable securities, and, prior to October 2018, expenses resulting from the revaluation of our redeemable convertible preferred stock warrant liability. Our redeemable convertible preferred stock warrant was converted to a common stock warrant exercisable for the same number of shares, and our redeemable convertible preferred stock warrant liability was reclassified to additional paid-in capital upon the completion of our IPO in October 2018. Income Tax Benefit (Provision) We account for income taxes in accordance with the liability method. Under the liability method, deferred assets and liabilities are recognized based upon anticipated future tax consequences attributable to differences between financial statement carrying amounts of assets and liabilities and their respective tax bases. The provision for income taxes is comprised of the current tax liability and the change in deferred tax assets and liabilities. We establish a valuation allowance to the extent that it is more likely than not that deferred tax assets will not be recoverable against future taxable income. Deferred tax assets and liabilities are measured using the enacted tax rates that will be in effect for the years in which those tax assets are expected to be realized or settled. We regularly assess the likelihood that deferred tax assets will be realized from recoverable income taxes or recovered from future taxable income based on the realization criteria set forth in the relevant authoritative guidance. To the extent that we believe any amounts are less likely than not to be realized, we record a valuation allowance to reduce our deferred tax assets. The realization of deferred tax assets is dependent upon future earnings, if any, the timing and amount of which are uncertain. Accordingly, the net deferred tax assets have been fully offset by a valuation allowance. If we subsequently realize deferred tax assets that were previously determined to be unrealizable, the respective valuation allowance would be reversed, resulting in an adjustment to earnings in the period such determination is made. In addition, the calculation of tax liabilities involves dealing with uncertainties in the application of complex tax regulations. We recognize potential liabilities based on an estimate of whether, and the extent to which, additional taxes will be due. We account for uncertain tax positions in accordance with the relevant guidance, which prescribes a recognition threshold and measurement approach for uncertain tax positions taken or expected to be taken in our income tax return, and also provides guidance on recognition, classification, interest and penalties, accounting in interim periods, disclosure, and transition. The guidance utilizes a two-step approach for evaluation of uncertain tax positions. The first step is to determine if the weight of available evidence indicates a tax position is more likely than not to be sustained upon audit. The second step is to measure the tax benefit as the largest amount that is more likely than not to be realized on ultimate settlement. A liability is reported for unrecognized tax benefits resulting from uncertain tax positions taken or expected to be taken in a tax return. Any interest and penalties related to unrecognized tax benefits are recorded as income tax expense. Results of Operations The following table sets forth our consolidated results of operations for the years ended December 31, 2019, 2018 and 2017 (in thousands): Comparison of the Years Ended December 31, 2019 and 2018 Revenue For the year ended December 31, 2019, total revenue was $300.6 million, an increase of $47.2 million, or 19%, as compared to 2018. Marketplace revenue represented 89% of total revenue and increased by $44.5 million, or 20%, compared to 2018. Marketplace revenue increased primarily due to an increase in GSV, which grew by 19% in 2019 as compared to 2018. GSV grew primarily driven by an 18% increase in the number of core clients as of December 31, 2019 compared to December 31, 2018. We believe these increases in marketplace revenue, GSV, and core clients were primarily due to investments in sales and marketing to acquire new clients and drive brand awareness, the launch of new offerings such as Upwork Plus and Upwork Business, the recent changes made in the pricing and packaging of Connects purchases in 2019, and investments in research and development to build new product features, and we intend to continue to focus on these efforts. Freelancer service fees generated $168.8 million and $149.9 million of marketplace revenue during the years ended December 31, 2019 and 2018, respectively. Client payment processing and administration fees generated $43.9 million and $35.5 million of marketplace revenue during the years ended December 31, 2019 and 2018, respectively. Managed services revenue represented 11% and 12% of total revenue for the year ended December 31, 2019 and 2018, respectively. Managed services revenue increased by $2.8 million, or 9%, for the year ended December 31, 2019 compared to 2018, primarily due to an increase in client demand for our managed services offering and a resulting increase in the amount of freelancer services used to deliver our managed services offering. Managed services revenue grew at a slower rate than our marketplace revenue in 2019 compared to 2018, and we anticipate this trend to continue, as we primarily focus on increasing client usage of and spend on our marketplace offerings. Cost of Revenue and Gross Margin For the year ended December 31, 2019, cost of revenue increased by $6.7 million, or 8%, compared to 2018. The increase was partially due to a $2.3 million, or 9%, increase in cost of freelancer services to deliver managed services, which was driven by a corresponding increase of $2.8 million in managed services revenue for the year ended December 31, 2019 compared to 2018. In general, the cost of freelancer services to deliver managed services is directly correlated to our managed services revenue. Other components of cost of revenue increased by $4.4 million, which included an increase of $5.8 million in payment processing fees due to an increase in client spend on our platform and $0.9 million in amortization of capitalized platform development costs, partially offset by a $1.7 million reduction in third-party hosting costs due to our migration to AWS and a $0.6 million reduction in personnel-related costs, amortization of licensed software, and other costs. Research and Development For the year ended December 31, 2019, research and development expense increased by $8.5 million, or 15%, as compared to 2018. The increase was primarily due to an increase in personnel-related costs of $8.8 million and an increase of $1.7 million in amortization of licensed software, partially offset by the capitalization of $1.3 million of additional internal-use software and platform development costs and a $0.7 million reduction in third-party services and other costs during 2019. Sales and Marketing For the year ended December 31, 2019, sales and marketing expense increased by $22.9 million, or 31%, as compared to 2018. This increase was primarily due to year-over-year increases of $13.9 million in marketing and advertising costs due to our ongoing digital marketing and advertising programs and our TV and radio ad campaign that commenced in the second quarter of 2019, $6.1 million in personnel-related costs to build out our enterprise sales team, including sales commissions that we expense as incurred, and $2.9 million in amortization of licensed software, and facilities-related and other costs resulting from ongoing business growth. In an effort to accelerate our acquisition of Upwork Enterprise and Business clients, we continue to invest in our sales and marketing capabilities and are focused on increasing our investment in our enterprise sales team. General and Administrative For the year ended December 31, 2019, general and administrative expense increased by $18.0 million, or 36%, as compared to 2018. This increase was primarily due to increases of $11.3 million in personnel-related costs, which included adding additional personnel primarily within our finance and accounting organization to support our being a public company, $3.0 million in other professional services expenses (including audit, compliance, and legal services), $1.9 million related to increased rent, insurance, and other costs associated with our new office leases, $1.1 million in non-income taxes, and $0.7 million of expense related to our Tides Foundation common stock warrant. Provision for Transaction Losses For the year ended December 31, 2019, provision for transaction losses decreased by $1.9 million, or 33%, as compared to 2018. These decreases were mainly due to improved payment collection processes and reducing fraudulent activity on our platform. For the year ended December 31, 2019, provision for transaction losses represented approximately 1% of revenue for the same period. While we expect provision for transaction losses to fluctuate as a percentage of revenue from period to period, 1% of revenue is lower than historical levels due to the timing of cash receipts at the end of 2019, as compared to 2018. We expect provisions for transaction losses to be between 1% and 2% of revenue and to increase proportionally as GSV grows. Interest Expense and Other (Income) Expense, Net For the year ended December 31, 2019, interest expense decreased by $0.7 million, as compared to 2018. This resulted from a reduction in the interest rate on our Second Term Loan (as defined below), which was the prime rate plus 5.25% per annum for most of 2018 and was reduced to the prime rate plus 0.25% per annum in October 2018 as a result of our IPO, resulting in a corresponding reduction in interest expense. See “Note 7-Debt” of the notes to our consolidated financial statements included elsewhere in this Annual Report. For the year ended December 31, 2019, other income, net was $3.4 million, as compared to other expense, net of $6.1 million for the year ended December 31, 2018. During 2019, we received interest income from our cash equivalents and marketable securities of $2.5 million, as compared to $6.1 million of expense we incurred in 2018 related to the revaluation of our redeemable convertible preferred stock warrant liability. Our redeemable convertible preferred stock warrant converted to a common stock warrant exercisable for the same number of shares, and our redeemable convertible preferred stock warrant liability was reclassified to additional paid-in capital upon completion of our IPO. Accordingly, we did not incur this expense during the year ended December 31, 2019, nor will this expense recur in future periods. Comparison of the Years Ended December 31, 2018 and 2017 Revenue Total revenue was $253.4 million in 2018, an increase of $50.8 million, or 25%, compared to 2017. Marketplace revenue represented 88% of total revenue for 2018, an increase of $45.8 million, or 26%, compared to 2017. Marketplace revenue increased primarily due to an increase in GSV. GSV grew by 28% in 2018 compared to 2017, primarily driven by a 22% increase in the number of core clients and higher client spend retention, which increased to 108% for 2018 from 99% for 2017. We believe these increases were primarily due to investments in sales and marketing to acquire new clients and drive brand awareness and research and development to build new product features. Freelancer service fees generated $149.9 million and $120.9 million of marketplace revenue in 2018 and 2017, respectively. Client payment processing and administration fees generated $35.5 million and $27.9 million of marketplace revenue in 2018 and 2017, respectively. Managed services revenue represented 12% of total revenue in both 2018 and 2017. Managed services revenue increased $5.0 million, or 20%, in 2018 compared to 2017, primarily due to an increase in the amount of freelancer services engaged by a client through our managed services offering. Cost of Revenue and Gross Margin Cost of revenue increased by $16.0 million, or 24%, in 2018 compared to 2017. The increase was primarily due to the increase in other components of cost of revenue, which included increases of $6.2 million in payment processing fees due to an increase in client spend on our platform, $2.4 million in third-party hosting costs directly related to increased usage of AWS, $1.1 million related to increased personnel-related costs, $1.0 million in costs directly associated with expanding our customer support team due to increased activity on our platform, and $0.8 million attributed to normal operating costs that increased due to the increase in revenue. Costs of freelancer services to deliver managed services increased by $4.5 million, or 23%, in 2018 compared to 2017, primarily due to a corresponding increase of $5.0 million in managed services revenue in 2018 as compared to 2017. Research and Development Research and development expense increased by $9.9 million, or 22%, in 2018 compared to 2017. The increase was primarily due to an increase in personnel-related costs of $10.9 million, an increase of $1.1 million in amortization of licensed software, an increase of $0.8 million in facilities-related and other costs, and an increase of $0.3 million in third-party hosting costs, partially offset by $3.1 million of additional internal-use software and platform development costs capitalized in 2018 and lower costs incurred from outside professional services of approximately $0.1 million. Sales and Marketing Sales and marketing expense increased by $19.9 million, or 38%, in 2018, as compared to 2017. This increase was primarily due to increases of $10.0 million in personnel-related costs to build out our enterprise sales team, including sales commissions that we expense as incurred, $7.7 million in marketing and advertising costs associated with online and offline marketing programs to drive brand awareness and attract new users, $1.8 million of facilities-related costs for our sales office, and $0.4 million related to travel and other miscellaneous costs. General and Administrative General and administrative expense increased by $12.0 million, or 32%, in 2018 compared to 2017. This increase was primarily due to increases of $7.1 million in personnel-related costs, which included adding additional personnel primarily within our finance and accounting organization and higher stock-based compensation, $1.8 million in professional expenses related to us preparing to become a public company, $1.4 million in facilities-related and other costs, $1.1 million in software licenses, $0.4 million in non-income taxes, and $0.2 million related to the shares that are expected to vest and become exercisable under our Tides Foundation common stock warrant. Provision for Transaction Losses Provision for transaction losses increased by $1.6 million, or 37%, in 2018 compared to 2017. The increase was due to growth in GSV and related trade and client receivables, partially offset by reductions resulting from increased efforts to reduce fraudulent activity on the platform. Interest Expense and Other (Income) Expense, Net Interest expense increased $1.1 million in 2018 as compared to 2017. This increase was due to a higher amount of outstanding borrowings in 2018. See “Note 7-Debt” of the notes to our consolidated financial statements included elsewhere in this Annual Report. Other expense, net increased $6.1 million in 2018 compared to 2017, primarily due to the revaluation of our convertible preferred stock warrant liability. The value of the convertible preferred stock warrant liability increased significantly due to the completion of our IPO and the final IPO offering price being significantly higher than the historical estimated fair value used to revalue the convertible preferred stock warrant liability. The expenses related to the convertible preferred stock warrant liability will not recur in future periods. Quarterly Results of Operations The following tables summarize our selected unaudited quarterly consolidated statements of operations data for each of the eight quarters in the period ended December 31, 2019. The information for each of these quarters has been prepared on a basis consistent with our audited financial statements included elsewhere in this Annual Report and, in the opinion of management, includes all adjustments of a normal, recurring nature that are necessary for the fair statement of the results of operations for these periods in accordance with U.S. GAAP. The data should be read in conjunction with our audited financial statements and notes thereto included elsewhere in this Annual Report. Our historical quarterly results are not necessarily indicative of the results that may be expected for a full year or in any future period. On December 31, 2019, we adopted Topic 606 effective as of January 1, 2019 using the modified retrospective method. Financial results for the year ended December 31, 2019 and the three months ended March 31, June 30, September 30, and December 31, 2019 are presented in accordance with this new revenue recognition standard and accordingly, financial results for the three months ended March 31, June 30, and September 30, 2019 differ from those amounts previously disclosed in our prior quarterly reports on Form 10-Q. Historical financial results for reporting periods prior to 2019 are presented in conformity with amounts previously disclosed under the prior revenue recognition standard, Topic 605. The following table summarizes the impact of adopting Topic 606 on our consolidated statements of operations for the periods indicated. The impact of adopting FASB ASU No. 2016-02, Leases (Topic 842) on our consolidated statements of operations for the periods indicated was immaterial. The following table sets forth our unaudited quarterly consolidated results of operations data for each of the periods indicated as a percentage of total revenue: Liquidity and Capital Resources Prior to our IPO, we financed our operations and capital expenditures primarily through sales of convertible preferred stock, bank borrowings, and utilization of cash generated from operations in the periods in which we generated cash flows from operations. In October 2018, we completed our IPO, from which we received aggregate net proceeds of $109.4 million after deducting underwriting discounts and commissions but before deducting offering expenses payable by us. At the end of 2018, we invested a portion of the net proceeds from our IPO in money market funds with maturities of 90 days or less from the date of purchase. As of December 31, 2019 and 2018, we had $48.4 million and $129.1 million in cash and cash equivalents, respectively. Beginning in 2019, we purchased various marketable securities consisting of commercial paper, treasury bills, and U.S. government securities, all of which have contractual maturities within 24 months from the date of purchase and are classified as available-for-sale marketable securities within our consolidated balance sheet. As of December 31, 2019, we had total marketable securities of $85.5 million. We believe our existing cash and cash equivalents, marketable securities, cash flow from operations (in periods in which we generate cash flow from operations), and amounts available for borrowing under the Loan Agreement referred to below under “-Term and Revolving Loans” will be sufficient to meet our working capital requirements for at least the next 12 months. To the extent existing cash and cash equivalents, cash from marketable securities, cash from operations (in periods in which we generate cash flow from operations), and amounts available for borrowing under the Loan Agreement are insufficient to fund our working capital requirements, or should we require additional cash for other purposes, we will need to raise additional funds. In the future, we may attempt to raise additional capital through the sale of equity securities or through equity-linked or debt financing arrangements. If we raise additional funds by issuing equity or equity-linked securities, the ownership and economic interests of our existing stockholders will be diluted. If we raise additional financing by incurring additional indebtedness, we will be subject to additional debt service requirements and could also be subject to additional restrictive covenants, such as limitations on our ability to incur additional debt, and other operating restrictions that could adversely impact our ability to conduct our business. Any future indebtedness we incur may result in terms that could also be unfavorable to our equity investors. There can be no assurances that we will be able to raise additional capital on terms we deem acceptable, or at all. The inability to raise additional capital as and when required would have an adverse effect, which could be material, on our results of operations, financial condition and ability to achieve our business objectives. Escrow Funding Requirements We offer escrow services to users of our platform. As such, we are licensed as an internet escrow agent and are therefore required to hold our users’ escrowed cash and in-transit cash in trust as an asset and record a corresponding liability for escrow funds held on behalf of freelancers and clients on our balance sheet. Escrow regulations require us to fund the trust with our operating cash to cover shortages due to the timing of cash receipts from clients for completed hourly billings. Freelancers submit their billings for hourly contracts to their clients on a weekly basis every Sunday and the aggregate amount of such billings is added to escrow funds payable to freelancers on the same day. As of Sunday each week, we have not yet collected funds for hourly billings from clients as these funds are in transit. Therefore, in order to satisfy escrow funding requirements, every Sunday we fund the shortage of cash in trust with our own operating cash and typically collect this cash shortage from clients within the next several days. As a result, we expect our total cash and cash flows from operating activities to be impacted when a quarter ends on a Sunday, as occurred on December 31, 2017, September 30, 2018, March 31, 2019 and June 30, 2019. As of December 31, 2019 and 2018, funds held in escrow, including funds in transit, were $108.7 million and $98.2 million, respectively. To the extent we have not yet collected funds for hourly billings from clients which are in-transit due to timing differences in receipt of cash from clients and payments of cash to freelancers, we may, from time to time, utilize the revolving line of credit under our Loan Agreement to satisfy escrow funding requirements. We drew down $25.0 million under the revolving line of credit for such purpose in each of March and June 2019, which we subsequently repaid in April and July 2019, respectively. We drew down $15.0 million under the revolving line of credit for the same purpose in September 2018, which we subsequently repaid in October 2018. Term and Revolving Loans In 2017, we entered into the Loan Agreement. The aggregate amount of the facility is up to $49.0 million, consisting of a term loan in the original principal amount of $15.0 million (the “First Term Loan”), a term loan in the original principal amount of $9.0 million (the “Second Term Loan” and, together with the First Term Loan, the “Term Loans”), and a revolving line of credit, which permits borrowings of up to $25.0 million subject to customary conditions. Among other things, we may only borrow funds under the revolving line of credit if, after giving effect thereto, our total borrowings under the line of credit do not exceed a specified percentage of eligible trade and client accounts receivable. The First Term Loan, Second Term Loan, and revolving line of credit mature in March 2022, September 2022, and September 2020, respectively. All borrowings under the Loan Agreement bear interest at floating rates, and, therefore, our borrowing costs are affected by changes in market interest rates. Specifically, the First Term Loan bears interest at the prime rate plus 0.25% per annum and has a repayment term of 18 months of interest-only payments that ended in March 2019, followed by equal monthly installments of principal plus interest until the maturity in March 2022. Accordingly, we commenced repayment of the First Term Loan in April 2019 and repaid $3.8 million during the year ended December 31, 2019. In September 2018, we entered into a second amendment (the “Second Amendment”) to the Loan Agreement, which, among other changes, provided for a reduction in the interest rate for the Second Term Loan, from the prime rate plus 5.25% per annum to the prime rate plus 0.25% per annum, from and after the occurrence of an initial public offering by us with net proceeds of more than $50.0 million. This reduction became effective following the completion of our IPO in October 2018. See “Note 7-Debt” in the notes to our consolidated financial statements included elsewhere in this Annual Report for further information regarding the Second Amendment. The Second Term Loan has a repayment term of 17 months of interest-only payments that ended in March 2019, followed by equal monthly installments of principal plus interest until the maturity in September 2022. Accordingly, we commenced repayment of the Second Term Loan in April 2019 and repaid $1.9 million of principal during the year ended December 31, 2019. The revolving line of credit bears interest at the prime rate with accrued interest due monthly. As described above under “-Escrow Funding Requirements,” to the extent we have not yet collected funds for hourly billings from clients that are in-transit due to timing differences in receipt of cash from clients, we may utilize the revolving line of credit to satisfy escrow funding requirements. In each of March and June 2019, we drew down $25.0 million under the revolving line of credit for such purpose, which we subsequently repaid in April and July 2019, respectively. We drew down $15.0 million under the revolving line of credit for such purpose in September 2018, which we subsequently repaid in October 2018. For further information, see “Note 7-Debt” in the notes to our consolidated financial statements included elsewhere in this Annual Report. Our obligations under the Loan Agreement are secured by first priority liens on substantially all of our assets excluding our intellectual property (but including proceeds therefrom) and the funds and assets held by our subsidiary Upwork Escrow Inc. The Loan Agreement prohibits us from pledging our intellectual property. The Loan Agreement also includes a restriction on dividend payments, other than dividends payable solely in common stock. The Loan Agreement contains affirmative covenants, including a covenant requiring that we maintain a certain adjusted quick ratio, and also contains certain non-financial covenants. In March 2019, we entered into the third amendment to the Loan Agreement, which, among other changes, (i) amended the adjusted quick ratio financial covenant to provide that we will maintain an adjusted quick ratio of 1.75 to 1.00 (previously 1.30 to 1.00), (ii) reduced the frequency with which we are required to provide certain financial information to the lender during periods in which we maintain an adjusted quick ratio of 2.50 to 1.00, and (iii) eliminated the minimum EBITDA covenant with which we were required to comply. We were in compliance with our covenants under the Loan Agreement as of December 31, 2019 and 2018. As of December 31, 2019, we had $18.3 million outstanding pursuant to the Term Loans and no borrowings outstanding under the revolving line of credit. As of December 31, 2018, we had $24.0 million outstanding pursuant to the Term Loans and no borrowings outstanding under the revolving line of credit. Cash Flows The following table summarizes our cash flows for the years ended December 31, 2019, 2018 and 2017 (in thousands): (1)We used $13.4 million of our operating cash on December 31, 2017, which fell on a Sunday, to temporarily fund the trust account associated with our escrow services. See the section titled “-Liquidity and Capital Resources-Escrow Funding Requirements.” Operating Activities Our largest source of cash from operating activities is revenue generated from our platform. Our primary uses of cash from operating activities are for personnel-related expenditures, marketing activities, including advertising, payment processing fees, amounts paid to freelancers to deliver services for clients under our managed services offering, and third-party hosting costs. In addition, because we are licensed as an internet escrow agent, our total cash and cash provided by (used in) operating activities may be impacted by the timing of the end of our fiscal quarter as discussed in the section titled “-Liquidity and Capital Resources-Escrow Funding Requirements.” Net cash provided by operating activities during 2019 was $1.1 million, which resulted from non-cash charges of $32.2 million, offset by a net loss of $16.7 million and net cash outflows of $14.4 million from changes in operating assets and liabilities. The change in operating assets and liabilities primarily resulted from the increase in trade and client receivables of $10.9 million. Due to fluctuations in revenue and the number of transactions on our platform, coupled with fluctuations in the timing of cash receipts from clients, our trade and client receivables will likely continue to fluctuate in the future. Net cash provided by operating activities during 2018 was $13.7 million, which resulted from a net loss of $19.9 million, offset by non-cash charges of $10.4 million for stock-based compensation, $4.9 million for depreciation and amortization, $6.1 million and $0.2 million related to the change in fair value of our redeemable convertible preferred stock warrant liability and expense related to our Tides Foundation common stock warrant, respectively, $5.1 million for provision for transaction losses, $0.2 million for amortization of debt issuance costs and loss on disposal of fixed assets, and net cash inflows of $6.7 million from changes in operating assets and liabilities. The changes in operating assets and liabilities included cash inflows of $3.5 million resulting from a decrease in trade and client receivables due to the timing of collections year-over-year. Additionally, changes in accounts payable and accrued expenses and other liabilities generated cash inflows of $1.6 million and $2.9 million, respectively. These cash inflows were partially offset by $1.3 million related to cash spent on prepaid expenses and other assets. Net cash used in operating activities during 2017 was $4.0 million, which resulted from a net loss of $4.1 million and net cash outflows of $15.4 million from changes in operating assets and liabilities, primarily offset by non-cash charges of $6.8 million for stock-based compensation, $4.3 million for provision for transaction losses, and $4.2 million for depreciation and amortization. The net cash outflows from changes in operating assets and liabilities were primarily the result of increases of $8.9 million in trade and client receivables and $0.5 million in prepaid expenses and other assets and a decrease of $6.1 million in accrued expenses and other liabilities. The increase in trade and client receivables was primarily because the last calendar day of 2017 (i.e., December 31, 2017) fell on a Sunday, requiring us to fund the shortage of cash in the trust until we collect this from clients over the next few days, and an increase in our trade and client receivables for our Upwork Enterprise clients, that pay us on net terms. The decrease in accrued expenses and other liabilities was primarily due to fluctuations in timing of cash payments. Investing Activities Net cash used in investing activities during 2019 was $100.9 million, which was primarily a result of investing $168.8 million in various marketable securities during 2019, as well as $5.9 million of internal-use software and platform development costs that we paid during the period and purchases of property and equipment of $10.8 million primarily for leasehold improvements and furniture related to our new office leases in Santa Clara, California and Chicago, Illinois. These uses of cash were partially offset by sales of marketable securities of $84.5 million. Net cash used in investing activities during 2018 was $6.8 million, which resulted from capitalized internal-use software and platform development costs of $3.8 million and purchases of property and equipment of $3.0 million primarily for leasehold improvements and furniture. Net cash used in investing activities during 2017 was $2.3 million, which resulted from purchases of property and equipment of $1.8 million and capitalized internal-use software and platform development costs of $0.5 million. Financing Activities Net cash provided by financing activities during 2019 was $29.4 million, which resulted primarily from cash received from stock option exercises of $18.2 million, proceeds from our employee stock purchase program of $6.4 million, and a reduction in escrow funds payable of $10.5 million, partially offset by net repayments of debt of $5.7 million. Net cash provided by financing activities during 2018 was $112.1 million, which was primarily due to proceeds received from our IPO, net of underwriting discounts and commissions, of $109.4 million, cash received from the exercise of stock options and common stock warrants of $8.2 million, and a reduction in escrow funds payable of $10.9 million, partially offset by net repayments of debt of $10.0 million, payments of taxes related to net share settlements of $0.2 million, and the payment of costs related to our IPO of $6.2 million. Net cash provided by financing activities during 2017 was $27.7 million primarily due to proceeds from borrowings of $33.8 million, net of borrowing costs, under the Loan Agreement, $2.8 million from the exercise of stock options and a convertible preferred stock warrant, and a reduction in escrow funds payable of $27.3 million, offset by the repayment of $17.0 million in borrowings under a prior loan and security agreement, and a repurchase by us of convertible preferred stock for $19.2 million. Obligations and Other Commitments Our principal commitments consist of obligations under our non-cancellable operating leases for office space and the Loan Agreement. The following table summarizes our contractual obligations as of December 31, 2019 (in thousands): (1)Represents minimum operating lease payments under operating leases for office facilities, excluding potential lease renewals, net of tenant improvement allowances. In the ordinary course of business, we enter into contracts and agreements that contain a variety of representations and warranties and provide for indemnification. In addition, we have entered into indemnification agreements with our directors and executive officers and certain key employees that require us, among other things, to indemnify them against certain liabilities that may arise by reason of their status or service as our directors, executive officers, or employees. The terms of such obligations may vary. To date, we have not paid any material claims or been required to defend any actions related to our indemnification obligations. As of December 31, 2019, we had accrued liabilities related to uncertain non-income tax positions based on management’s best estimate of its liability, which are reflected on our consolidated balance sheet. We could be subject to examination in various jurisdictions related to income and non-income tax matters. The resolution of these types of matters, giving recognition to the recorded reserve, could have an adverse impact on our business. Off-Balance Sheet Arrangements As of December 31, 2019, we did not have any relationships with other entities or financial partnerships such as entities often referred to as structured finance or special purpose entities that have been established for the purpose of facilitating off-balance sheet arrangements or other contractually narrow or limited purposes. Critical Accounting Policies and Estimates Our consolidated financial statements are prepared in accordance with U.S. GAAP. The preparation of the consolidated financial statements requires us to make estimates and assumptions that affect the reported amounts of assets, liabilities, revenue, expenses, and related disclosures. We evaluate our estimates and assumptions on an ongoing basis using historical experience and other factors and adjust those estimates and assumptions when facts and circumstances dictate. Actual results could materially differ from these estimates and assumptions. An accounting policy is deemed to be critical if it requires an accounting estimate to be made based on assumptions about matters that are highly uncertain at the time the estimate is made, if different estimates reasonably could have been used, or if changes in the estimate that are reasonably possible could materially impact the financial statements. We believe estimates and assumptions associated with the evaluation of revenue recognition criteria, including the determination of revenue reporting as gross versus net in our revenue arrangements, internal-use software and platform development costs, the fair values of stock-based awards, and income taxes have the greatest potential impact on our consolidated financial statements. Therefore, we consider these to be our critical accounting policies and estimates. Revenue Recognition We operate an online talent solution that enables freelancers to market their services to prospective clients and clients to find and work with freelancers. Both freelancers and clients are our customers. We primarily generate revenue from freelancers and clients from marketplace and managed service offerings. We account for revenue in accordance with Topic 606, which we adopted on December 31, 2019 effective as of January 1, 2019 using the modified retrospective method. Revenue is recognized upon transfer of control of promised services to customers in an amount that reflects the consideration we expect to receive in exchange for those services. See “Note 2-Basis of Presentation and Summary of Significant Accounting Policies” and “Note 3-Revenue” of the notes to our consolidated financial statements included elsewhere in this Annual Report for a further description of our revenue recognition policies. Goodwill Goodwill represents the excess of the aggregate fair value of the consideration transferred over the fair value of the net tangible and identifiable assets acquired in 2014 as a result of the combination of Elance and oDesk described above under “Business-Corporate Information.” The total accounting purchase price of this combination was $147.4 million. Elance and oDesk each considered a number of factors when deciding whether to consummate the 2014 combination between the two companies. The business reasons for the combination, and the rationale for the purchase price, included creating greater scale and visibility of the combined company to gain increased market share by attracting new users, improving operational efficiencies, and benefits from cost synergies. Additional factors included our expectations regarding the ongoing changes in the labor market, including the impact of technology in reducing the prevailing inefficiencies in the labor market, which we believed would result in a greater market opportunity for the combined company than had the two companies remained independent. Goodwill from this combination is not amortized but is assessed for impairment at least annually, or more frequently if events or changes in circumstances indicate the goodwill may be impaired. We conduct our annual assessment during the fourth quarter of each calendar year based on a single reporting unit structure. We have the option to first assess qualitative factors to determine whether the existence of events or circumstances leads to a determination that it is more likely than not that the fair value of the reporting unit is less than its carrying amount. If, after assessing the totality of events or circumstances, we determine it is not more likely than not that the fair value of the reporting unit is less than its carrying amount, then additional impairment testing is not required. However, if we conclude otherwise, then we are required to perform the first of a two-step impairment test. The first step involves comparing the estimated fair value of the reporting unit with its respective book value, including goodwill. If the estimated fair value exceeds book value, goodwill is considered not to be impaired and no additional steps are necessary. If, however, the fair value of the reporting unit is less than book value, then a second step is required that compares the carrying amount of the goodwill with its implied fair value. The estimate of implied fair value of goodwill may require valuations of certain internally-generated and unrecognized intangible and tangible net assets. If the carrying amount of goodwill exceeds the implied fair value of the goodwill, an impairment loss is recognized in an amount equal to the excess. For 2019 and 2018, we conducted our goodwill impairment testing by performing the first step of the two-step impairment model. The fair value was determined by us using quoted market prices of our common stock. We determined that the fair value of our reporting unit exceeded the net book value of our reporting unit, and as such, we concluded that there was no impairment of goodwill at the impairment testing date. For 2017, we conducted our goodwill impairment testing by assessing qualitative factors to determine whether it was more likely than not that the fair value of our reporting unit was less than its carrying amount. As part of this assessment, we considered factors, including but not limited to, the overall macroeconomic environment, specific industry and market conditions, cost factors, our overall financial performance against expectations, changes in strategy or the manner in which we use our assets, and changes in key management personnel. While we had a history of operating losses, our operating results improved in 2017 compared to 2016. No other indicators of impairment were identified during our assessment. Furthermore, we considered the most recent valuations of our common stock, which indicated that there was substantial excess of fair value over book value. Accordingly, we concluded there was no impairment to goodwill at the impairment testing date. Internal-Use Software and Platform Development Costs We capitalize certain internal-use software and platform development costs associated with creating and enhancing internal-use software related to our software platform and technology infrastructure. These costs include personnel and related employee benefits expenses for employees who are directly associated with and who devote time to software projects, and external direct costs of materials and services consumed in developing or obtaining the software. Software development costs that do not meet the criteria for capitalization are expensed as incurred and recorded in research and development expenses in our consolidated statements of operations. Software development activities generally consist of three stages: (i) the planning stage; (ii) the application and infrastructure development stage; and (iii) the post-implementation stage. Costs incurred in the planning and post-implementation stages of software development, including costs associated with the post configuration training and repairs and maintenance of the developed technologies, are expensed as incurred. We capitalize costs associated with software developed for internal use when both the preliminary project stage is completed and management has authorized further funding for the completion of the project. Costs incurred in the application and infrastructure development stages, including significant enhancements and upgrades, are capitalized. Capitalization ends once a project is substantially complete and the software and technologies are ready for their intended purpose. Internal-use software and platform development costs are amortized using a straight-line method over the estimated useful life of two years, commencing when the software is ready for its intended use. Amortization expense related to capitalized-internal use software is allocated to each functional expense based on headcount. Amortization expenses related to capitalized platform development costs are included in cost of revenue. Stock-Based Compensation We measure and recognize compensation expense for all stock-based awards granted to service providers, including stock options, RSUs, purchase rights granted under our 2018 Employee Stock Purchase Plan (“2018 ESPP”) based on the estimated fair value of the award on the grant date. We calculate the estimated fair value of stock options and purchase rights granted under the 2018 ESPP on the date of grant using the Black-Scholes option pricing model, which is impacted by the fair value of our common stock, as well as changes in assumptions regarding a number of highly complex and subjective variables. These variables include, but are not limited to, the expected dividend yield, the expected term of the awards, the risk-free interest rates and the expected common stock price volatility over the term of the option awards. Prior to our IPO, the estimated fair value of our common stock was determined by our board of directors, and had been based in part upon contemporaneous valuations performed at periodic intervals by unrelated third-party specialists. Because there had been no public market for our common stock, our board of directors considered this independent valuation and other factors, including, but not limited to, our actual operating and financial performance, the current status of the technical and commercial success of our operations, our financial condition, the stage of development and competition to establish the fair value of our common stock at the time of grant of stock options. Following our IPO, we use the quoted market price of our common stock as reported on The Nasdaq Global Select Market for the fair value of RSUs and stock options and purchase rights under our 2018 ESPP. We generally recognize the fair value of stock options and RSUs on a straight-line basis over the period during which a service provider is required to provide services in exchange for the award (generally the vesting period). We recognize the fair value of purchase rights granted under the 2018 ESPP as an expense on a straight-line basis over the offering period and account for forfeitures as they occur. Income Taxes We utilize the asset and liability method under which deferred tax assets and liabilities arise from the temporary differences between the tax basis of an asset or liability and its reported amount in the consolidated financial statements, as well as from net operating loss and tax credit carryforwards. Deferred tax amounts are determined by using the tax rates expected to be in effect when the taxes will actually be paid or refunds received, as provided for under current tax law. A valuation allowance is established when necessary to reduce deferred tax assets to the amount expected to be realized. We regularly review our tax positions and benefits to be realized. We recognize tax liabilities based upon our estimate of whether, and the extent to which, additional taxes will be due when such estimates are more likely than not to be sustained. An uncertain income tax position will be recognized only if it is more likely than not to be sustained. We recognize interest and penalties related to income tax matters as income tax expense. See “Note 2-Basis of Presentation and Summary of Significant Accounting Policies” and “Note 11-Stock-Based Compensation” of the notes to our consolidated financial statements included elsewhere in this Annual Report for a further description of our policies related to stock-based compensation. Recent Accounting Pronouncements See “Note 2-Basis of Presentation and Summary of Significant Accounting Policies” of the notes to our consolidated financial statements included elsewhere in this Annual Report for recently issued accounting pronouncements not yet adopted as of the date of this Annual Report.

<s>[INST] Overview Business We operate the largest online talent solution that enables businesses to find and work with highlyskilled independent professionals, as measured by GSV. GSV represents the total amount that clients spend on our marketplace offerings and our managed services offering as well as additional fees we charge to both clients and freelancers for other services. Freelancers are an increasingly soughtafter, critical, and expanding segment of the global workforce. We define freelancers as users of our platform that advertise and provide services to clients through our platform, and we define clients as users of our platform that work with freelancers through our platform. The freelancers on our platform include independent professionals and agencies of varying sizes. The clients on our platform range in size from small businesses to Fortune 500 companies. Our platform enabled $2.1 billion of GSV in over 180 countries for the year ended December 31, 2019. For purposes of determining countries where we enable GSV, we include both the countries in which the clients that paid for the applicable services are located, as well as the countries in which the freelancers that provided those services are located. We generate a majority of our revenue from fees charged to freelancers. We also generate revenue through fees charged to clients for transacting payments through our platform and fees for premium offerings, foreign currency exchange fees, and Upwork Payroll service fees. In addition, we provide a managed services offering where we engage freelancers to complete projects, directly invoice the client, and assume responsibility for work performed. As noted above, on December 31, 2019, we adopted Topic 606 effective as of January 1, 2019 using the modified retrospective method. As a result, revenue results for the year ended December 31, 2019 are presented in accordance with this new revenue recognition standard while historical revenue results for reporting periods prior to 2019 are presented in conformity with amounts previously disclosed under the prior revenue recognition standard, Topic 605. We generated revenue of $300.6 million in 2019, $253.4 million in 2018, and $202.6 million in 2017, representing yearoveryear increases of 19% in 2019 and 25% in 2018. Financial Highlights for 2019 In 2019, our platform enabled $2.1 billion of GSV, representing an increase of 19% over the prior year, and our total revenue was $300.6 million, representing an increase of 19% over the prior year. Our marketplace revenue was $268.3 million, representing an increase of 20% over the prior year. Longterm and recurring use of our platform by freelancers and clients are the primary drivers of growth in our marketplace and an increase in these types of use improve revenue visibility. For the year ended December 31, 2019, in addition to acquiring new clients, our total client spend retention was 102%, compared to 108% for the year ended December 31, 2018. For additional information related to how we calculate client spend retention and a discussion of periodoverperiod changes in this amount, see the section titled “Key Financial and Operational Metrics” below. Additionally, we have made significant investments to grow our business, including investments in sales and marketing to acquire new clients and drive brand awareness, investments in research and development to build new product features and launch new offerings, and investments in operations and personnel, and we intend to continue to focus on these efforts. As a result, we generated a net loss of $16.7 million in 2019 compared to a net loss of $19.9 million in 2018. Our adjusted EBITDA was $7.4 million in 2019, an increase of 95% from 2018. Adjusted EBITDA is a financial measure that is not prepared in accordance with, and is not an alternative to, financial measures prepared in accordance with U.S. GAAP. See the section titled “Selected Consolidated Financial DataNonGAAP Financial Measures” for a definition of adjusted EBITDA [/INST] Negative. </s>

YETI Holdings, Inc.

2019-03-20

2018-12-29

Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations The following discussion and analysis contains forward-looking statements within the meaning of the federal securities laws, and should be read in conjunction with the disclosures we make concerning risks and other factors that may affect our business and operating results, including those set forth in Part I, Item 1A, “Risk Factors” of this Report. The information contained in this section should also be read in conjunction with our consolidated financial statements and related notes and the information contained elsewhere in this Report. See also “Forward-Looking Statements” immediately prior to Part I, Item 1, “Business” in this Report. Business Overview We are a designer, marketer, retailer, and distributor of a variety of innovative, branded, premium products to a wide-ranging customer base. Our mission is to ensure that each YETI product delivers exceptional performance and durability in any environment, whether in the remote wilderness, at the beach, or anywhere else life takes our customers. By consistently delivering high-performing products, we have built a following of engaged brand loyalists throughout the United States, Canada, Australia, and elsewhere, ranging from serious outdoor enthusiasts to individuals who simply value products of uncompromising quality and design. Our relationship with customers continues to thrive and deepen as a result of our innovative new product introductions, expansion and enhancement of existing product families, and multifaceted branding activities. General Components of Our Results of Operations Net Sales. Net sales are comprised of wholesale channel sales to our retail partners and sales through our DTC channel. Net sales in both channels reflect the impact of product returns as well as discounts for certain sales programs or promotions. We discuss the net sales of our products in our two primary categories: Coolers & Equipment and Drinkware. Our Coolers & Equipment category includes hard coolers, soft coolers, outdoor equipment and other products, as well as accessories and replacement parts for these products. Our Drinkware category includes our stainless-steel drinkware products and related accessories. In addition, our Other category is primarily comprised of ice substitutes, and YETI-branded gear, such as shirts, hats, and other miscellaneous products. Gross profit. Gross profit reflects net sales less cost of goods sold, which primarily includes the purchase cost of our products from our third-party contract manufacturers, inbound freight and duties, product quality testing and inspection costs, depreciation expense of our molds and equipment, and the cost of customizing Drinkware products. We calculate gross margin as gross profit divided by net sales. Gross margin in our DTC sales channel is generally higher than that on sales in our wholesale channel. Selling, general, and administrative expenses. Selling, general, and administrative (“SG&A”) expenses consist primarily of marketing costs, employee compensation and benefits costs, costs of our outsourced warehousing and logistics operations, costs of operating on third-party DTC marketplaces, professional fees and services, non-cash stock-based compensation, cost of product shipment to our customers, depreciation and amortization expense, and general corporate infrastructure expenses. Change in Fiscal Year and Reporting Calendar. Effective January 1, 2017, we converted our fiscal year-end from a calendar year ending December 31 to a “52 to 53-week” year ending on the Saturday closest in proximity to December 31, such that each quarterly period will be 13 weeks in length, except during a 53-week year when the fourth quarter will be 14 weeks. This did not have a material effect on our consolidated financial statements and, therefore, we did not retrospectively adjust our financial statements. Results of Operations The following table sets forth selected statement of operations data, and their corresponding percentage of net sales, for the periods indicated (dollars in thousands): _________________________ (1) See “Non-GAAP Financial Measures” section below for the definitions of our non-GAAP financial measures as well as reconciliations of the non-GAAP financial measures to their most directly comparable GAAP financial measure. Year Ended December 29, 2018 Compared to Year Ended December 30, 2017 Net Sales Net sales increased $139.6 million, or 22%, to $778.8 million in fiscal 2018 from $639.2 million in fiscal 2017. The increase in net sales was driven by increases in net sales from our DTC and wholesale channels. DTC channel net sales increased $93.0 million, or 48%, to $287.4 million in fiscal 2018 from $194.4 million in fiscal 2017. The DTC channel net sales increase was primarily driven by net sales increases in both Drinkware and Coolers & Equipment. Wholesale channel net sales increased $46.6 million, or 10%, to $491.4 million in fiscal 2018 from $444.9 million in fiscal 2017. The wholesale channel net sales increase was primarily driven by an increase in Drinkware net sales. Net sales in our two primary product categories were as follows: · Drinkware net sales increased $113.9 million, or 37%, to $424.2 million in fiscal 2018 from $310.3 million in fiscal 2017. The increase in Drinkware net sales was primarily driven by the expansion of our Drinkware product line, new accessories, and the introduction of new colorways during fiscal 2018. · Coolers & Equipment net sales increased $19.0 million, or 6%, to $331.2 million in fiscal 2018 from $312.2 million in fiscal 2017. The increase in Coolers & Equipment net sales was primarily driven by the expansion of our hard cooler and soft cooler products, as well as the introduction of several new storage, transport, and outdoor living products during fiscal 2018. Gross Profit Gross profit increased $88.5 million, or 30%, to $383.1 million in fiscal 2018 from $294.6 million in fiscal 2017. Gross margin increased 310 basis points to 49.2% in fiscal 2018 from 46.1% in fiscal 2017. The increase in gross margin was primarily driven by the following: · leveraging fixed costs on higher net sales, which favorably impacted gross margin by approximately 180 basis points; · cost improvements across our product portfolio, which favorably impacted gross margin by approximately 170 basis points; · charges incurred in 2017 for inventory reserves that were not repeated in 2018, which favorably impacted gross margin by approximately 150 basis points; · increased higher-margin DTC channel sales, which favorably impacted gross margin by approximately 110 basis points; · charges incurred in 2017 for pricing actions related to our first-generation Hopper that were not repeated in 2018, which favorably impacted gross margin by approximately 30 basis points; and · decreased provisions for sales returns in 2018 compared to 2017, which favorably impacted gross margin by approximately 30 basis points The above increases in gross margin were partially offset by price reductions on select hard cooler, soft cooler, and Drinkware products in the second half of 2017 and in 2018 to reposition these products in the market to create pricing space for new product introductions, which reduced gross margin by approximately 360 basis points in 2018. Selling, General, and Administrative Expenses SG&A expenses increased by $50.3 million, or 22%, to $281.0 million in fiscal 2018 from $230.6 million in fiscal 2017. As a percentage of net sales, SG&A expenses remained consistent at 36.1% in fiscal 2018 and 2017. SG&A expenses were impacted by the following: a $17.8 million increase in employee costs resulting from increased headcount to support the growth in our business; a $16.6 million increase in variable expenses such as marketplace fees, credit card fees and distribution costs primarily as a result of increased net sales; a $6.9 million increase in professional fees, including the impact of reversing a previously recognized consulting fee in 2017 that was contingent upon the completion of our IPO attempt in 2016; a $3.1 million increase in information technology-related costs; a $2.3 million increase in depreciation and amortization expense; and a $1.5 million increase in other costs primarily due to an increase in facilities and utility costs and other operating expenses. Non-Operating Expenses Interest expense decreased by $1.3 million to $31.3 million in fiscal 2018 from $32.6 million in fiscal 2017. The decrease in interest expense was primarily due to decreased borrowings under our Credit Facility. Income tax expense decreased by $4.8 million to $11.9 million in fiscal 2018 from $16.7 million in fiscal 2017. Our effective tax rate for fiscal 2018 was 17% compared to 52% for fiscal 2017. The decrease in effective tax rate was due to the federal tax rate reduction in 2018, a benefit from a revaluation of state deferred tax assets, and the stock compensation tax benefit of exercised options in 2018 primarily in connection with our IPO, partially offset by an increase in state income tax expense. In addition, the income tax expense in fiscal 2017 was unusually high due to the revaluation of our net deferred tax assets as a result of the enactment of the Tax Act, which reduced the U.S. federal corporate tax rate from 35% to 21%. Year Ended December 30, 2017 Compared to Year Ended December 31, 2016 Net Sales Net sales decreased $179.7 million, or 22%, to $639.2 million in fiscal 2017, compared to $818.9 million in fiscal 2016. This decrease was primarily driven by a decline in net sales in our wholesale channel of $296.1 million, or 40%, which was partially offset by increased net sales in our DTC channel of $116.4 million, or 149%. Wholesale channel net sales declined significantly in both Coolers & Equipment and Drinkware in fiscal 2017 primarily as a result of excess levels of inventory of YETI product in our wholesale channel at the end of fiscal 2016. This wholesale channel inventory situation was caused by retail partners overbuying in the first half of fiscal 2016 in response to rapid fiscal 2015 product sell-through and resulting product shortages, a challenging overall U.S. retail environment, and inventory liquidations by certain competitors at low relative prices. DTC net sales increased significantly in both Coolers & Equipment and Drinkware. The increase in DTC net sales was largely attributable to our continued commitment to and significant investments in the DTC channel, which resulted in enhanced customer engagement with YETI.com, increased focus on selling through YETI Authorized on the Amazon Marketplace, and growth in custom Drinkware and hard cooler sales to customers and businesses. Net sales in our two primary product categories were as follows: · Coolers & Equipment net sales decreased by $37.2 million, or 11%, to $312.2 million in fiscal 2017, compared to $349.5 million in fiscal 2016. The decline was driven by lower hard cooler and soft cooler net sales in the wholesale channel, partially offset by an increase in both hard and soft cooler net sales in the DTC channel. Both channels benefited from expansion of our soft cooler Hopper FlipTM family product offerings, the introduction of premium storage buckets, a second-generation Hopper soft cooler, our PangaTM submersible duffel bags, and limited edition hard coolers. · Drinkware net sales decreased by $137.0 million, or 31%, to $310.3 million in fiscal 2017, compared to $447.3 million in fiscal 2016. The decline was driven by a decrease in the wholesale channel, partially offset by an increase in the DTC channel. Both channels benefited from new product introductions, including Rambler Jugs, the Rambler 14 oz. Mug, and additional Drinkware accessories, as well as the addition of Drinkware colorways. During the first half of fiscal 2017, we implemented a series of commercial actions aimed at better positioning us for long-term growth, such as implementing a series of pricing actions, introducing new products, growing our DTC business, focusing and diversifying our independent dealer base, rationalizing our manufacturing supplier base, strengthening our team by adding several key executives and increasing our employee count, and investing in enhanced information systems. These initiatives proved highly successful in reducing excess channel inventory and improving retailer sell-through, which fostered net sales growth in the second half of fiscal 2017. Gross Profit Gross profit decreased $119.4 million, or 29%, to $294.6 million in fiscal 2017, compared to $414.0 million in fiscal 2016. Gross margin decreased 450 basis points to 46.1% from 50.6% in 2016. The decrease in gross margin was primarily driven by: · adding incremental, value-add features, and related costs to certain of our Drinkware products, which reduced gross margin by approximately 180 basis points; · the incremental manufacturing costs of YETI Custom Drinkware LLC (“YCD”), reflecting a full year in fiscal 2017 compared to five months during fiscal 2016, reduced gross margin by approximately 170 basis points. During the third quarter of 2016, we began consolidating Rambler On as a VIE, which was acquired by YCD, our wholly owned subsidiary, during 2017; · price reductions on several hard cooler, soft cooler, and Drinkware products to reposition these products in the market to create pricing space for planned new product introductions, which reduced gross margin by approximately 160 basis points; · additional costs related to reworking certain Drinkware finished goods inventories to add color as well as customization, which reduced gross margin by approximately 130 basis points; and · disposition of certain prior generation, excess end-of-life soft cooler inventories through a peripheral bulk sales channel at a low gross margin, which reduced gross margin by approximately 90 basis points. These factors, which contributed to the aggregate reduction of consolidated gross margin, were partially offset by the favorable impact of: · reduced air freight on incoming Drinkware product deliveries as a percentage of net sales in fiscal 2017 versus fiscal 2016, which favorably impacted gross margin by approximately 250 basis points; and · an increase in the mix of higher margin DTC net sales in fiscal 2017 compared to fiscal 2016, which favorably impacted gross margin by approximately 80 basis points. Selling, General, and Administrative Expenses SG&A decreased $95.1 million, or 29%, to $230.6 million in fiscal 2017, compared to $325.8 million in fiscal 2016. As a percentage of net sales, SG&A decreased to 36.1% in 2017 from 39.8% in 2016. The decrease in SG&A was primarily driven by a non-recurring charge to non-cash stock-based compensation of $104.4 million recognized in the first quarter of 2016, resulting from the accelerated vesting of certain outstanding stock options. After adjusting for the non-recurring charge to non-cash stock-based compensation expense, SG&A increased by $9.3 million in fiscal 2017. The increase in SG&A was driven primarily by increases in the following: Amazon Marketplace fees of $16.8 million; costs for outsourced warehousing and logistics and outbound freight of $8.1 million; depreciation and amortization of $5.3 million; and information technology expenses of $4.0 million. These SG&A increases were partially offset by a $15.8 million reduction in professional fees, largely related to our fiscal 2016 IPO preparation, and a $12.7 million reduction in marketing expense. Non-Operating Expenses Interest expense was $32.6 million in fiscal 2017, compared to $21.7 million in fiscal 2016. The increase in interest expense was primarily due to additional long-term indebtedness incurred under the Credit Facility in May 2016. Other income was $0.7 million in fiscal 2017, compared to other expense of $1.2 million in fiscal 2016. Other income in fiscal 2017 related to settlements received in certain actions to enforce our intellectual property in excess of amounts netted against related intangibles. Other expense in fiscal 2016 related to losses on early retirement of debt, primarily from unamortized deferred financing costs on our prior credit facility, which was outstanding at the time of repayment in May 2016. Income tax expense was $16.7 million in fiscal 2017 compared to $16.5 million in fiscal 2016. The effective tax rate increased to 52% in 2017 from 25% in fiscal 2016. We recognized additional income tax expense of $5.7 million in fiscal 2017, primarily due to the revaluation of our net deferred tax assets based on the enactment of the Tax Act. In addition, income tax expense was lower than usual in fiscal 2016 due to a higher benefit from the research and development credit and the consolidation of Rambler On as a variable interest entity. Rambler On was a partnership, and as a nontaxable pass-through entity, no income tax was recorded on its income. Non-GAAP Financial Measures We define Adjusted Operating Income and Adjusted Net Income as operating income and net income, respectively, adjusted for non-cash stock-based compensation expense, asset impairment charges, investments in new retail locations and international market expansion, transition to Cortec majority ownership, transition to the ongoing senior management team, and transition to a public company, and, in the case of Adjusted Net Income, also adjusted for accelerated amortization of deferred financing fees and the loss from early extinguishment of debt resulting from early prepayments of debt, and the tax impact of all adjustments. Adjusted Net Income per share is calculated using Adjusted Net Income, as defined above, and diluted weighted average shares outstanding. We define Adjusted EBITDA as net income before interest expense, net, provision (benefit) for income taxes and depreciation and amortization, adjusted for the impact of certain other items, including: non-cash stock-based compensation expense; asset impairment charges; accelerated amortization of deferred financing fees and loss from early extinguishment of debt resulting from the early prepayment of debt; investments in new retail locations and international market expansion; transition to Cortec majority ownership; transition to the ongoing senior management team; and transition to a public company. The expenses incurred related to these transitional events include: management fees and contingent consideration related to the transition to Cortec majority ownership; severance, recruiting, and relocation costs related to the transition to our ongoing senior management team; consulting fees, recruiting fees, salaries and travel costs related to members of our Board of Directors, fees associated with Sarbanes-Oxley Act compliance, and incremental audit and legal fees in connection with our transition to a public company. All of these transitional costs are reported in SG&A expenses. Adjusted Operating Income, Adjusted Net Income, Adjusted Net Income per diluted share, and Adjusted EBITDA are not defined by GAAP and may not be comparable to similarly titled measures reported by other entities. We use these non-GAAP measures, along with GAAP measures, as a measure of profitability. These measures help us compare our performance to other companies by removing the impact of our capital structure; the effect of operating in different tax jurisdictions; the impact of our asset base, which can vary depending on the book value of assets and methods used to compute depreciation and amortization; the effect of non-cash stock-based compensation expense, which can vary based on plan design, share price, share price volatility, and the expected lives of equity instruments granted; as well as certain expenses related to what we believe are events of a transitional nature. We also disclose Adjusted Operating Income, Adjusted Net Income, and Adjusted EBITDA as a percentage of net sales to provide a measure of relative profitability. We believe that these non-GAAP measures, when reviewed in conjunction with GAAP financial measures, and not in isolation or as substitutes for analysis of our results of operations under GAAP, are useful to investors as they are widely used measures of performance and the adjustments we make to these non-GAAP measures provide investors further insight into our profitability and additional perspectives in comparing our performance to other companies and in comparing our performance over time on a consistent basis. Adjusted Operating Income, Adjusted Net Income, and Adjusted EBITDA have limitations as profitability measures in that they do not include the interest expense on our debts, our provisions for income taxes, and the effect of our expenditures for capital assets and certain intangible assets. In addition, all of these non-GAAP measures have limitations as profitability measures in that they do not include the effect of non-cash stock-based compensation expense, the effect of asset impairments, the effect of investments in new retail locations and international market expansion, and the impact of certain expenses related to transitional events that are settled in cash. Because of these limitations, we rely primarily on our GAAP results. In the future, we may incur expenses similar to those for which adjustments are made in calculating Adjusted Operating Income, Adjusted Net Income, and Adjusted EBITDA. Our presentation of these non-GAAP measures should not be construed as a basis to infer that our future results will be unaffected by extraordinary, unusual or non-recurring items. The following table reconciles operating income to Adjusted Operating Income, net income to Adjusted Net Income, and net income to Adjusted EBITDA for the periods indicated (in thousands): _________________________ (1) These costs are reported in SG&A expenses. (2) Represents retail store pre-opening expenses and costs for expansion into new international markets. (3) Represents management service fees paid to Cortec, our majority stockholder. The management services agreement with Cortec was terminated immediately following the completion of our IPO. (4) Represents severance, recruiting, and relocation costs related to the transition to our ongoing senior management team. (5) Represents fees and expenses in connection with our transition to, and prior to our becoming, a public company, including consulting fees, recruiting fees, salaries, and travel costs related to members of our Board of Directors, fees associated with Sarbanes-Oxley Act compliance, and incremental audit and legal fees associated with being a public company. The 2017 activity primarily consists of the reversal of a previously recognized consulting fee that was contingent upon the completion of our IPO attempt during 2016. (6) Represents the loss on extinguishment of debt of $0.7 million and accelerated amortization of deferred financing fees of $0.6 million resulting from the voluntary repayments and prepayments of the term loans under our Credit Facility. During the fourth quarter of fiscal 2018, we voluntarily repaid in full the $47.6 million outstanding balance of the Term Loan B (as defined below) and made a voluntary repayment of $2.4 million to the Term Loan A (as defined below). During the third quarter of fiscal 2018, we made a voluntary prepayment of $30.1 million to the Term Loan B. As a result of the voluntary repayment of the Term Loan B prior to its maturity on May 19, 2022, we recorded a loss from extinguishment of debt relating to the write-off of unamortized financing fees associated with the Term Loan B. (7) Represents the tax impact of adjustments calculated at an expected statutory tax rate of 23.3% for fiscal 2018. (8) Depreciation and amortization expenses are reported in SG&A expenses and cost of goods sold. Liquidity and Capital Resources Our cash requirements have principally been for working capital purposes, long-term debt repayments, and capital expenditures. We fund our working capital, primarily inventory, and accounts receivable, and capital investments from cash flows from operating activities, cash on hand, and borrowings available under our Revolving Credit Facility (as defined below). As of December 29, 2018, we had $29.6 million of working capital (excluding cash), a cash balance of $80.1 million, and $80.0 million available for borrowing under our Revolving Credit Facility. The recent changes in our working capital requirements generally reflect the growth in our business. Although we cannot predict with certainty all of our particular short term cash uses or the timing or amount of cash requirements, to operate and grow our business, we believe that our available cash on hand, along with amounts available under our Credit Facility will be sufficient to satisfy our liquidity requirements for at least the next twelve months. However, the continued growth of our business, including our expansion into international markets and opening and operating our own retail locations, may significantly increase our expenses, including our capital expenditures and cash requirements. For fiscal 2019, we expect capital expenditures for property and equipment to be between $35 million and $40 million, including new product development, technology systems infrastructure, opening of retail stores in Chicago, Illinois and Charleston, South Carolina, investments in production molds and tooling and equipment, and the expansion of our Drinkware customization facility. In addition, the amount of our future product sales is difficult to predict, and actual sales may not be in line with our forecasts. As a result, we may be required to seek additional funds in the future from issuances of equity or debt, obtaining additional credit facilities, or loans from other sources. Credit Facility In May 2016, we entered into an agreement providing for a $650.0 million senior secured credit facility (the “Credit Facility”). The Credit Facility provides for: (a) a $100.0 million Revolving Credit Facility maturing on May 19, 2021 (the “Revolving Credit Facility”); (b) a $445.0 million Term loan A maturing on May 19, 2021 (the “Term Loan A”); and (c) a $105.0 million term loan B maturing on May 19, 2022 (the “Term Loan B”). As further described below, we repaid the Term Loan B in full during the fourth quarter of fiscal 2018. As of December 29, 2018, our interest rate on the Term Loan A was 6.35%. Interest is due at the end of each quarter if we have selected to pay interest based on the base rate or at the end of each LIBOR period if we have selected to pay interest based on LIBOR. On July 15, 2017, we amended the Credit Facility to reset the net leverage ratio covenant for the period ended June 2017 and thereafter, and we incurred $2.0 million in additional deferred financing fees. At December 29, 2018, we had $331.4 million principal amount of indebtedness outstanding under the Credit Facility. At December 30, 2017, we had $481.7 million principal amount of indebtedness outstanding under the Credit Facility. Revolving Credit Facility The Revolving Credit Facility, which matures May 19, 2021, allows us to borrow up to $100.0 million, including the ability to issue up to $20.0 million in letters of credit. While our issuance of letters of credit does not increase our borrowings outstanding under our Revolving Credit Facility, it does reduce the amount available. As of December 29, 2018 and December 30, 2017, we had no borrowings outstanding under the Revolving Credit Facility. As of December 29, 2018, we had $20.0 million principal amount in outstanding letters of credit with a 4.0% annual fee to supplement our supply chain finance program. Term Loan A The Term Loan A is a $445.0 million term loan facility, maturing on May 19, 2021. Principal payments of $11.1 million are due quarterly with the entire unpaid balance due at maturity. As of December 29, 2018, we had $331.4 million principal amount of indebtedness outstanding under the Term Loan A. Term Loan B The Term Loan B was a $105.0 million term loan facility that would have matured on May 19, 2022. Principal payments of $0.3 million were due quarterly with the entire unpaid balance due at maturity. During the fourth quarter of 2018, we voluntarily repaid in full the $47.6 million principal amount outstanding and $0.6 million of accrued interest outstanding under our Term Loan B, using the net proceeds from our IPO plus additional cash on hand. As a result of the voluntary repayment of the Term Loan B prior to maturity, we recorded a loss from extinguishment of debt of $0.7 million relating to the write-off of unamortized financing fees associated with the Term Loan B. Other Terms of the Credit Facility We may request incremental term loans, incremental equivalent debt, or revolving commitment increases (each an “Incremental Increase”) of amounts of not more than $125.0 million in total plus an additional amount if our total secured net leverage ratio (as defined in the Credit Facility) is equal to or less than 2.50 to 1.00. In the event that any lenders fund any of the Incremental Increases, the terms and provisions of each Incremental Increase, including the interest rate, shall be determined by us and the lenders, but in no event shall the terms and provisions, when taken as a whole and subject to certain exceptions, of the applicable Incremental Increase, be more favorable to any lender providing any portion of such Incremental Increase than the terms and provisions of the loans provided under the Revolving Credit Facility, the Term Loan A, and the Term Loan B, as applicable. The Credit Facility is (a) jointly and severally guaranteed by our wholly owned subsidiaries, YETI Coolers, LLC, which we refer to as YETI Coolers, and YETI Custom Drinkware LLC, which we refer to as YCD, and any future subsidiaries, together, the Guarantors, and (b) secured by a first-priority lien on substantially all of our and the Guarantors’ assets, subject to certain customary exceptions. The Credit Facility requires us to comply with certain financial ratios, including: · At the end of each fiscal quarter, a total net leverage ratio (as defined in the Credit Facility) for the four quarters then ended of not more than 6.50 to 1.00, 5.50 to 1.00, 4.50 to 1.00, 4.25 to 1.00, 4.00 to 1.00, and 3.50 to 1.00 for the quarters ended December 30, 2017, March 31, 2018, June 30, 2018, September 30, 2018, December 31, 2018, and March 31, 2019 and thereafter, respectively; and · At the end of each fiscal quarter, an interest coverage ratio (as defined in the Credit Facility) for the four quarters then ended of not less than 3.00 to 1.00. In addition, the Credit Facility contains customary financial and non-financial covenants limiting, among other things, mergers and acquisitions; investments, loans, and advances; affiliate transactions; changes to capital structure and the business; additional indebtedness; additional liens; the payment of dividends; and the sale of assets, in each case, subject to certain customary exceptions. The Credit Facility contains customary events of default, including payment defaults, breaches of representations and warranties, covenant defaults, defaults under other material debt, events of bankruptcy and insolvency, failure of any guaranty or security document supporting the Credit Facility to be in full force and effect, and a change of control of our business. We were in compliance with all covenants under the Credit Facility as of December 29, 2018. Equity Repurchase of Common Stock In March 2018, we purchased 0.4 million shares of our common stock at $4.95 per share from one of our stockholders for $2.0 million. We accounted for this purchase using the par value method, and subsequently retired these shares. Stock splits In October 2018, we effected a 0.397-for-1 reverse stock split of all outstanding shares of our common stock. Share and per share data disclosed for all periods has been retroactively adjusted to reflect the effects of this stock split. This stock split was effected prior to the completion of our IPO, discussed below. In May 2016, our Board of Directors approved a 2,000-for-1 stock split of all outstanding shares of our common stock. In connection with the stock split, the number of authorized capital stock was increased from 200,000 to 400 million shares. Capital Stock Increase In October 2018, the Board of Directors approved an increase in our authorized capital stock of 200.0 million shares of common stock and 30.0 million shares of preferred stock. Following this increase our authorized capital stock of 630.0 million shares consisted of 600.0 million shares of common stock and 30.0 million shares of preferred stock. No shares were issued in connection with the increase in authorized capital stock. This capital stock increase occurred prior to the completion our IPO, discussed below. Initial Public Offering On October 24, 2018, we completed our IPO of 16,000,000 shares of our common stock, including 2,500,000 shares of our common stock sold by us and 13,500,000 shares of our common stock sold by selling stockholders. The underwriters were also granted an option to purchase up to an additional 2,400,000 shares from the selling stockholders, at the public offering price, less the underwriting discount, for 30 days after October 24, 2018, which the underwriters exercised, in part, on November 28, 2018 by purchasing an additional 918,830 shares of common stock at the public offering price of $18.00 per share, less the underwriting discount, from selling stockholders. We did not receive any proceeds from the sale of shares by selling stockholders. Based on our IPO price of $18.00 per share, we received net proceeds of $42.4 million after deducting underwriting discounts and commissions of $2.6 million. Additionally, we incurred offering costs of $4.6 million. On November 29, 2018, we used the net proceeds from the IPO plus additional cash on hand to repay our Term Loan B as described above. Cash Flows from Operating, Investing and Financing Activities The following table summarizes our cash flows from operating, investing and financing activities for the periods indicated (in thousands): Operating Activities 2018. Net cash provided by operating activities of $176.1 million for fiscal 2018 was primarily driven by the favorable impact of a decrease in net working capital items of $71.7 million, net income of $57.8 million, and total non-cash items of $46.6 million. The change in net working capital items was primarily due to a $43.7 million increase in accounts payable and accrued expenses related to amounts owed to our third-party manufacturers as well as increased accrued incentive compensation, and a $29.6 million decrease in inventory driven by effective inventory management coupled with increased sales in the fourth quarter of fiscal 2018. Non-cash items primarily consisted of depreciation and amortization of $24.7 million and stock-based compensation expense of $13.2 million. 2017. Net cash provided by operating activities of $147.8 million for fiscal 2017 was primarily driven by the favorable impact of a decrease in net working capital items of $86.7 million, total non-cash items of $45.6 million, and net income of $15.4 million. The change in net working capital was primarily due to a $71.0 million decrease in inventory driven by effective inventory management coupled with increasing sales in the third and fourth quarters of fiscal 2017, a $28.0 million increase in accounts payable and accrued expenses primarily related to extending payment terms with vendors, and a decrease in other current assets of $17.9 million related to migrating towards payment terms with vendors versus prepayments, offset by an increase in accounts receivable of $29.9 million due to higher wholesale sales at the end of 2017. Non-cash items primarily consisted of depreciation and amortization of $20.8 million and stock-based compensation expense of $13.4 million. 2016. Net cash provided by operating activities of $28.9 million for fiscal 2016 was primarily driven by total non-cash items of $115.6 million and net income of $48.8 million, offset by the unfavorable impact of an increase in net working capital items of $135.4 million. Non-cash items primarily consisted of stock-based compensation expense of $118.4 million, deferred income taxes of $15.8 million, and depreciation and amortization of $11.7 million. The change in net working capital was primarily due to a $150.6 million increase in inventory due to increased demand after experiencing supply constraints in 2015. Investing Activities 2018. Net cash used in investing activities of $31.7 million for the fiscal year ended December 29, 2018 was primarily related to $20.9 million of purchases of property and equipment for technology systems infrastructure, production molds, tooling, and equipment, and facilities, and $11.0 million of purchases of intangibles such as trade dress and trademark assets. 2017. Net cash used in investing activities of $38.7 million for the fiscal year ended December 30, 2017 was primarily related to $42.2 million of purchases of property and equipment for technology systems infrastructure, facilities, and production molds, as well as tooling and equipment, partially offset by $4.9 million of net cash inflow from purchases of intangibles activity reflecting cash proceeds from the settlement of litigation matters, partially offset by additions to patents, trade dress, and trademarks. In 2017, we acquired Rambler On and paid approximately $2.9 million for the acquisition, which increased our cash flows used in investing activities. 2016. Net cash used in investing activities of $55.9 million for the fiscal year ended December 31, 2016 was primarily related to $35.6 million of purchases of property and equipment production molds, as well as tooling and equipment, technology systems infrastructure, and facilities, and $24.7 million of purchases of intangibles for patents, trademarks, and trade dress. In addition, Cash flows from investing activities for 2016 were positively impacted by the cash at Rambler On, which totaled $5.0 million at the time of consolidation. Financing Activities 2018. Net cash used in financing activities was $118.0 million for the fiscal year ended December 29, 2018 primarily resulted from $151.8 million of repayments of long-term debt, $2.5 million in dividend payments, and $2.0 million to repurchase common stock from one stockholder that was subsequently retired. These financing activity outflows were partially offset by $38.1 of net proceeds from our IPO. 2017. Net cash used in financing activities was $72.2 million for the fiscal year ended December 30, 2017 primarily resulted from $45.6 million of repayments of long-term debt, a $20.0 million repayment of borrowings outstanding under our Revolving Credit Facility, $2.8 million dividend payments to certain option holders, and $2.0 million paid for financing fees related to the amendment to our Credit Facility. 2016. Net cash provided by financing activities was $8.0 million for the fiscal year ended December 31, 2016 primarily resulted from $473.8 million of net borrowings under the Credit Facility, net of financing fees, partially offset by $453.9 million in dividend payments and $9.6 million of payments of tax withholding obligations in connection with the exercise of stock options. Contractual Obligations The following table summarizes our contractual obligations as of December 29, 2018 (in thousands): Off-Balance Sheet Arrangements. As of December 29, 2018 and December, 30, 2017, we had no off-balance sheet debt or arrangements. Critical Accounting Policies and Estimates Our discussion and analysis of our financial condition and results of operations are based upon our consolidated financial statements, which have been prepared in accordance with GAAP. In preparing the consolidated financial statements, we make estimates and judgments that affect the reported amounts of assets, liabilities, sales, expenses, and related disclosure of contingent assets and liabilities. We re-evaluate our estimates on an on-going basis. Our estimates are based on historical experience and on various other assumptions that we believe to be reasonable under the circumstances. Because of the uncertainty inherent in these matters, actual results may differ from these estimates and could differ based upon other assumptions or conditions. The critical accounting policies that reflect our more significant judgments and estimates used in the preparation of our consolidated financial statements include those noted below. Within the context of these critical accounting policies, we are not currently aware of any reasonably likely events or circumstances that would result in materially different amounts being reported Revenue Recognition Revenue is recognized when persuasive evidence of an arrangement exists, and title and risks of ownership have passed to the customer, based on the terms of sale. Goods are usually shipped to customers with free-on-board (“FOB”) shipping point terms; however, our practice has been to bear the responsibility of the delivery to the customer. In the case that product is lost or damaged in transit to the customer, we generally take the responsibility to provide new product. In effect, we apply a synthetic FOB destination policy and therefore recognize revenue when the product is delivered to the customer. For our national accounts, delivery of our products typically occurs at shipping point, as such customers take delivery at our distribution center. Our terms of sale provide limited return rights. We may accept, and have at times accepted, returns outside our terms of sale at our sole discretion. We may also, at our sole discretion, provide our retail partners with sales discounts and allowances. We record estimated sales returns, discounts, and miscellaneous customer claims as reductions to net sales at the time revenues are recorded. We base our estimates upon historical experience and trends, and upon approval of specific returns or discounts. Actual returns and discounts in any future period are inherently uncertain and thus may differ from our estimates. If actual or expected future returns and discounts were significantly greater or lower than the reserves we had established, we would record a reduction or increase to net sales in the period in which we made such determination. A 10% change in our estimated reserve for sales returns, discounts, and miscellaneous claims for fiscal 2018 would have impacted net sales by $0.7 million. Inventory Inventories are comprised primarily of finished goods and are carried at the lower of cost (weighted-average cost method) or market (net realizable value). We make ongoing estimates relating to the net realizable value of inventories based upon our assumptions about future demand and market conditions. If the estimated net realizable value is less than cost, we reflect the lower value of that inventory. This methodology recognizes inventory exposures at the time such losses are identified rather than at the time the inventory is actually sold. Due to customer demand and inventory constraints, we have not historically taken material adjustments to the carrying value of our inventory. Physical inventory counts and cycle counts are taken on a regular basis. We provide for estimated inventory shrinkage since the last physical inventory date. Historically, physical inventory shrinkage has not been significant. Valuation of Goodwill and Indefinite-Lived Intangible Assets Goodwill and intangible assets are recorded at cost, or at their estimated fair values at the date of acquisition. We review goodwill and indefinite-lived intangible assets for impairment annually or whenever events or changes in circumstances indicate the carrying amount may be impaired. In conducting our annual impairment test, we first review qualitative factors to determine whether it is more likely than not that the fair value of the asset, or reporting units, is less than its carrying amount. If factors indicate that the fair value is less than its carrying amount, we perform a quantitative assessment, analyzing the expected present value of future cash flows to quantify the amount of impairment, if any. We perform our annual impairment tests in the fourth quarter of each fiscal year. We have not historically taken any impairments of our goodwill or indefinite-lived intangible assets, and a 10% reduction in the fair value of our reporting unit would not result in a goodwill impairment. Valuation of Long-Lived Assets We review our long-lived assets, which include property and equipment and definite-lived intangible assets, for impairment whenever events or changes in circumstances indicate the carrying amount of such assets may not be recoverable. An impairment loss on our long-lived assets exists when the estimated undiscounted cash flows expected to result from the use of the asset and its eventual disposition are less than its carrying amount. Any impairment loss recognized represents the excess of the long-lived asset’s carrying value over the estimated fair value. Product Warranty Warranty liabilities are recorded at the time of sale for the estimated costs that may be incurred under the terms of our limited warranty. We make and revise these estimates primarily on the number of units under warranty, historical experience of warranty claims, and an estimated per unit replacement cost. The liability for warranties is included in accrued expenses in our consolidated balance sheets. The specific warranty terms and conditions vary depending upon the product sold but are generally warranted against defects in material and workmanship ranging from three to five years. Our warranty only applies to the original owner. If actual product failure rates or repair costs differ from estimates, revisions to the estimated warranty liabilities would be required and could materially affect our financial condition and operating results. Stock Options We measure compensation expense for all stock-based awards at fair value on the date of grant and recognize compensation expense over the service period for awards expected to vest. We use the Black-Scholes-Merton (“Black-Scholes”) option pricing model to determine the fair value of stock option awards, which uses the expected option term, stock price volatility, and the risk-free interest rate. The expected option term assumption reflects the period for which we believe the option will remain outstanding. We elected to use the simplified method to determine the expected option term, which is the average of the options’ vesting and contractual terms. Our computation of expected volatility is based on the historical volatility of selected comparable publicly traded companies over a period equal to the expected term of the option. The risk-free interest rate reflects the U.S. Treasury yield curve for a similar instrument with the same expected term in effect at the time of the grant. The assumptions used in calculating the fair value of stock-based compensation awards represent management’s best estimates, but the estimates involve inherent uncertainties and the application of management judgment. If any of the assumptions used in the Black-Scholes model changes significantly, stock-based compensation expense for future option awards may differ materially compared with the awards granted previously. Costs relating to stock-based compensation are recognized in SG&A expenses in our consolidated statements of operations, and forfeitures are recognized as they occur. Recent Accounting Pronouncements For a description of recent accounting pronouncements, see the notes to our consolidated financial statements included herein.

<s>[INST] Business Overview We are a designer, marketer, retailer, and distributor of a variety of innovative, branded, premium products to a wideranging customer base. Our mission is to ensure that each YETI product delivers exceptional performance and durability in any environment, whether in the remote wilderness, at the beach, or anywhere else life takes our customers. By consistently delivering highperforming products, we have built a following of engaged brand loyalists throughout the United States, Canada, Australia, and elsewhere, ranging from serious outdoor enthusiasts to individuals who simply value products of uncompromising quality and design. Our relationship with customers continues to thrive and deepen as a result of our innovative new product introductions, expansion and enhancement of existing product families, and multifaceted branding activities. General Components of Our Results of Operations Net Sales. Net sales are comprised of wholesale channel sales to our retail partners and sales through our DTC channel. Net sales in both channels reflect the impact of product returns as well as discounts for certain sales programs or promotions. We discuss the net sales of our products in our two primary categories: Coolers & Equipment and Drinkware. Our Coolers & Equipment category includes hard coolers, soft coolers, outdoor equipment and other products, as well as accessories and replacement parts for these products. Our Drinkware category includes our stainlesssteel drinkware products and related accessories. In addition, our Other category is primarily comprised of ice substitutes, and YETIbranded gear, such as shirts, hats, and other miscellaneous products. Gross profit. Gross profit reflects net sales less cost of goods sold, which primarily includes the purchase cost of our products from our thirdparty contract manufacturers, inbound freight and duties, product quality testing and inspection costs, depreciation expense of our molds and equipment, and the cost of customizing Drinkware products. We calculate gross margin as gross profit divided by net sales. Gross margin in our DTC sales channel is generally higher than that on sales in our wholesale channel. Selling, general, and administrative expenses. Selling, general, and administrative (“SG&A”) expenses consist primarily of marketing costs, employee compensation and benefits costs, costs of our outsourced warehousing and logistics operations, costs of operating on thirdparty DTC marketplaces, professional fees and services, noncash stockbased compensation, cost of product shipment to our customers, depreciation and amortization expense, and general corporate infrastructure expenses. Change in Fiscal Year and Reporting Calendar. Effective January 1, 2017, we converted our fiscal yearend from a calendar year ending December 31 to a “52 to 53week” year ending on the Saturday closest in proximity to December 31, such that each quarterly period will be 13 weeks in length, except during a 53week year when the fourth quarter will be 14 weeks. This did not have a material effect on our consolidated financial statements and, therefore, we did not retrospectively adjust our financial statements. Results of Operations The following table sets forth selected statement of operations data, and their corresponding percentage of net sales, for the periods indicated (dollars in thousands): _________________________ (1) See “NonGAAP Financial Measures” section below for the definitions of our nonGAAP financial measures as well as reconciliations of the nonGAAP financial measures to their most directly comparable GAAP financial measure. Year Ended December 29, 2018 Compared to Year Ended December 30, 2017 Net Sales Net sales increased $139.6 million, or 22%, to $778.8 million in fiscal 2018 from $639.2 million in fiscal 2017. The increase in net sales was driven by increases in net sales from our DTC and wholesale channels. DTC channel net sales increased $93.0 million, or 48%, to $287.4 million in fiscal 2018 from $194.4 million in fiscal 2017. The DTC channel net sales increase was primarily driven by net sales increases in both Drinkware and Coolers & Equipment. Wholesale channel net sales increased $46. [/INST] Negative. </s>

YETI Holdings, Inc.

2020-02-18

2019-12-28

Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations The following discussion and analysis contains forward-looking statements within the meaning of the federal securities laws, and should be read in conjunction with the disclosures we make concerning risks and other factors that may affect our business and operating results, including those set forth in Part I, Item 1A, “Risk Factors” of this Report. The information contained in this section should also be read in conjunction with our consolidated financial statements and related notes and the information contained elsewhere in this Report. See also “Forward-Looking Statements” immediately prior to Part I, Item 1, “Business” in this Report. Business Overview We are a growing designer, marketer, retailer, and distributor of a variety of innovative, branded, premium products to a wide-ranging customer base. Our mission is to ensure that each YETI product delivers exceptional performance and durability in any environment, whether in the remote wilderness, at the beach, or anywhere else life takes our customers. By consistently delivering high-performing products, we have built a following of engaged brand loyalists throughout the United States, Canada, Australia, and elsewhere, ranging from serious outdoor enthusiasts to individuals who simply value products of uncompromising quality and design. Our relationship with customers continues to thrive and deepen as a result of our innovative new product introductions, expansion and enhancement of our existing product families, and multifaceted branding activities. General Components of Our Results of Operations Net Sales. Net sales are comprised of wholesale channel sales to our retail partners and sales through our DTC channel. Net sales in both channels reflect the impact of product returns as well as discounts for certain sales programs or promotions. We discuss the net sales of our products in our two primary categories: Coolers & Equipment and Drinkware. Our Coolers & Equipment category includes hard coolers, soft coolers, outdoor equipment and other products, as well as accessories and replacement parts for these products. Beginning in 2019, we began reporting Boomer Dog Bowl net sales in our Coolers & Equipment instead of in our Other category. Our Drinkware category includes our stainless-steel drinkware products and related accessories. In addition, our Other category is primarily comprised of ice substitutes, and YETI-branded gear, such as shirts, hats, and other miscellaneous products. Gross profit. Gross profit reflects net sales less cost of goods sold, which primarily includes the purchase cost of our products from our third-party contract manufacturers, inbound freight and duties, product quality testing and inspection costs, depreciation expense of our molds and equipment, and the cost of customizing Drinkware products. We calculate gross margin as gross profit divided by net sales. Gross margin in our DTC sales channel is generally higher than that on sales in our wholesale channel. Selling, general, and administrative expenses. Selling, general, and administrative (“SG&A”) expenses consist primarily of marketing costs, employee compensation and benefits costs, costs of our outsourced warehousing and logistics operations, costs of operating on third-party DTC marketplaces, professional fees and services, non-cash stock-based compensation, cost of product shipment to our customers, depreciation and amortization expense, and general corporate infrastructure expenses. Change in Fiscal Year and Reporting Calendar. Effective January 1, 2017, we converted our fiscal year-end from a calendar year ending December 31 to a 52- to 53-week year ending on the Saturday closest in proximity to December 31, such that each quarterly period will be 13 weeks in length, except during a 53-week year when the fourth quarter will be 14 weeks. Fiscal year 2020 will be a 53-week period. Unless otherwise stated, references to particular years, quarters, months and periods refer to our fiscal years ended in December and the associated quarters, months, and periods of those fiscal years. Our change in fiscal year did not have a material effect on our consolidated financial statements and, therefore, we did not retrospectively adjust our financial statements. Results of Operations The following table sets forth selected statement of operations data, and their corresponding percentage of net sales, for the periods indicated (dollars in thousands): Year Ended December 28, 2019 Compared to Year Ended December 29, 2018 Net Sales Net sales increased $134.9 million, or 17%, to $913.7 million in 2019 from $778.8 million in 2018. The increase in net sales was driven by increases in net sales from our DTC and wholesale channels. DTC channel net sales increased $98.7 million, or 34%, to $386.1 million in 2019 from $287.4 million in 2018. The DTC channel net sales increase was driven by strong performance in both primary product categories, particularly Drinkware. Wholesale channel net sales increased $36.2 million, or 7%, to $527.6 million in 2019 from $491.4 million in 2018. The wholesale channel net sales increase was primarily driven by strong performance across both primary product categories. Net sales in our two primary product categories were as follows: •Drinkware net sales increased $102.1 million, or 24%, to $526.2 million in 2019 from $424.2 million in 2018. The increase in Drinkware net sales was primarily driven by the expansion of our Drinkware product offerings during 2019, including the introduction of new colorways, sizes, and accessories, and strong demand for customization. •Coolers & Equipment net sales increased $37.7 million, or 11%, to $368.9 million in 2019 from $331.2 million in 2018. The increase in Coolers & Equipment net sales was primarily driven by strong performance in outdoor living products, bags, hard coolers, soft coolers, and cargo. Gross Profit Gross profit increased $92.2 million, or 24%, to $475.3 million in 2019 from $383.1 million in 2018. Gross margin increased 280 basis points to 52.0% in 2019 from 49.2% in 2018. The increase in gross margin was primarily driven by: •cost improvements across our product portfolio, particularly in our Drinkware category, which favorably impacted gross margin by approximately 270 basis points; •an increase in the mix of higher margin DTC channel net sales, which favorably impacted gross margin by approximately 150 basis points; and •lower inbound air freight, reflecting higher costs to expedite Drinkware inventory supply in the prior period, which favorably impacted gross margin by approximately 80 basis points. These factors, which contributed to the increase in gross margin were partially offset by the unfavorable impact of: •increased tariff rates, which reduced gross margin by approximately 100 basis points; •higher inventory reserves, which reduced gross margin by approximately 70 basis points; and •end-of-life price reductions on our Hopper Two 30 soft cooler implemented in the second quarter of 2019 and other impacts, which reduced gross margin by approximately 50 basis points. Selling, General, and Administrative Expenses SG&A expenses increased by $104.6 million, or 37%, to $385.5 million in 2019 from $281.0 million in 2018. As a percentage of net sales, SG&A expenses increased 610 basis points to 42.2% in 2019. The increase in SG&A expenses were primarily driven by: •an increase in general and administrative expenses of $66.9 million, or 450 basis points, comprised of: -higher non-cash stock-based compensation expense, primarily driven by pre-IPO performance-based restricted stock units (“RSUs”) that vested and were fully recognized in the fourth quarter of 2019; -increased personnel to support long-term growth in our business; -higher temporary labor and information technology expenses to support growth and continued development of our omni-channel capabilities; -incremental costs incurred in connection with our ongoing transition to a public company, including costs incurred in connection with our secondary offerings in May 2019 and November 2019; -increased depreciation and amortization expense; and -increased facilities costs; -partially offset by a decrease in other operating expenses; and •an increase in selling expenses of $37.6 million, or 160 basis points, comprised of: -higher variable selling expenses, driven by our faster growing DTC channel net sales, including marketplace fees, outbound freight, and credit card fees; and -higher marketing expenses, which were broad-based across both brand and performance marketing efforts. Non-Operating Expenses Interest expense was $21.8 million in 2019, compared to $31.3 million in 2018. The decrease in interest expense was primarily due to decreased outstanding long-term debt under our Credit Facility. Income tax expense was $16.8 million in 2019, compared to $11.9 million in 2018. Our effective tax rate for 2019 was 25% compared to 17% for 2018. The increase in effective tax rate was primarily due to an increase in state income tax expense due to expanding our operations to additional states and a discrete tax expense associated with the pre-IPO performance-based RSUs that vested and were fully recognized in the fourth quarter of 2019. In addition, income tax expense in 2018 was lower due to a benefit from a revaluation of state deferred tax assets and the stock compensation tax benefit of exercised options primarily in connection with our IPO. Year Ended December 29, 2018 Compared to Year Ended December 30, 2017 Net Sales Net sales increased $139.6 million, or 22%, to $778.8 million in 2018 from $639.2 million in 2017. The increase in net sales was driven by increases in net sales from our DTC and wholesale channels. DTC channel net sales increased $93.0 million, or 48%, to $287.4 million in 2018 from $194.4 million in 2017. The DTC channel net sales increase was primarily driven by net sales increases in both Drinkware and Coolers & Equipment. Wholesale channel net sales increased $46.6 million, or 10%, to $491.4 million in 2018 from $444.9 million in 2017. The wholesale channel net sales increase was primarily driven by an increase in Drinkware net sales. Net sales in our two primary product categories were as follows: •Drinkware net sales increased $113.9 million, or 37%, to $424.2 million in 2018 from $310.3 million in 2017. The increase in Drinkware net sales was primarily driven by the expansion of our Drinkware product line, new accessories, and the introduction of new colorways during 2018. •Coolers & Equipment net sales increased $19.0 million, or 6%, to $331.2 million in 2018 from $312.2 million in 2017. The increase in Coolers & Equipment net sales was primarily driven by the expansion of our hard cooler and soft cooler products, as well as the introduction of several new storage, transport, and outdoor living products during 2018. Gross Profit Gross profit increased $88.5 million, or 30%, to $383.1 million in 2018 from $294.6 million in 2017. Gross margin increased 310 basis points to 49.2% in 2018 from 46.1% in 2017. The increase in gross margin was primarily driven by the following: •leveraging fixed costs on higher net sales, which favorably impacted gross margin by approximately 180 basis points; •cost improvements across our product portfolio, which favorably impacted gross margin by approximately 170 basis points; •charges incurred in 2017 for inventory reserves that were not repeated in 2018, which favorably impacted gross margin by approximately 150 basis points; •increased higher-margin DTC channel sales, which favorably impacted gross margin by approximately 110 basis points; •charges incurred in 2017 for pricing actions related to our first-generation Hopper that were not repeated in 2018, which favorably impacted gross margin by approximately 30 basis points; and •decreased provisions for sales returns in 2018 compared to 2017, which favorably impacted gross margin by approximately 30 basis points. The above increases in gross margin were partially offset by price reductions on select hard cooler, soft cooler, and Drinkware products, which began in the second half of 2017 and in 2018 to reposition these products in the market to create pricing space for new product introductions, which reduced gross margin by approximately 360 basis points in 2018. Selling, General, and Administrative Expenses SG&A expenses increased by $50.3 million, or 22%, to $281.0 million in 2018 from $230.6 million in 2017. As a percentage of net sales, SG&A expenses remained consistent at 36.1% in 2018 and 2017. SG&A expenses were impacted by the following: •an increase in employee costs resulting from increased headcount to support the growth in our business; •an increase in variable expenses such as marketplace fees, credit card fees and distribution costs primarily as a result of increased net sales; •an increase in professional fees, including the impact of reversing a previously recognized consulting fee in 2017 that was contingent upon the completion of our IPO attempt in 2016; •an increase in information technology-related costs; •an increase in depreciation and amortization expense; and •an increase in other costs primarily due to an increase in facilities and utility costs and other operating expenses. Non-Operating Expenses Interest expense decreased by $1.3 million to $31.3 million in 2018 from $32.6 million in 2017. The decrease in interest expense was primarily due to decreased outstanding long-term debt under our Credit Facility. Income tax expense decreased by $4.8 million to $11.9 million in 2018 from $16.7 million in 2017. Our effective tax rate for 2018 was 17% compared to 52% for 2017. The decrease in effective tax rate was due to the federal tax rate reduction in 2018, a benefit from a revaluation of state deferred tax assets, and the stock compensation tax benefit of exercised options in 2018 primarily in connection with our IPO, partially offset by an increase in state income tax expense due to expanding our operations to additional states. In addition, the income tax expense in 2017 was unusually high due to the revaluation of our net deferred tax assets as a result of the enactment of the Tax Act, which reduced the U.S. federal corporate tax rate from 35% to 21%. Liquidity and Capital Resources General Our cash requirements have principally been for working capital purposes, long-term debt repayments, and capital expenditures. We fund our working capital, primarily inventory, and accounts receivable, and capital investments from cash flows from operating activities, cash on hand, and borrowings available under our Revolving Credit Facility (as defined below). We believe that our cash on hand, cash from operations, borrowings available under our Revolving Credit Facility will be sufficient to satisfy our liquidity needs and capital expenditure requirements for at least the next twelve months. Current Liquidity As of December 28, 2019, we had $117.7 million of working capital (excluding cash), a cash balance of $72.5 million, and $150.0 million available for borrowing under our Revolving Credit Facility. Credit Facility At December 28, 2019, we had $300.0 million principal amount of indebtedness outstanding under the Credit Facility (as defined in Note 9 of the Notes to Consolidated Financial Statements). We were in compliance with all covenants under the Credit Facility as of December 28, 2019. In December 2019, we entered into a second amendment to the credit agreement governing our Credit Facility (the “Amendment”) to, among other things, extend the maturity dates of the Revolving Credit Facility and Term Loan A. See Note 9 of the Notes to Consolidated Financial Statements for further discussion. Revolving Credit Facility The Revolving Credit Facility, which matures on December 17, 2024, allows us to borrow up to $150.0 million, including the ability to issue up to $20.0 million in letters of credit. While our issuance of letters of credit does not increase our borrowings outstanding under our Revolving Credit Facility, it does reduce the amount available. As of December 28, 2019 and December 29, 2018, we had no borrowings outstanding under the Revolving Credit Facility. As of December 28, 2019, we had no outstanding letters of credit. As of December 29, 2018, we had $20.0 million principal amount outstanding letters of credit with a 4.0% annual fee to supplement our supply chain finance program. Term Loan A The Term Loan A is a $300.0 million term loan facility, maturing on December 17, 2024. Principal payments of $3.8 million are due quarterly during 2020 and $5.6 million quarterly during 2021 to 2024 with the entire unpaid balance due at maturity. As of December 28, 2019, we had $300.0 million principal amount of indebtedness outstanding under the Term Loan A with an interest rate of 3.99%, which was based on LIBOR. Interest is due at the end of each quarter if we have selected to pay interest based on the base rate or at the end of each LIBOR period if we have selected to pay interest based on LIBOR. Repurchase of Common Stock In March 2018, we purchased 0.4 million shares of our common stock at $4.95 per share from one of our stockholders for $2.0 million. We accounted for this purchase using the par value method, and subsequently retired these shares. Stock Splits In October 2018, we effected a 0.397-for-1 reverse stock split of all outstanding shares of our common stock. Share and per share data disclosed for all periods has been retroactively adjusted to reflect the effects of this stock split. This stock split was effected prior to the completion of our IPO, discussed below. Capital Stock Increase In October 2018, the Board of Directors approved an increase in our authorized capital stock of 200.0 million shares of common stock and 30.0 million shares of preferred stock. Following this increase our authorized capital stock of 630.0 million shares consisted of 600.0 million shares of common stock and 30.0 million shares of preferred stock. No shares were issued in connection with the increase in authorized capital stock. This capital stock increase occurred prior to the completion our IPO, discussed below. Public Offerings of Common Stock On October 29, 2018, we completed our IPO of 16.0 million shares of our common stock at $18.00 per share, including 2.5 million shares of our common stock sold by us and 13.5 million shares of our common stock sold by selling stockholders. The underwriters were also granted an option to purchase up to an additional 2.4 million shares from the selling stockholders, at the public offering price, less the underwriting discount, for 30 days after October 24, 2018, which the underwriters exercised, in part, on November 28, 2018 by purchasing an additional 0.9 million shares of common stock at the public offering price of $18.00 per share, less the underwriting discount, from selling stockholders. We did not receive any proceeds from the sale of shares by selling stockholders. Based on our IPO price of $18.00 per share, we received net proceeds of $42.4 million after deducting underwriting discounts and commissions of $2.6 million. Additionally, we incurred offering costs of $4.6 million. On November 29, 2018, we used the proceeds plus additional cash on hand to repay $50.0 million of outstanding borrowings under our Term Loan B as described above. On May 15, 2019, we completed a secondary offering of 10.9 million shares of our common stock at a public offering price of $28.50 per share, all of which shares were sold by selling stockholders. We did not receive any proceeds from this offering. On November 12, 2019, we completed a secondary offering of 11.5 million shares of our common stock at a public offering price of $29.00 per share, all of which shares were sold by selling stockholders. We did not receive any proceeds from this offering. Cash Flows from Operating, Investing and Financing Activities The following table summarizes our cash flows from operating, investing and financing activities for the periods indicated (in thousands): Operating Activities 2019. Net cash provided by operating activities of $86.9 million for 2019 was primarily driven by net income of $50.4 million and total non-cash items of $100.4 million, offset by the unfavorable impact of an increase in net working capital items of $63.9 million. Non-cash items primarily consisted of stock-based compensation expense of $52.3 million, depreciation and amortization of $29.0 million, deferred income taxes of $15.6 million, the amortization of deferred financing fees of $2.2 million, the loss on modification and extinguishment related to the Amendment of our Credit Facility of $0.6 million, and the impairment of long-lived assets of $0.6 million. The change in net working capital items was primarily due to a $40.5 million increase in inventory, primarily reflecting a strategic buildup of Drinkware in advance of potential tariffs as well as investments to support anticipated sales growth; a $19.9 million increase in accounts receivable; a $6.8 million increase in other current assets primarily related to an increase in prepaid information technology expenses; and a $3.1 million decrease in taxes payable, offset by a $6.6 million increase in accounts payable and accrued expenses related to trade payables primarily related to extending payment terms with vendors. 2018. Net cash provided by operating activities of $176.1 million for 2018 was primarily driven by net income of $57.8 million, total non-cash items of $46.6 million, and the favorable impact of a decrease in net working capital items of $71.7 million. Non-cash items primarily consisted of depreciation and amortization of $24.7 million and stock-based compensation expense of $13.2 million. The change in net working capital items was primarily due to a $43.7 million increase in accounts payable and accrued expenses related to extending payment terms with vendors, as well as increased accrued incentive compensation, and a $29.6 million decrease in inventory driven by effective inventory management coupled with increased sales in the fourth quarter of 2018. 2017. Net cash provided by operating activities of $147.8 million for 2017 was primarily driven by net income of $15.4 million, total non-cash items of $45.6 million, and the favorable impact of a decrease in net working capital items of $86.7 million. Non-cash items primarily consisted of depreciation and amortization of $20.8 million and stock-based compensation expense of $13.4 million. The change in net working capital was primarily due to a $71.0 million decrease in inventory driven by effective inventory management coupled with increasing sales in the third and fourth quarters of 2017, a $28.0 million increase in accounts payable and accrued expenses primarily related to extending payment terms with vendors, and a decrease in other current assets of $17.9 million related to transitioning towards payment terms with vendors versus prepayments, offset by an increase in accounts receivable of $29.9 million due to higher wholesale sales at the end of 2017. Investing Activities 2019. Net cash used in investing activities of $48.7 million for 2019 was primarily related to $32.1 million of purchases of property and equipment for technology systems infrastructure, production molds, tooling, and equipment, and facilities, and $16.6 million of additions of intangibles such as trade dress, patents, and trademark assets. 2018. Net cash used in investing activities of $31.7 million for 2018 was primarily related to $20.9 million of purchases of property and equipment for technology systems infrastructure, production molds, tooling, and equipment, and facilities, and $11.0 million of additions of intangibles such as trade dress and trademark assets. 2017. Net cash used in investing activities of $38.7 million for 2017 was primarily related to $42.2 million of purchases of property and equipment for technology systems infrastructure, facilities, and production molds, as well as tooling and equipment, partially offset by $4.9 million of net cash inflow from purchases of intangibles activity reflecting cash proceeds from the settlement of litigation matters, partially offset by additions to patents, trade dress, and trademarks. In 2017, we acquired Rambler On and paid approximately $2.9 million for the acquisition, which increased our cash flows used in investing activities. Financing Activities 2019. Net cash used in financing activities was $45.7 million for 2019 primarily resulted from $34.9 million of repayments of long-term debt, $13.5 million of taxes paid related to the net share settlement of stock-based compensation, $0.6 million in dividend payments, and $0.1 million of net borrowings related to the Amendment of our Credit Facility, net of deferred financing fees. These financing activity outflows were partially offset by $3.5 million of proceeds from employee stock transactions. 2018. Net cash used in financing activities was $118.0 million for 2018 primarily resulted from $151.8 million of repayments of long-term debt, $2.5 million in dividend payments, and $2.0 million to repurchase common stock from one stockholder that was subsequently retired. These financing activity outflows were partially offset by $38.1 million of net proceeds from our IPO. 2017. Net cash used in financing activities was $72.2 million for 2017 primarily resulted from $45.6 million of repayments of long-term debt, a $20.0 million repayment of borrowings outstanding under our Revolving Credit Facility, $2.8 million dividend payments to certain option holders, and $2.0 million paid for financing fees related to the amendment to our Credit Facility. For 2020, we expect capital expenditures for property and equipment to be between $30 million and $35 million, including new product development, technology systems infrastructure, opening of new retail stores, and investments in production molds and tooling and equipment. Contractual Obligations The following table summarizes our contractual obligations as of December 28, 2019 (in thousands): Off-Balance Sheet Arrangements. As of December 28, 2019, we had no off-balance sheet debt or arrangements. Critical Accounting Policies and Estimates Our discussion and analysis of our financial condition and results of operations are based upon our consolidated financial statements, which have been prepared in accordance with GAAP. In preparing the consolidated financial statements, we make estimates and judgments that affect the reported amounts of assets, liabilities, sales, expenses, and related disclosure of contingent assets and liabilities. We re-evaluate our estimates on an on-going basis. Our estimates are based on historical experience and on various other assumptions that we believe to be reasonable under the circumstances. Because of the uncertainty inherent in these matters, actual results may differ from these estimates and could differ based upon other assumptions or conditions. See Note 1 of the Notes to Consolidated Financial Statements for our significant accounting policies. The following describes significant judgments and estimates used in the application of these policies. Within the context of these critical accounting policies, we are not currently aware of any reasonably likely events or circumstances that would result in materially different amounts being reported. Revenue Recognition As discussed in the “Recently Adopted Accounting Standards” section in Note 1 of the Notes to Consolidated Financial Statements, we adopted the new revenue recognition standard at the beginning of 2019. Revenue transactions associated with the sale of YETI branded coolers, equipment, drinkware, apparel and accessories comprise a single performance obligation, which consists of the sale of products to customers either through our wholesale or DTC channels. Revenue is recognized when performance obligations are satisfied through the transfer of control of promised goods to the customers, based on the terms of sale. The transfer of control typically occurs at a point in time based on consideration of when the customer has an obligation to pay for the goods, and physical possession of, legal title to, and the risks and rewards of ownership of the goods has been transferred, and the customer has accepted the goods. Revenue from wholesale transactions is generally recognized at the time products are shipped based on contractual terms with the customer. Revenue from our DTC channel is generally recognized at the point of sale in our retail stores and at the time products are shipped for e-commerce transactions and corporate sales based on contractual terms with the customer. Revenue is recognized net of estimates of variable consideration, including product returns, customer discounts and allowances, sales incentive programs, and miscellaneous claims from customers. We determine these estimates based on contract terms, evaluations of historical experience, anticipated trends, and other factors. The actual amount of customer returns and customer allowances, which is inherently uncertain, may differ from our estimates. The duration of contractual arrangements with our customers is typically less than one year. Payment terms with wholesale customers vary depending on creditworthiness and other considerations, with the most common being net 30 days. Payment is due at the time of sale for retail store transactions and at the time of shipment for e-commerce transactions. Certain products that we sell include a limited warranty which does not meet the definition of a performance obligation within the context of the contract. Product warranty costs are estimated based on historical and anticipated trends and are recorded as cost of goods sold at the time revenue is recognized. Revenue from the sale of gift cards is initially deferred and recognized as a contract liability until the gift card is redeemed by the customer. We elected to account for shipping and handling as fulfillment activities, and not as separate performance obligations. Shipping and handling fees billed to customers are included in net sales. All shipping and handling activity costs are recognized as selling, general and administrative expenses at the time the related revenue is recognized. Sales taxes collected from customers and remitted directly to government authorities are excluded from net sales and cost of goods sold. Our terms of sale provide limited return rights. We may accept, and have at times accepted, returns outside our terms of sale at our sole discretion. We may also, at our sole discretion, provide our retail partners with sales discounts and allowances. We record estimated sales returns, discounts, and miscellaneous customer claims as reductions to net sales at the time revenues are recorded. We base our estimates upon historical experience and trends, and upon approval of specific returns or discounts. Actual returns and discounts in any future period are inherently uncertain and thus may differ from our estimates. If actual or expected future returns and discounts were significantly greater or lower than the reserves we had established, we would record a reduction or increase to net sales in the period in which we made such determination. A 10% change in our estimated reserve for sales returns, discounts, and miscellaneous claims for 2019 would have impacted net sales by $0.7 million. For periods prior to adoption, revenue was recognized when persuasive evidence of an arrangement existed, and title and risks of ownership had passed to the customer, based on the terms of sale. Goods were usually shipped to customers with free-on-board (“FOB”) shipping point terms; however, our practice was to bear the responsibility of the delivery to the customer. In the case that product was lost or damaged in transit to the customer, we generally took the responsibility to provide new product. In effect, we applied a synthetic FOB destination policy and therefore recognized revenue when the product was delivered to the customer. For our national accounts, delivery of our products typically occurred at shipping point, as such customers took delivery at our distribution center. Inventory Inventories are comprised primarily of finished goods and are carried at the lower of cost (weighted-average cost method) or market (net realizable value). We make ongoing estimates relating to the net realizable value of inventories based upon our assumptions about future demand and market conditions. If the estimated net realizable value is less than cost, we reflect the lower value of that inventory. This methodology recognizes inventory exposures at the time such losses are identified rather than at the time the inventory is actually sold. Due to customer demand and inventory constraints, we have not historically taken material adjustments to the carrying value of our inventory. Our inventory valuation reflects adjustments for anticipated inventory losses that have occurred since the last physical inventory. We estimate inventory shrinkage based on historical trends from physical inventory counts and cycle counts. We perform physical inventory counts and cycle counts throughout the year and adjust the shrink provision accordingly. Historically, physical inventory shrinkage has not been significant. Valuation of Goodwill and Indefinite-Lived Intangible Assets Goodwill and intangible assets are recorded at cost, or at their estimated fair values at the date of acquisition. We review goodwill and indefinite-lived intangible assets for impairment annually or whenever events or changes in circumstances indicate the carrying amount may be impaired. In conducting our annual impairment test, we first review qualitative factors to determine whether it is more likely than not that the fair value of the asset, or reporting units, is less than its carrying amount. If factors indicate that the fair value is less than its carrying amount, we perform a quantitative assessment, analyzing the expected present value of future cash flows to quantify the amount of impairment, if any. Based on our qualitative assessment, we determined that it is not more likely than not that the fair value of each reporting unit is lower than its carrying value; therefore, the quantitative impairment test was not required. We did not record any goodwill or indefinite-lived intangible assets impairment charges during the years ended December 28, 2019, December 29, 2018 or December 30, 2017. Valuation of Long-Lived Assets We assess the recoverability of our long-lived assets, which include property and equipment, operating lease right-of-use-assets, and definite-lived intangible assets, for impairment whenever events or changes in circumstances indicate the carrying amount of such assets may not be recoverable. An impairment loss on our long-lived assets exists when the estimated undiscounted cash flows expected to result from the use of the asset and its eventual disposition are less than its carrying amount. If the carrying amount exceeds the sum of the undiscounted cash flows, an impairment charge is recognized based on the amount by which the carrying amount of the assets exceeds the estimated fair value of the assets. Assets to be disposed of are reported at the lower of the carrying amount or estimated fair value less costs to sell. Product Warranty Warranty liabilities are recorded at the time of sale for the estimated costs that may be incurred under the terms of our limited warranty. We make and revise these estimates primarily on the number of units under warranty, historical experience of warranty claims, and an estimated per unit replacement cost. The liability for warranties is included in accrued expenses in our consolidated balance sheets. The specific warranty terms and conditions vary depending upon the product sold but are generally warranted against defects in material and workmanship ranging from three to five years. Our warranty only applies to the original owner. If actual product failure rates or repair costs differ from estimates, revisions to the estimated warranty liabilities would be required and could materially affect our financial condition and operating results. Stock Options We measure compensation expense for all stock-based awards at fair value on the date of grant and recognize compensation expense over the service period for awards expected to vest. We use the Black-Scholes-Merton (“Black-Scholes”) option pricing model to determine the fair value of stock option awards, which uses the expected option term, stock price volatility, and the risk-free interest rate. The expected option term assumption reflects the period for which we believe the option will remain outstanding. We elected to use the simplified method to determine the expected option term, which is the average of the options’ vesting and contractual terms. Our computation of expected volatility is based on the historical volatility of selected comparable publicly traded companies over a period equal to the expected term of the option. The risk-free interest rate reflects the U.S. Treasury yield curve for a similar instrument with the same expected term in effect at the time of the grant. The assumptions used in calculating the fair value of stock-based compensation awards represent management’s best estimates, but the estimates involve inherent uncertainties and the application of management judgment. If any of the assumptions used in the Black-Scholes model changes significantly, stock-based compensation expense for future option awards may differ materially compared with the awards granted previously. Costs relating to stock-based compensation are recognized in SG&A expenses in our consolidated statements of operations, and forfeitures are recognized as they occur. Recent Accounting Pronouncements For a description of recent accounting pronouncements, including the respective dates of adoption and expected effects on our results of operations and financial condition, see “Recently Adopted Accounting Guidance” and “Recent Accounting Guidance Not Yet Adopted” in Note 1 of the Notes to Consolidated Financial Statements included herein.

<s>[INST] Business Overview We are a growing designer, marketer, retailer, and distributor of a variety of innovative, branded, premium products to a wideranging customer base. Our mission is to ensure that each YETI product delivers exceptional performance and durability in any environment, whether in the remote wilderness, at the beach, or anywhere else life takes our customers. By consistently delivering highperforming products, we have built a following of engaged brand loyalists throughout the United States, Canada, Australia, and elsewhere, ranging from serious outdoor enthusiasts to individuals who simply value products of uncompromising quality and design. Our relationship with customers continues to thrive and deepen as a result of our innovative new product introductions, expansion and enhancement of our existing product families, and multifaceted branding activities. General Components of Our Results of Operations Net Sales. Net sales are comprised of wholesale channel sales to our retail partners and sales through our DTC channel. Net sales in both channels reflect the impact of product returns as well as discounts for certain sales programs or promotions. We discuss the net sales of our products in our two primary categories: Coolers & Equipment and Drinkware. Our Coolers & Equipment category includes hard coolers, soft coolers, outdoor equipment and other products, as well as accessories and replacement parts for these products. Beginning in 2019, we began reporting Boomer Dog Bowl net sales in our Coolers & Equipment instead of in our Other category. Our Drinkware category includes our stainlesssteel drinkware products and related accessories. In addition, our Other category is primarily comprised of ice substitutes, and YETIbranded gear, such as shirts, hats, and other miscellaneous products. Gross profit. Gross profit reflects net sales less cost of goods sold, which primarily includes the purchase cost of our products from our thirdparty contract manufacturers, inbound freight and duties, product quality testing and inspection costs, depreciation expense of our molds and equipment, and the cost of customizing Drinkware products. We calculate gross margin as gross profit divided by net sales. Gross margin in our DTC sales channel is generally higher than that on sales in our wholesale channel. Selling, general, and administrative expenses. Selling, general, and administrative (“SG&A”) expenses consist primarily of marketing costs, employee compensation and benefits costs, costs of our outsourced warehousing and logistics operations, costs of operating on thirdparty DTC marketplaces, professional fees and services, noncash stockbased compensation, cost of product shipment to our customers, depreciation and amortization expense, and general corporate infrastructure expenses. Change in Fiscal Year and Reporting Calendar. Effective January 1, 2017, we converted our fiscal yearend from a calendar year ending December 31 to a 52 to 53week year ending on the Saturday closest in proximity to December 31, such that each quarterly period will be 13 weeks in length, except during a 53week year when the fourth quarter will be 14 weeks. Fiscal year 2020 will be a 53week period. Unless otherwise stated, references to particular years, quarters, months and periods refer to our fiscal years ended in December and the associated quarters, months, and periods of those fiscal years. Our change in fiscal year did not have a material effect on our consolidated financial statements and, therefore, we did not retrospectively adjust our financial statements. Results of Operations The following table sets forth selected statement of operations data, and their corresponding percentage of net sales, for the periods indicated (dollars in thousands): Year Ended December 28, 2019 Compared to Year Ended December 29, 2018 Net Sales Net sales increased $134.9 million, or 17%, to $913.7 million in 2019 from $778.8 million in 2018. The increase in net sales was driven by increases in net sales from our DTC and wholesale channels. DTC channel net sales increased $98.7 million, or 34%, to $386.1 million in 2019 from $287.4 million in 2018. The DTC channel net sales increase [/INST] Negative. </s>

AVROBIO, Inc.

2019-03-25

2018-12-31

Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations Our management’s discussion and analysis of our financial condition and results of operations are based upon our consolidated financial statements included in this Annual Report on Form 10-K, which have been prepared by us in accordance with United States (“U.S.”) generally accepted accounting principles, or GAAP, and with Regulation S-X promulgated under the Securities Exchange Act of 1934, as amended. This discussion and analysis should be read in conjunction with these consolidated financial statements and the notes thereto included elsewhere in this Annual Report on Form 10-K. Some of the information contained in this discussion and analysis or set forth elsewhere in this Annual Report on Form 10-K, including information with respect to our plans and strategy for our business, includes forward-looking statements that involve risks and uncertainties. As a result of many factors, including those factors set forth in Part I, Item 1A. Risk Factors of this Annual Report on Form 10-K, our actual results could differ materially from the results described in or implied by the forward-looking statements contained in the following discussion and analysis. Overview We are a Phase 2 clinical stage gene therapy company focused on developing potentially curative ex vivo lentiviral-based gene therapies to treat rare diseases following a single dose treatment regimen. Our gene therapies employ hematopoietic stem cells that are harvested from the patient and then modified with lentiviral vectors to insert a functional copy of the gene that is defective in the target disease. We believe that our approach, which is designed to transform stem cells from patients into therapeutic products, has the potential to provide curative benefit for a range of diseases. Our initial focus is on a group of rare genetic diseases referred to as lysosomal storage diseases, which today are primarily managed with enzyme replacement therapies, or ERTs. We are initially targeting rare diseases in which current standard of care provides the mechanistic proof that the enzymes or proteins produced endogenously following treatment with our gene therapies can offer benefit to patients. Typically, in lysosomal storage diseases, a gene mutation results in the deficiency or malfunctioning of an enzyme or other protein. This results in the inability of lysosomes to properly process cellular byproducts. As a result, these byproducts accumulate to toxic levels in the body’s cells and, in turn, disrupt the function of multiple tissues and organs. Fabry disease, Gaucher disease and Pompe disease are primarily managed by bi-weekly, multi-hour infusions with ERTs that seek to exogenously replace the missing enzyme. However, given the characteristics of most ERTs, they typically only remain in the plasma for a short period of time and thus, are not ideal because they are only dosed every two weeks. These existing therapies manage, rather than cure, the underlying diseases and, as a result, patients continue to have disease progression. Further, the frequent, periodic and life-long dosing schedule required for ERTs results in significant costs for the healthcare system and is burdensome for the patient. We seek to develop promising gene therapy programs by applying our expertise in gene and cellular therapies and clinical and regulatory strategy and execution to efficiently bring these potentially curative therapies to patients. In our initial programs, we leverage years of extensive preclinical and early clinical research by leading international researchers, as well as our internal research efforts, to advance potential therapies. We plan to identify and develop future product candidates through our own internal research efforts as well as through collaborations with leading academics. Since our inception in 2015, we have devoted substantially all of our resources to organizing and staffing our company, business planning, raising capital, acquiring or discovering product candidates and securing related intellectual property rights, conducting discovery, research and development activities for our programs and planning for potential commercialization. We do not have any products approved for sale and have not generated any revenue from product sales. To date, we have funded our operations with proceeds from the sales of preferred stock and our initial public offering, or IPO. Through December 31, 2018, we had received gross proceeds of $87.5 million from the sales of our preferred stock and $114.7 million from the sales of common stock through our IPO. Since our inception, we have incurred significant operating losses. Our ability to generate product revenue sufficient to achieve profitability will depend heavily on the successful development and eventual commercialization of one or more of our current or future product candidates and programs. Our net losses were $46.4 million and $18.6 million for the years ended December 31, 2018 and 2017, respectively. As of December 31, 2018 we had an accumulated deficit of $71.7 million. We expect to continue to incur significant expenses for at least the next several years as we advance our product candidates from discovery through preclinical development and clinical trials and seek regulatory approval of our product candidates. In addition, if we obtain marketing approval for any of our product candidates, we expect to incur significant commercialization expenses related to product manufacturing, marketing, sales and distribution. We may also incur expenses in connection with the in-licensing or acquisition of additional product candidates. Furthermore, we expect to incur additional costs associated with operating as a public company, including significant legal, accounting, investor relations and other expenses that we did not incur as a private company. As a result, we will need substantial additional funding to support our continuing operations and pursue our growth strategy. Until such time as we can generate significant revenue from product sales, if ever, we expect to finance our operations with proceeds from outside sources, with a majority of such proceeds to be derived from sales of equity, including the net proceeds from our IPO. We also plan to pursue additional funding from outside sources, including our expansion of, or our entry into, new borrowing arrangements; research and development incentive payments from the Australian government; and our entry into potential future collaboration agreements for one or more of our programs. We may be unable to raise additional funds or enter into such other agreements or arrangements when needed on favorable terms, or at all. If we fail to raise capital or enter into such agreements as, and when, needed, we may have to significantly delay, scale back or discontinue the development and commercialization of one or more of our product candidates or delay our pursuit of potential in-licenses or acquisitions. Because of the numerous risks and uncertainties associated with product development, we are unable to predict the timing or amount of increased expenses or when or if we will be able to achieve or maintain profitability. Even if we are able to generate product sales, we may not become profitable. If we fail to become profitable or are unable to sustain profitability on a continuing basis, we may be unable to continue our operations at planned levels and be forced to reduce or terminate our operations. As of December 31, 2018, we had cash and cash equivalents of $126.3 million. We believe that our existing cash and cash equivalents as of December 31, 2018 will enable us to fund our operating expenses and capital expenditure requirements into the second half of 2020. We have based this estimate on assumptions that may prove to be wrong, and we could exhaust our available capital resources sooner than we expect. See “-Liquidity and Capital Resources.” To finance our operations beyond that point, we will need to raise additional capital, which cannot be assured. On December 13, 2018, we dosed the second patient in our ongoing Phase 2 clinical trial of AVR-RD-01 for Fabry disease. In 2018, we held a pre-Investigational New Drug, or pre-IND, meeting with the U.S. Food and Drug Administration, or FDA, to discuss the requirements to commence clinical trials in the United States. We expect to open a U.S. site for our ongoing Phase 2 clinical trial of AVR-RD-01 in the second half of 2019. In addition, on November 22, 2018 and February 21, 2019, the fourth and fifth patients were dosed in the ongoing investigator-sponsored Phase 1 clinical trial of AVR-RD-01 for Fabry disease, respectively. On October 1, 2018 and February 6, 2019, we released clinical data from the investigator-sponsored Phase 1 clinical trial and our Phase 2 clinical trial of AVR-RD-01 for Fabry disease. In December 2018, clearance was received from the FDA for the IND application for the planned academic sponsored Phase 1/2 clinical trial of AVR-RD-04. In September 2018, we received acceptance of the Clinical Trial Application, or CTA, in Canada for the planned Phase 1/2 clinical trial for AVR-RD-02. Components of Our Consolidated Results of Operations Revenue We have not generated any revenue from product sales and do not expect to generate any revenue from the sale of products in the near future. If development efforts for our product candidates are successful and result in regulatory approval or additional license agreements with third parties, we may generate revenue in the future from product sales. Operating Expenses Research and Development Expenses Research and development expenses consist primarily of costs incurred in connection with the discovery and development of our product candidates. We expense research and development costs as incurred. These expenses consist of costs incurred in connection with the development of our product candidates, including: • license maintenance fees and milestone fees incurred in connection with various license agreements; • expenses incurred under agreements with contract research organizations, or CROs, contract manufacturing organizations, or CMOs, as well as investigative sites and consultants that conduct our clinical trials, preclinical studies and other scientific development services; • manufacturing scale-up expenses and the cost of acquiring and manufacturing preclinical and clinical trial materials and commercial materials, including manufacturing validation batches; • employee-related expenses, including salaries, related benefits, travel and stock-based compensation expense for employees engaged in research and development functions; • costs related to compliance with regulatory requirements; and • allocated facilities costs, depreciation and other expenses, which include rent and utilities. We recognize external development costs based on an evaluation of the progress to completion of specific tasks using information provided to us by our service providers. Our direct research and development expenses are tracked on a program-by-program basis for our product candidates and consist primarily of external costs, such as fees paid to outside consultants, CROs, CMOs, and central laboratories in connection with our preclinical development, process development, manufacturing and clinical development activities. Our direct research and development expenses by program also include fees incurred under license agreements. We do not allocate employee costs or facility expenses, including depreciation or other indirect costs, to specific programs because these costs are deployed across multiple programs and, as such, are not separately classified. We use internal resources primarily to oversee the research and discovery as well as for managing our preclinical development, process development, manufacturing and clinical development activities. These employees work across multiple programs and, therefore, we do not track their costs by program. The table below summarizes our research and development expenses incurred by program (in thousands): Research and development activities are central to our business model. Product candidates in later stages of clinical development generally have higher development costs than those in earlier stages of clinical development, primarily due to the increased size and duration of later-stage clinical trials. As a result, we expect that our research and development expenses will increase substantially over the next several years, particularly as we increase personnel costs, including stock-based compensation, contractor costs and facilities costs, as we continue to advance the development of our product candidates. We also expect to incur additional expenses related to milestone and royalty payments payable to third parties with whom we have entered into license agreements to acquire the rights to our product candidates. The successful development and commercialization of our product candidates is highly uncertain. At this time, we cannot reasonably estimate or know the nature, timing and costs of the efforts that will be necessary to complete the preclinical and clinical development of any of our product candidates or when, if ever, material net cash inflows may commence from any of our product candidates. This uncertainty is due to the numerous risks and uncertainties associated with product development and commercialization, including the uncertainty of: • the scope, progress, outcome and costs of our preclinical development activities, clinical trials and other research and development activities; • establishing an appropriate safety profile with IND-enabling studies; • successful patient enrollment in, and the design, initiation and completion of, clinical trials; • the timing, receipt and terms of any marketing approvals from applicable regulatory authorities; • establishing commercial manufacturing capabilities or making arrangements with third-party manufacturers; • development and timely delivery of commercial-grade drug formulations that can be used in our clinical trials and for commercial launch; • obtaining, maintaining, defending and enforcing patent claims and other intellectual property rights; • significant and changing government regulation; • launching commercial sales of our product candidates, if and when approved, whether alone or in collaboration with others; • maintaining a continued acceptable safety profile of the product candidates following approval; and • the risks disclosed in the section entitled “Risk Factors” of this Annual Report on Form 10-K. We may never succeed in achieving regulatory approval for any of our product candidates. We may obtain unexpected results from our clinical trials. We may elect to discontinue, delay or modify clinical trials of some product candidates or focus on others. Any changes in the outcome of any of these variables with respect to the development of our product candidates in preclinical and clinical development could mean a significant change in the costs and timing associated with the development of these product candidates. For example, if the FDA, or another regulatory authority were to delay our planned start of clinical trials or require us to conduct clinical trials or other testing beyond those that we currently expect, or if we experience significant delays in enrollment in any of our planned clinical trials, we could be required to expend significant additional financial resources and time on the completion of clinical development of that product candidate. Identifying potential product candidates and conducting preclinical testing and clinical trials is a time-consuming, expensive and uncertain process that takes years to complete, and we may never generate the necessary data or results required to obtain marketing approval and achieve product sales. In addition, our product candidates, if approved, may not achieve commercial success. General and Administrative Expenses General and administrative expenses consist primarily of salaries, related benefits, travel and stock-based compensation expense for personnel in executive, finance and administrative functions. General and administrative expenses also include professional fees for legal, consulting, accounting and audit services. We anticipate that our general and administrative expenses will increase in the future as we increase our headcount to support our continued research activities and development of our product candidates. We also anticipate that we will incur increased accounting, audit, legal, regulatory, compliance, director and officer insurance costs as well as investor and public relations expenses associated with being a public company. We anticipate the additional costs for these services will substantially increase our general and administrative expenses. Additionally, if and when we believe a regulatory approval of a product candidate appears likely, we anticipate an increase in payroll and expense as a result of our preparation for commercial operations, especially as it relates to the sales and marketing of our product candidate. Other Income (Expense) Interest Income Interest income consists of interest earned on money market funds and other bank deposits. Other Expense Other expense consists of foreign exchange gain or loss. Change in Fair Value of Preferred Stock Warrant Liability In connection with entering into our loan agreement, we agreed to issue a warrant to purchase shares of our preferred stock to the lender. Prior to the completion of our IPO, we classified the warrant as a liability on our consolidated balance sheet and we were required to remeasure to fair value at each reporting date. We recognized changes in the fair value of the warrant liability as a component of other income (expense), net in our consolidated statements of operations and comprehensive loss. Upon the closing of our IPO, the warrant to purchase preferred stock was converted to a warrant to purchase common stock. The carrying amount of the warrant to purchase preferred stock as of the date of our IPO was transferred to additional paid in capital. No further revaluation is needed for the warrant to purchase common stock. Change in Fair Value of Derivative Liability Our stock purchase agreement with University Health Network, or UHN, provides for a payment to UHN upon completion of an initial public offering, which included our IPO, if UHN’s fully-diluted percentage ownership of our company is reduced within a range of specified percentages. We classified the IPO dilution payment obligation as a liability on our consolidated balance sheet and we were required to remeasure to fair value at each reporting date. We recognized changes in the fair value of the derivative liability as a component of other income (expense), net in our consolidated statements of operations and comprehensive loss. On June 21, 2018, in connection with our IPO, we remeasured the fair value of the derivative liability to $2.0 million as we were required to pay the dilution payment as mentioned above, which was paid in July 2018. Consolidated Results of Operations Comparison of the Years Ended December 31, 2018 and 2017 The following table summarizes our consolidated results of operations for the years ended December 31, 2018 and 2017 (in thousands): Research and Development Expenses The following table summarizes our research and development expenses incurred during the years ended December 31, 2018 and 2017 (in thousands): Research and development expenses were $35.1 million for the year ended December 31, 2018, compared to $15.2 million for the year ended December 31, 2017. The increase of $19.9 million was primarily due to increases of $4.6 million in direct costs for our Fabry program, $4.9 million in direct costs connected with our Gaucher program, $0.2 million in direct costs related to our Cystinosis program, and $10.4 million in unallocated research and development expenses, all partially offset by a decrease of $0.1 million in direct costs for our AML program. The increase in direct costs for our Fabry program was primarily due to pre-clinical, clinical and process development costs of $1.1 million, as well as CMO, CRO and consulting fees of $3.5 million. The increase in direct costs for our Gaucher program was primarily due to pre-clinical and process development costs of $3.0 million, as well as CMO, CRO and consulting fees of $1.7 million. The increase in direct costs for our Cystinosis program was primarily due to pre-clinical and process development costs of $0.4 million, as well as CRO and consulting fees of $0.7 million, all partially off-set by a decrease in upfront license cost of $1.0 million paid to GenStem. The increase in unallocated research and development expenses was primarily due to an increase of $6.1 million in personnel-related costs, including stock-based compensation as a result of hiring additional personnel in our research and development department, an increase of $0.7 million in consulting expenses, an increase in lab supplies and pre-clinical and process development costs of $0.8 million and an increase of $2.2 million in facility costs, rent expense and other miscellaneous expenses. Personnel-related costs for the years ended December 31, 2018 and 2017 included stock-based compensation expense of $0.9 million and less than $0.1 million, respectively. General and Administrative Expenses General and administrative expenses were $11.1 million for the year ended December 31, 2018, compared to $3.2 million for the year ended December 31, 2017. The increase of $8.0 million was primarily due to increases of $4.2 million in personnel-related costs, including stock-based compensation, $1.4 million in consulting expense, $0.6 million in professional fees, $0.6 million in legal fees, $0.2 million in depreciation expense, $0.3 million in facility expense and $0.6 million in other miscellaneous expenses. The increase in personnel-related costs was due to the hiring of additional personnel in our general and administrative functions, including the hiring of our former CFO in late 2017. Professional fees increased due to costs associated with the preparation of our financial statements as well as ongoing business operations. The increase in facility expense was primarily due to the addition of increased office space as a result of the continued growth of employee headcount. Other Income (Expense), net Other income (expense), net was an expense of $0.1 million for the year ended December 31, 2018, compared to a net expense of $0.3 million for the year ended December 31, 2017. The decrease in other expense of $0.2 million was primarily due to a $1.7 million increase in interest income, partially offset by an increase of $1.5 million in the change in fair value of derivative liability and the preferred stock warrant liability. Liquidity and Capital Resources Since our inception, we have not generated any revenue and have incurred significant operating losses and negative cash flows from our operations. We have funded our operations to date primarily with proceeds from the sale of preferred stock and our common stock through our IPO. Through December 31, 2018, we had received gross cash proceeds of $87.5 million and $114.7 million from sales of our preferred stock and IPO, respectively. Cash in excess of immediate requirements is invested primarily with a view to liquidity and capital preservation. Cash Flows The following table summarizes our cash flows for each of the periods presented (in thousands): Operating Activities During the year ended December 31, 2018, operating activities used $37.6 million of cash and cash equivalents, resulting from our net loss of $46.4 million, partially offset by non-cash charges of $4.6 million and net cash provided by changes in our operating assets and liabilities of $4.2 million. Net cash provided by changes in our operating assets and liabilities for the year ended December 31, 2018 consisted primarily of a $5.3 million increase in accrued expenses and other current liabilities and a $2.0 million increase in accounts payable, partially offset by a $0.1 million increase in other assets and a $3.0 million increase in prepaid expenses and other current assets. The increases in accrued expenses and other current liabilities were primarily due to ongoing research, development, and clinical trial work, and an increase in the incentive bonus accrual as of December 31, 2018. The increase in prepaid expenses and other current assets was primarily due to a $0.8 million increase in prepaid development costs, a $1.3 million increase in tax incentive refund receivable from the Australian government and a $0.2 million increase in interest income receivable. During the year ended December 31, 2017, operating activities used $16.4 million of cash and cash equivalents, resulting from our net loss of $18.6 million, partially offset by non-cash charges of $0.7 million and net cash provided by changes in our operating assets and liabilities of $1.6 million. Net cash provided by changes in our operating assets and liabilities for the year ended December 31, 2017 consisted primarily of a $1.5 million increase in accrued expenses and other current liabilities, a $0.5 million increase in other long-term liability and a $0.2 million increase in accounts payable, partially offset by a $0.2 million increase in other assets and a $0.3 million increase in prepaid expenses and other current assets. The increases in accrued expenses and other current liabilities were primarily due to ongoing research, development, and clinical trial work, and an increase in the incentive bonus accrual as of December 31, 2017. The increase in prepaid expenses and other current assets was primarily due to a $0.1 million increase in prepaid development costs associated with our Gaucher program and a $0.1 million increase in prepaid rent upon commencement of two new leases during 2017. Investing Activities During the years ended December 31, 2018 and 2017, we used $1.8 million and $0.4 million of cash and cash equivalents in investing activities consisting of purchases of property and equipment. Financing Activities During the year ended December 31, 2018, net cash provided by financing activities was $160.3 million, primarily consisting of net cash proceeds of $104.0 million from our IPO proceeds and $58.3 million from our issuance of Series B preferred stock in January 2018. During the year ended December 31, 2017, net cash provided by financing activities was $17.4 million, primarily consisting of net cash proceeds of $17.4 million from our issuance of Series A preferred stock in March 2017 and October 2017. Term Loan Agreement In June 2017, we entered into a Loan and Security Agreement, which we refer to as the Loan Agreement, with Silicon Valley Bank, or SVB, providing a senior secured non-revolving loan facility of up to an aggregate principal amount of $10.0 million, available for us to draw down in three tranches until October 31, 2018, subject to the satisfaction of certain milestones for each tranche. Through the end of the drawdown period on October 31, 2018, we had not drawn down from the facility. The Loan Agreement expired on October 31, 2018. The first tranche of $3.5 million was made available upon entry into the Loan Agreement as we satisfied the borrowing conditions at such time. The second tranche of $3.5 million would be made available after the funding of the first tranche amounts and upon confirmation by SVB that either we have met certain clinical and developmental milestones, or we have subsequently obtained at least $7.5 million in cash proceeds from the sale of our equity securities from investors reasonably acceptable to SVB. The third tranche of $3.0 million would be made available after the funding of the first and second tranche amounts and upon confirmation by SVB that we have subsequently obtained at least an additional $6.5 million in cash proceeds from the sale of our equity securities to investors reasonably acceptable to SVB, and we have received a signed and enforceable term sheet from investors acceptable to SVB committing to provide financing on or before March 31, 2018 in an amount equal to at least 12 months of operating expenses. In January 2018, we received gross cash proceeds of $60.5 million from the sale of our Series B preferred stock. Any outstanding principal amounts under the Loan Agreement would accrue interest at a floating per annum rate equal to the greater of 1% and the “prime rate,” as published in the Wall Street Journal, minus 3%. Payments on the Loan Agreement are interest only, payable monthly in arrears, until November 1, 2018, which can be extended by six months if the third tranche is drawn. Thereafter, principal and interest amounts are repayable over a 30-month period, unless the third tranche is funded and the initial interest-only period is extended by six months, in which case principal and interest amounts are repayable over a 24-month period. Pursuant to the Loan Agreement, we provided a first priority security interest in all existing and after-acquired assets, excluding intellectual property and certain other assets owned by us. The Loan Agreement contained a negative pledge on our intellectual property. In connection with the Loan Agreement, we issued a warrant to SVB to purchase shares of our Series A preferred stock at an exercise price of $0.7949 per share. This warrant was initially exercisable for 28,305 shares of Series A preferred stock. Up to an additional 160,397 shares of Series A preferred stock may become subject to this warrant, with the proportion of such additional shares equal to the percentage of the full $10.0 million aggregate principal amount under the Loan Agreement that we draw down thereunder. Following the completion of our IPO, this warrant was initially exercisable for 6,850 shares of common stock, and up to an additional 38,818 shares of common stock may become subject to this warrant. In July 2018, the initially exercisable warrant of 6,850 shares was net exercised for 6,091 shares of common stock. The Loan Agreement allowed us to voluntarily prepay all but not less than all the outstanding amounts thereunder. A scaling prepayment fee of 1% or 0.5% would be assessed if we prepay the amounts within the first anniversary of funding, or between the first and second anniversary of funding, respectively. No prepayment fee would be assessed if we prepay the amounts after the second anniversary of funding. A final payment fee of 6.75% multiplied by the original principal amount of each tranche drawn is due upon the earliest to occur of the maturity date of the Loan Agreement, the termination of the Loan Agreement, the acceleration of the Loan Agreement or repayment or prepayment of such borrowings. The Loan Agreement contained customary indemnification obligations and customary events of default, including, among other things, our failure to fulfill certain of our obligations under the Loan Agreement and the occurrence of a material adverse change in our business, operations or condition, a material impairment of the prospect of repayment of any portion of the loan, or a material impairment in the perfection or priority of the SVB’s lien in the collateral or in the value of such collateral. In the event of default by us under the Loan Agreement, SVB would be entitled to exercise its remedies thereunder, including the right to accelerate the debt, upon which we may be required to repay all amounts then outstanding under the Loan Agreement or SVB may take possession of the collateral securing the Loan Agreement. The Loan Agreement included certain restrictions on, among other things, our ability to incur additional indebtedness, change the name or location of our business, merge with or acquire other entities, pay dividends or make other distributions to holders of our capital stock, make certain investments, engage in transactions with affiliates, create liens, open new deposit accounts, sell assets or pay subordinated debt. In October 2018, we amended the Loan Agreement with our lender to, among other things, permit us to create a Massachusetts securities corporation. In addition, we were required at all times, if we maintain cash or other investments in the securities corporation’s accounts, to have on deposit in operating, depository and securities accounts in our name maintained with our lender, cash in an amount equal to 105% of the then-outstanding loan amount. Funding Requirements We expect our expenses to increase substantially in connection with our ongoing activities, particularly as we advance the preclinical activities and clinical trials of our product candidates. In addition, we expect to continue to incur additional costs associated with operating as a public company that we had not incurred as a private company. Our expenses will also increase as we: • continue our development of our product candidates, including continuing enrollment in our ongoing Phase 2 clinical trial for AVR-RD-01; • initiate additional clinical trials and preclinical studies for our other product candidates; • seek to identify and develop or in-license or acquire additional product candidates and technologies; • seek to industrialize our ex vivo lentiviral gene therapy approach into a robust, scalable and, if approved, commercially viable process; • seek marketing approvals for our product candidates that successfully complete clinical trials, if any; • establish a sales, marketing and distribution infrastructure to commercialize any product candidates for which we may obtain marketing approval; • hire and retain additional personnel, such as clinical, quality control, commercial and scientific personnel; • expand our infrastructure and facilities to accommodate our growing employee base, including adding equipment and physical infrastructure to support our research and development; and • continue to transition our organization to operating as a public company. We believe that our existing cash and cash equivalents as of December 31, 2018 will enable us to fund our operating expenses and capital expenditure requirements into the second half of 2020. We have based these estimates on assumptions that may prove to be wrong, and we could utilize our available capital resources sooner than we expect. If we receive regulatory approval for AVR-RD-01 or our other product candidates, we expect to incur significant commercialization expenses related to product manufacturing, sales, marketing and distribution, depending on where we choose to commercialize. Until such time, if ever, that we can generate product revenue sufficient to achieve profitability, we expect to finance our cash needs through a combination of equity offerings, debt financings, collaboration agreements, government and other third-party funding, strategic alliances, licensing arrangements or marketing and distribution arrangements. Debt financing and preferred equity financing, if available, may involve agreements that include covenants limiting or restricting our ability to take specific actions, such as incurring additional debt, making capital expenditures or declaring dividends. If we raise additional funds through government and other third-party funding, collaboration agreements, strategic alliances, licensing arrangements or marketing and distribution arrangements, we may have to relinquish valuable rights to our technologies, future revenue streams, research programs or product candidates or grant licenses on terms that may not be favorable to us. If we are unable to raise additional funds through equity or debt financings when needed, we may be required to delay, limit, reduce or terminate our product development or future commercialization efforts or grant rights to develop and market products or product candidates that we would otherwise prefer to develop and market ourselves. Contractual Obligations and Commitments The following table summarizes our contractual obligations as of December 31, 2018 and the effects that such obligations are expected to have on our liquidity and cash flows in future periods (in thousands): (1) Represents future minimum lease payments under our non-cancelable operating leases for office and laboratory space, which are located in Cambridge, Massachusetts. Those leases will expire from October 2020 to January 2023. The minimum lease payments above do not include any related common area maintenance charges or real estate taxes. We enter into contracts in the normal course of business with CROs, CMOs and other third parties for clinical trials, preclinical research studies and testing and manufacturing services. Payments due upon cancellation consist only of payments for services provided or expenses incurred, including noncancelable obligations of our service providers, up to the date of cancellation. These payments are not included in the preceding table as the amount and timing of such payments are not known. Additionally, the table above excludes the $2.0 million payment that we made to UHN following the closing of our IPO. In addition, pursuant to our license agreements with UHN, BioMarin, GenStem and the Lund University rights holders, we are required to make certain milestone and royalty payments to our licensors. See “Business-License Agreements” for additional details regarding our payment obligations to these licensors. Critical Accounting Policies and Significant Judgments and Estimates Our consolidated financial statements are prepared in accordance with generally accepted accounting principles in the United States. The preparation of our consolidated financial statements and related disclosures requires us to make estimates and judgments that affect the reported amounts of assets, liabilities, revenue, costs and expenses, and the disclosure of contingent assets and liabilities in our financial statements. We base our estimates on historical experience, known trends and events and various other factors that we believe are reasonable under the circumstances, the results of which form the basis for making judgments about the carrying values of assets and liabilities that are not readily apparent from other sources. We evaluate our estimates and assumptions on an ongoing basis. Our actual results may differ from these estimates under different assumptions or conditions. While our significant accounting policies are described in more detail in Note 2 to our consolidated financial statements appearing elsewhere in this report, we believe that the following accounting policies are those most critical to the judgments and estimates used in the preparation of our consolidated financial statements. Accrued Research and Development Expenses As part of the process of preparing our consolidated financial statements, we are required to estimate our accrued research and development expenses. This process involves reviewing open contracts and purchase orders, communicating with our personnel to identify services that have been performed on our behalf and estimating the level of service performed and the associated cost incurred for the service when we have not yet been invoiced or otherwise notified of actual costs. The majority of our service providers invoice us in arrears for services performed, on a pre-determined schedule or when contractual milestones are met; however, some require advanced payments. We make estimates of our accrued expenses as of each balance sheet date in the consolidated financial statements based on facts and circumstances known to us at that time. We periodically confirm the accuracy of these estimates with the service providers and make adjustments if necessary. Examples of estimated accrued research and development expenses include fees paid to: • vendors, including central laboratories, in connection with preclinical development activities; • CROs and investigative sites in connection with preclinical and clinical studies; and • CMOs in connection with drug substance and drug product formulation of preclinical and clinical trial materials. We base our expenses related to preclinical studies and clinical trials on our estimates of the services received and efforts expended pursuant to quotes and contracts with multiple research institutions and CROs that conduct and manage preclinical studies and clinical trials on our behalf. The financial terms of these agreements are subject to negotiation, vary from contract to contract and may result in uneven payment flows. There may be instances in which payments made to our vendors will exceed the level of services provided and result in a prepayment of the expense. Payments under some of these contracts depend on factors such as the successful enrollment of patients and the completion of clinical trial milestones. In accruing service fees, we estimate the time period over which services will be performed and the level of effort to be expended in each period. If the actual timing of the performance of services or the level of effort varies from the estimate, we adjust the accrual or the amount of prepaid expenses accordingly. Although we do not expect our estimates to be materially different from amounts actually incurred, our understanding of the status and timing of services performed relative to the actual status and timing of services performed may vary and may result in reporting amounts that are too high or too low in any particular period. To date, there have not been any material adjustments to our prior estimates of accrued research and development expenses. Stock-Based Compensation We measure stock options and other stock-based awards granted to employees and members of our board of directors for their services as directors based on the fair value on the date of the grant and recognize the corresponding compensation expense of those awards over the requisite service period, which is generally the vesting period of the respective award. We have only issued stock options with service-based vesting conditions and record the expense for these awards using the straight-line method. Prior to the adoption of Accounting Standards Update (ASU) No. 2018-07, Compensation-Stock Compensation (Topic 718): Improvements to Nonemployee Share-Based Payment Accounting (ASU 2018-07), as discussed in Note 2 to our consolidated financial statements appearing at the end of this document, the measurement date for non-employee awards was generally the date the services are completed, resulting in financial reporting period adjustments to stock-based compensation during the vesting terms for changes in the fair value of the awards. After the adoption of ASU 2018-07, the measurement date for non-employee awards is the later of the adoption date of ASU 2018-07, or the date of grant, without change in the fair value of the award. We estimate the fair value of each stock option grant using the Black-Scholes option-pricing model, which uses as inputs the estimated fair value of our common stock and assumptions we make for the volatility of our common stock, the expected term of our stock options, the risk-free interest rate for a period that approximates the expected term of our stock options and our expected dividend yield. We determined the assumptions for the Black-Scholes option-pricing model as discussed below. Each of these inputs is subjective and generally requires significant judgment to determine. • Fair Value of Our Common Stock. The fair value of our common stock is determined based on the quoted market price of our common stock. Prior to our IPO, our stock was not publicly traded, and therefore we estimated the fair value of our common stock, as discussed in “Determination of the Fair Value of Common Stock” below. • Expected Term. The expected term represents the period that the stock-based awards are expected to be outstanding. The expected term of stock options granted has been determined using the simplified method, which uses the midpoint between the vesting date and the contractual term. • Risk-Free Interest Rate. The risk-free interest rate is based on the U.S. Treasury yield curve in effect at the date of grant for zero-coupon U.S. Treasury constant maturity notes with terms approximately equal to the stock-based award’s expected term. • Expected Volatility. Because we do not have a trading history of our common stock, the expected volatility was derived from the average historical stock volatilities of several public companies within our industry that we consider to be comparable to our business over a period equivalent to the expected term of the stock-based awards. • Dividend Rate. The expected dividend is zero as we have not paid and do not anticipate paying any dividends in the foreseeable future. If any of the assumptions used in the Black-Scholes model change significantly, stock-based compensation for future awards may differ materially compared with the awards granted previously. Determination of the Fair Value of Common Stock The fair value of our common stock is determined based on the quoted market price of our common stock. Prior to our IPO, there was no public market for our common stock, and consequently, the estimated fair value of our common stock was determined by our board of directors as of the date of each option grant, with input from management, considering third-party valuations of our common stock as well as our board of directors’ assessment of additional objective and subjective factors that it believed were relevant and which may have changed from the date of the most recent third-party valuation through the date of the grant. These third-party valuations were performed in accordance with the guidance outlined in the American Institute of Certified Public Accountants’ Accounting and Valuation Guide, Valuation of Privately-Held-Company Equity Securities Issued as Compensation. After a public trading market for our common stock was established following the closing of our IPO, it was no longer necessary for our board of directors to estimate the fair market value of our common stock in connection with our accounting for granted equity awards. Valuation of Derivative Liability The fair value of the derivative liability recognized in connection with our stock purchase agreement with UHN was determined based on significant inputs not observable in the market, which represents a Level 3 measurement within the fair value hierarchy. The fair value of the derivative liability was determined using the probability-weighted expected return method, or PWERM, which considered as inputs the type and probability of occurrence of an IPO dilution event, the amount of the payment, the expected timing of an IPO dilution event and a risk-adjusted discount rate. Valuation of Warrant Liability In connection with entering into the Loan Agreement, we agreed to issue a warrant to purchase shares of our Series A preferred stock to the lender. We classified the warrant as a liability on our consolidated balance sheet because the warrant represented a free-standing financial instrument that may have required us to transfer assets upon exercise. The warrant liability was initially recorded at fair value upon the date of the warrant issuance and was subsequently remeasured to fair value at each reporting date. Changes in the fair value of the warrant liability were recognized as a component of other income (expense), net in the consolidated statements of operations. We utilized the Black-Scholes option-pricing model, which incorporates assumptions and estimates, to value the warrant. We assessed these assumptions and estimates on a quarterly basis as additional information impacting the assumptions was obtained. Estimates and assumptions impacting the fair value measurement included the fair value per share of the underlying equity instruments issuable upon exercise of the warrant, the remaining contractual term of the warrant, risk-free interest rate, expected dividend yield and expected volatility of the underlying preferred stock. We have historically been a private company and lacked company-specific historical and implied volatility information of our stock. Therefore, we estimated expected stock volatility based on the historical volatility of publicly traded peer companies for a term equal to the remaining contractual term of the warrant. The risk-free interest rate was determined by reference to the U.S. Treasury yield curve for time periods approximately equal to the remaining contractual term of the warrant. We estimated a 0% dividend yield based on the fact that we have never paid or declared dividends. Upon the closing of our IPO, the preferred stock warrant became exercisable for common stock instead of preferred stock. The carrying amount of the warrant to purchase preferred stock as of the date of IPO was transferred to additional paid in capital. No further revaluation was required for the warrant to purchase common stock. Emerging Growth Company Status We are an “emerging growth company,” as defined in the Jumpstart Our Business Startups Act of 2012, or the JOBS Act, and we may take advantage of certain exemptions from various reporting requirements that are applicable to other public companies that are not emerging growth companies. We may take advantage of these exemptions until we are no longer an emerging growth company. Section 107 of the JOBS Act provides that an emerging growth company can take advantage of the extended transition period afforded by the JOBS Act for the implementation of new or revised accounting standards. We have elected to use the extended transition period for complying with new or revised accounting standards and, as a result of this election, our financial statements may not be comparable to companies that comply with public company effective dates. We may take advantage of these exemptions up until the last day of the fiscal year following the fifth anniversary of our IPO or such earlier time that we are no longer an emerging growth company. We would cease to be an emerging growth company if we have more than $1.07 billion in annual revenue, we have more than $700.0 million in market value of our stock held by non-affiliates (and we have been a public company for at least 12 months and have filed one annual report on Form 10-K) or we issue more than $1.0 billion of non-convertible debt securities over a three-year period. Off-Balance Sheet Arrangements We did not have during the periods presented, and we do not currently have, any off-balance sheet arrangements, as defined in the rules and regulations of the Securities and Exchange Commission. Recently Issued Accounting Pronouncements A description of recently issued accounting pronouncements that may potentially impact our financial position and results of operations is disclosed in Note 2 to our audited financial statements appearing elsewhere in this report.

<s>[INST] Overview We are a Phase 2 clinical stage gene therapy company focused on developing potentially curative ex vivo lentiviralbased gene therapies to treat rare diseases following a single dose treatment regimen. Our gene therapies employ hematopoietic stem cells that are harvested from the patient and then modified with lentiviral vectors to insert a functional copy of the gene that is defective in the target disease. We believe that our approach, which is designed to transform stem cells from patients into therapeutic products, has the potential to provide curative benefit for a range of diseases. Our initial focus is on a group of rare genetic diseases referred to as lysosomal storage diseases, which today are primarily managed with enzyme replacement therapies, or ERTs. We are initially targeting rare diseases in which current standard of care provides the mechanistic proof that the enzymes or proteins produced endogenously following treatment with our gene therapies can offer benefit to patients. Typically, in lysosomal storage diseases, a gene mutation results in the deficiency or malfunctioning of an enzyme or other protein. This results in the inability of lysosomes to properly process cellular byproducts. As a result, these byproducts accumulate to toxic levels in the body’s cells and, in turn, disrupt the function of multiple tissues and organs. Fabry disease, Gaucher disease and Pompe disease are primarily managed by biweekly, multihour infusions with ERTs that seek to exogenously replace the missing enzyme. However, given the characteristics of most ERTs, they typically only remain in the plasma for a short period of time and thus, are not ideal because they are only dosed every two weeks. These existing therapies manage, rather than cure, the underlying diseases and, as a result, patients continue to have disease progression. Further, the frequent, periodic and lifelong dosing schedule required for ERTs results in significant costs for the healthcare system and is burdensome for the patient. We seek to develop promising gene therapy programs by applying our expertise in gene and cellular therapies and clinical and regulatory strategy and execution to efficiently bring these potentially curative therapies to patients. In our initial programs, we leverage years of extensive preclinical and early clinical research by leading international researchers, as well as our internal research efforts, to advance potential therapies. We plan to identify and develop future product candidates through our own internal research efforts as well as through collaborations with leading academics. Since our inception in 2015, we have devoted substantially all of our resources to organizing and staffing our company, business planning, raising capital, acquiring or discovering product candidates and securing related intellectual property rights, conducting discovery, research and development activities for our programs and planning for potential commercialization. We do not have any products approved for sale and have not generated any revenue from product sales. To date, we have funded our operations with proceeds from the sales of preferred stock and our initial public offering, or IPO. Through December 31, 2018, we had received gross proceeds of $87.5 million from the sales of our preferred stock and $114.7 million from the sales of common stock through our IPO. Since our inception, we have incurred significant operating losses. Our ability to generate product revenue sufficient to achieve profitability will depend heavily on the successful development and eventual commercialization of one or more of our current or future product candidates and programs. Our net losses were $46.4 million and $18.6 million for the years ended December 31, 2018 and 2017, respectively. As of December 31, 2018 we had an accumulated deficit of $71.7 million. We expect to continue to incur significant expenses for at least the next several years as we advance our product candidates from discovery through preclinical development and clinical trials and seek regulatory approval of our product candidates. In addition, if we obtain marketing approval for any of our product candidates, we expect to incur significant commercialization expenses related to product manufacturing, marketing, sales and distribution. We may also incur expenses in connection with the inlicensing or acquisition of additional product candidates. Furthermore, we expect to incur additional costs associated with operating as a public company, including significant legal, accounting, investor relations and other exp [/INST] Negative. </s>

AVROBIO, Inc.

2020-03-16

2019-12-31

Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations Our management’s discussion and analysis of our financial condition and results of operations are based upon our consolidated financial statements included in this Annual Report on Form 10-K, which have been prepared by us in accordance with United States generally accepted accounting principles, or GAAP, and with Regulation S-X promulgated under the Securities Exchange Act of 1934, as amended. This discussion and analysis should be read in conjunction with the consolidated financial statements and the notes thereto included elsewhere in this Annual Report on Form 10-K. Some of the information contained in this discussion and analysis or set forth elsewhere in this Annual Report on Form 10-K, including information with respect to our plans and strategy for our business, includes forward-looking statements that involve risks and uncertainties. As a result of many factors, including those factors set forth in Part I, Item 1A. Risk Factors of this Annual Report on Form 10-K, our actual results could differ materially from the results described in or implied by the forward-looking statements contained in the following discussion and analysis. Overview We are a leading clinical-stage gene therapy company with a mission to free people from a lifetime of genetic disease. Our company is focused on developing potentially curative ex vivo lentiviral-based gene therapies to treat patients with rare diseases following a single dose treatment regimen. Our gene therapies employ hematopoietic stem cells that are harvested from the patient and then modified with a lentiviral vector to insert the equivalent of a functional copy of the gene that is defective in the target disease. We believe that our approach, which is designed to transform stem cells from patients into therapeutic products, has the potential to provide curative benefit for a range of diseases. Our initial focus is on a group of rare genetic diseases referred to as lysosomal diseases, some of which today are primarily managed with enzyme replacement therapies, or ERTs. These lysosomal diseases have well-understood biologies, identified patient populations, established standards of care yet with significant unmet needs, and represent large market opportunities with approximately $4.0 billion in worldwide net sales in 2019. Our initial pipeline is comprised of four lentiviral-based gene therapy programs, including AVR-RD-01 for the treatment of Fabry disease, AVR-RD-04 for the treatment of cystinosis, AVR-RD-02 for the treatment of Gaucher disease and AVR-RD-03 for the treatment of Pompe disease. AVR-RD-01 is currently being evaluated in an investigator-sponsored Phase 1 clinical trial and a company-sponsored Phase 2 clinical trial. Five patients have been dosed in the investigator-sponsored Phase 1 clinical trial of AVR-RD-01, and enrollment is complete. As of March 6, 2020, four patients have been dosed in our company-sponsored Phase 2 clinical trial of AVR-RD-01, and we are actively recruiting additional potential patients for our currently active sites in Australia, Canada and the United States. AVR-RD-04 is currently being studied by our collaborators at the University of California, San Diego, or UCSD, in a Phase 1/2 investigator-sponsored clinical trial, and as of March 6, 2020 one patient has been dosed. In January 2020, we announced that we received notice of clearance from the U.S. Food and Drug Administration, or FDA, regarding an Investigational New Drug, or IND, application for AVR-RD-02, our investigational gene therapy for the treatment of Gaucher disease. The Phase 1/2 clinical trial for AVR-RD-02 is actively recruiting in Australia and Canada, with additional sites planned in the United States. Our AVR-RD-03 program for Pompe disease is currently in preclinical development with the first IND-enabling preclinical study initiated in 2019. Since our inception in 2015, we have devoted substantially all of our resources to organizing and staffing our company, business planning, raising capital, acquiring or discovering product candidates and securing related intellectual property rights, conducting discovery, research and development activities for our programs and planning for potential commercialization. We do not have any products approved for sale and have not generated any revenue from product sales. To date, we have funded our operations with proceeds from the sales of preferred stock and our initial public offering, or IPO, and we have raised additional capital through an underwritten public offering that closed in July 2019, or the July 2019 Follow-On Offering, and an underwritten public offering that closed in February 2020, or the February 2020 Follow-On Offering. Through December 31, 2019, we had received gross cash proceeds of $87.5 million from sales of our preferred stock, and gross cash proceeds, before deducting underwriting discounts and commissions and expenses, of $114.7 million and $138.3 million from sales of our common stock through our IPO and July 2019 Follow-On Offering, respectively. Since our inception, we have incurred significant operating losses. Our ability to generate product revenue sufficient to achieve profitability will depend heavily on the successful development and eventual commercialization of one or more of our current or future product candidates and programs. Our net losses were $73.0 million and $46.4 million for the years ended December 31, 2019 and 2018, respectively. As of December 31, 2019, we had an accumulated deficit of $144.7 million. We expect to continue to incur significant expenses for at least the next several years as we advance our current and future product candidates from discovery through preclinical development and clinical trials and seek regulatory approval of our product candidates. In addition, if we obtain marketing approval for any of our product candidates, we expect to incur significant commercialization expenses related to product manufacturing, marketing, sales and distribution. We may also incur expenses in connection with the in-licensing or acquisition of additional product candidates. Furthermore, we expect to continue incurring additional costs associated with operating as a public company, including significant legal, accounting, investor relations and other expenses. As a result, we will need substantial additional funding to support our continuing operations and pursue our growth strategy. Until such time as we can generate significant revenue from product sales, if ever, we expect to finance our operations with proceeds from outside sources, with a majority of such proceeds to be derived from sales of equity, including the net proceeds from our IPO and follow-on offerings. We also plan to pursue additional funding from outside sources, including our expansion of, or our entry into, new borrowing arrangements; research and development incentive payments from the Australian government; and our entry into potential future collaboration agreements for one or more of our programs. We may be unable to raise additional funds or enter into such other agreements or arrangements when needed on favorable terms, or at all. If we fail to raise capital or enter into such agreements as, and when, needed, we may have to significantly delay, scale back or discontinue the development and commercialization of one or more of our product candidates or delay our pursuit of potential in-licenses or acquisitions. Because of the numerous risks and uncertainties associated with product development, we are unable to predict the timing or amount of increased expenses or when or if we will be able to achieve or maintain profitability. Even if we are able to generate product sales, we may not become profitable. If we fail to become profitable or are unable to sustain profitability on a continuing basis, we may be unable to continue our operations at planned levels and be forced to reduce or terminate our operations. As of December 31, 2019, we had cash and cash equivalents of $187.0 million. We believe that our existing cash and cash equivalents as of December 31, 2019, together with the estimated net proceeds of $93.5 million from our February 2020 Follow-on Offering, will enable us to fund our operating expenses and capital expenditure requirements into the second quarter of 2022. We have based this estimate on assumptions that may prove to be wrong, and we could exhaust our available capital resources sooner than we expect. See “-Liquidity and Capital Resources.” To finance our operations beyond that point, we will need to raise additional capital, which cannot be assured. Components of Our Consolidated Results of Operations Revenue We have not generated any revenue from product sales and do not expect to generate any revenue from the sale of products in the near future. If development efforts for our product candidates are successful and result in regulatory approval or additional license agreements with third parties, we may generate revenue in the future from product sales. Operating Expenses Research and Development Expenses Research and development expenses consist primarily of costs incurred in connection with the discovery and development of our product candidates. We expense research and development costs as incurred. These expenses consist of costs incurred in connection with the development of our product candidates, including: • license maintenance fees and milestone fees incurred in connection with various license agreements; • expenses incurred under agreements with contract research organizations, or CROs, contract manufacturing organizations, or CMOs, as well as investigative sites and consultants that conduct our clinical trials, preclinical studies and other scientific development services; • manufacturing scale-up expenses and the cost of acquiring and manufacturing preclinical and clinical trial materials and commercial materials, including manufacturing validation batches; • employee-related expenses, including salaries, related benefits, travel and stock-based compensation expense for employees engaged in research and development functions; • costs related to compliance with regulatory requirements; and • allocated facilities costs, depreciation and other expenses, which include rent and utilities. We recognize external development costs based on an evaluation of the progress to completion of specific tasks using information provided to us by our service providers. Our direct research and development expenses are tracked on a program-by-program basis for our product candidates and consist primarily of external costs, such as fees paid to outside consultants, CROs, CMOs, and central laboratories in connection with our preclinical development, process development, manufacturing and clinical development activities. Our direct research and development expenses by program also include fees incurred under license agreements. We do not allocate employee costs or facility expenses, including depreciation or other indirect costs, to specific programs because these costs are deployed across multiple programs and, as such, are not separately classified. We use internal resources primarily to oversee the research and discovery as well as for managing our preclinical development, process development, manufacturing and clinical development activities. These employees work across multiple programs and, therefore, we do not track their costs by program. We have modified the presentation within the following tables to include expenses related to other preclinical development activities outside of our already presented programs in our direct research and development expenses, which were previously included as other unallocated research and development expenses. We have adjusted prior period amounts to reflect the changes in presentation made in the current period. The table below summarizes our research and development expenses incurred by program (in thousands): Research and development activities are central to our business model. Product candidates in later stages of clinical development generally have higher development costs than those in earlier stages of clinical development, primarily due to the increased size and duration of later-stage clinical trials. As a result, we expect that our research and development expenses will increase substantially over the next several years, particularly as we increase personnel costs, including stock-based compensation, contractor costs and facilities costs, as we continue to advance the development of our product candidates. We also expect to incur additional expenses related to milestone and royalty payments payable to third parties with whom we have entered into license agreements to acquire the rights to our product candidates. The successful development and commercialization of our product candidates is highly uncertain. At this time, we cannot reasonably estimate or know the nature, timing and costs of the efforts that will be necessary to complete the preclinical and clinical development of any of our product candidates or when, if ever, material net cash inflows may commence from any of our product candidates. This uncertainty is due to the numerous risks and uncertainties associated with product development and commercialization, including the uncertainty of: • the scope, progress, outcome and costs of our preclinical development activities, clinical trials and other research and development activities; • establishing an appropriate safety profile with IND-enabling studies; • successful patient enrollment in, and the design, initiation and completion of, clinical trials; • the timing, receipt and terms of any marketing approvals from applicable regulatory authorities; • establishing commercial manufacturing capabilities or making arrangements with third-party manufacturers; • development and timely delivery of commercial-grade drug formulations that can be used in our clinical trials and for commercial launch; • obtaining, maintaining, defending and enforcing patent claims and other intellectual property rights; • significant and changing government regulation; • launching commercial sales of our product candidates, if and when approved, whether alone or in collaboration with others; • maintaining a continued acceptable safety profile of the product candidates following approval; and • the risks disclosed in the section entitled “Risk Factors” of this Annual Report on Form 10-K. We may never succeed in achieving regulatory approval for any of our product candidates. We may obtain unexpected results from our clinical trials. We may elect to discontinue, delay or modify clinical trials of some product candidates or focus on others. Any changes in the outcome of any of these variables with respect to the development of our product candidates in preclinical and clinical development could mean a significant change in the costs and timing associated with the development of these product candidates. For example, if the FDA, or another regulatory authority were to delay our planned start of clinical trials or require us to conduct clinical trials or other testing beyond those that we currently expect, or if we experience significant delays in enrollment in any of our planned clinical trials, we could be required to expend significant additional financial resources and time on the completion of clinical development of that product candidate. Identifying potential product candidates and conducting preclinical testing and clinical trials is a time-consuming, expensive and uncertain process that takes years to complete, and we may never generate the necessary data or results required to obtain marketing approval and achieve product sales. In addition, our product candidates, if approved, may not achieve commercial success. General and Administrative Expenses General and administrative expenses consist primarily of salaries, related benefits, travel and stock-based compensation expense for personnel in executive, finance and administrative functions. General and administrative expenses also include professional fees for legal, consulting, accounting and audit services. We anticipate that our general and administrative expenses will increase in the future as we increase our headcount to support our continued research activities and development of our product candidates. We also anticipate that we will continue to incur increased accounting, audit, legal, regulatory, compliance, director and officer insurance costs as well as investor and public relations expenses associated with being a public company. We anticipate the additional costs for these services will substantially increase our general and administrative expenses. Additionally, if and when we believe a regulatory approval of a product candidate appears likely, we anticipate an increase in payroll and other commercialization-related expenses as a result of our preparation for commercial operations, especially as it relates to the sales and marketing of our product candidate. Other Income (Expense) Interest Income Interest income consists of interest earned on money market funds and other bank deposits. Other Expense Other expense consists of foreign exchange gain or loss. Change in Fair Value of Preferred Stock Warrant Liability In connection with entering into a loan agreement, or the Loan Agreement, with Silicon Valley Bank, or SVB, in 2017, we agreed to issue a warrant to purchase shares of our preferred stock to SVB. Prior to the completion of our IPO, we classified the warrant as a liability on our consolidated balance sheet and we were required to remeasure to fair value at each reporting date. We recognized changes in the fair value of the warrant liability as a component of other income (expense), net in our consolidated statements of operations and comprehensive loss. On June 21, 2018, in connection with our IPO, the warrant to purchase preferred stock was converted to a warrant to purchase common stock. The carrying amount of the warrant to purchase preferred stock as of the date of our IPO was transferred to additional paid in capital. No further revaluation is needed for the warrant to purchase common stock. Change in Fair Value of Derivative Liability Our stock purchase agreement with University Health Network, or UHN, provides for a payment to UHN upon completion of an initial public offering, which included our IPO, if UHN’s fully-diluted percentage ownership of our company is reduced within a range of specified percentages. We classified the IPO dilution payment obligation as a liability on our consolidated balance sheet and we were required to remeasure to fair value at each reporting date. We recognized changes in the fair value of the derivative liability as a component of other income (expense), net in our consolidated statements of operations and comprehensive loss. On June 21, 2018, in connection with our IPO, we remeasured the fair value of the derivative liability to $2.0 million as we were required to pay the dilution payment as mentioned above, which was paid in July 2018. Consolidated Results of Operations Comparison of the Years Ended December 31, 2019 and 2018 The following table summarizes our consolidated results of operations for the years ended December 31, 2019 and 2018 (in thousands): Research and Development Expenses The following table summarizes our research and development expenses incurred during the years ended December 31, 2019 and 2018 (in thousands): Research and development expenses were $55.0 million for the year ended December 31, 2019, compared to $35.1 million for the year ended December 31, 2018. The increase of $19.9 million was primarily due to increases of $4.7 million in direct costs related to our Pompe program, $3.7 million in direct costs related to our Other programs, $2.9 million in direct costs related to our Cystinosis program, and $10.3 million in unallocated research and development expenses, all partially offset by a decrease of $0.9 million in direct costs related to our Gaucher program and a decrease of $0.8 million in direct costs related to our Fabry program. The increase in direct costs related to our Pompe program was primarily due to increases in preclinical and manufacturing costs of $4.7 million. The increase in direct costs related to our Cystinosis program was primarily due to an increase in preclinical and clinical expenses of $1.6 million and a license fee payment of $2.0 million, partially off-set by decreases in consulting fees of $0.4 million, and manufacturing costs of $0.2 million. The increase in direct costs related to our Other programs was primarily due to increases in preclinical and manufacturing costs of $3.7 million. The increase in unallocated research and development expenses was primarily due to an increase of $7.4 million in personnel-related costs, including stock-based compensation as a result of hiring additional personnel in our research and development department, and an increase of $2.5 million in facility costs and rent expense. Personnel-related costs for the years ended December 31, 2019 and 2018 included stock-based compensation expense of $3.6 million and $0.9 million, respectively. General and Administrative Expenses General and administrative expenses were $20.8 million for the year ended December 31, 2019, compared to $11.1 million for the year ended December 31, 2018. The increase of $9.7 million was primarily due to increases of $5.2 million in personnel-related costs including stock-based compensation and $4.4 million in costs associated with being a publicly traded company, including $1.9 million in professional fees, $1.7 million in consulting expenses, and $0.8 million in insurance costs. The increase in personnel-related costs was due to the hiring of additional personnel in our general and administrative functions. Other Income (Expense), net Other income (expense), net was income of $2.8 million for the year ended December 31, 2019, compared to a net expense of $0.1 million for the year ended December 31, 2018. The increase of $3.0 million was primarily due to a $1.2 million increase in interest income and a decrease of $1.8 million due to the change in the fair value of the derivative liability and the preferred stock warrant liability. Liquidity and Capital Resources Since our inception, we have not generated any revenue and have incurred significant operating losses and negative cash flows from our operations. We have funded our operations to date primarily with proceeds from the sale of preferred stock and our common stock through our IPO, and we have raised additional capital through our July 2019 Follow-On Offering and our February 2020 Follow-On Offering. Through December 31, 2019, we had received gross cash proceeds of $87.5 million from sales of our preferred stock, and gross cash proceeds, before deducting underwriting discounts and commissions and expenses, of $114.7 million and $138.3 million from sales of our common stock through our IPO and July 2019 Follow-On Offering, respectively. On July 1, 2019, we filed a shelf registration statement on Form S-3 with the SEC, or the July 2019 Shelf, which covers the offering, issuance and sale by us of up to an aggregate of $200.0 million of our common stock, preferred stock, debt securities, warrants and/or units. We simultaneously entered into a Sales Agreement with Cowen and Company, LLC, as sales agent, to provide for the offering, issuance and sale by us of up to $50.0 million of our common stock from time to time in “at-the-market” offerings under the July 2019 Shelf. The July 2019 Shelf was declared effective by the SEC on July 10, 2019. On December 20, 2019, we filed a shelf registration statement on Form S-3 with the SEC, or the December 2019 Shelf, which covers the offering, issuance and sale by us of up to an aggregate of $250.0 million of our common stock, preferred stock, debt securities, warrants and/or units. The December 2019 Shelf was declared effective by the SEC on January 14, 2020. In July 2019, we closed the July 2019 Follow-On Offering as an underwritten public offering under the July 2019 Shelf of 7,475,000 shares of our common stock at a public offering price of $18.50 per share, which included 975,000 shares of our common stock resulting from the full exercise of the underwriters’ option to purchase additional shares at the public offering price, less underwriting discounts and commissions. The net proceeds to us from this offering, after deducting underwriting discounts and commissions and other offering expenses payable by us, were approximately $129.5 million. In February 2020, we closed the February 2020 Follow-On Offering as an underwritten public offering under the December 2019 Shelf of 4,350,000 shares of our common stock at a public offering price of $23.00 per share, less underwriting discounts and commissions. The net proceeds to us from this offering, after deducting underwriting discounts and commissions and other offering expenses payable by us, were approximately $93.5 million. Cash in excess of immediate requirements is invested primarily with a view to liquidity and capital preservation. Cash Flows The following table summarizes our cash flows for each of the periods presented (in thousands): Operating Activities During the year ended December 31, 2019, operating activities used $67.7 million of cash and cash equivalents, resulting from our net loss of $73.0 million and net cash used by changes in our operating assets and liabilities of $2.2 million, offset in part by non-cash charges of $7.5 million. Net cash used by changes in our operating assets and liabilities for the year ended December 31, 2019 consisted primarily of a $4.9 million increase in prepaid expenses and other current assets and $0.2 million increase in other assets, partially offset by a $1.0 million increase in accounts payable and a $1.9 million increase in accrued expenses and other current liabilities. The increase in prepaid expenses and other current assets was primarily due to a $3.9 million increase in prepaid development costs, $0.6 million increase in prepaid insurance and a $0.6 million increase in tax incentive refund receivable from the Australian government. During the year ended December 31, 2018, operating activities used $37.6 million of cash and cash equivalents, resulting from our net loss of $46.4 million, partially offset by non-cash charges of $4.6 million and net cash provided by changes in our operating assets and liabilities of $4.2 million. Net cash provided by changes in our operating assets and liabilities for the year ended December 31, 2018 consisted primarily of a $5.3 million increase in accrued expenses and other current liabilities and a $2.0 million increase in accounts payable, partially offset by a $0.1 million increase in other assets and a $3.0 million increase in prepaid expenses and other current assets. The increases in accrued expenses and other current liabilities were primarily due to ongoing research, development, and clinical trial work, and an increase in the incentive bonus accrual as of December 31, 2018. The increase in prepaid expenses and other current assets was primarily due to a $0.8 million increase in prepaid development costs, a $1.3 million increase in tax incentive refund receivable from the Australian government and a $0.2 million increase in interest income receivable. Investing Activities During the years ended December 31, 2019 and 2018, we used $1.6 million and $1.8 million of cash and cash equivalents in investing activities consisting of purchases of property and equipment. Financing Activities During the year ended December 31, 2019, net cash provided by financing activities was $130.0 million, primarily consisting of net cash proceeds of $129.5 million from our July 2019 Follow-on Offering. During the year ended December 31, 2018, net cash provided by financing activities was $160.3 million, primarily consisting of net cash proceeds of $104.0 million from our IPO proceeds and $58.3 million from our issuance of Series B preferred stock in January 2018. Term Loan Agreement In June 2017, we entered into the Loan Agreement with SVB providing a senior secured non-revolving loan facility of up to an aggregate principal amount of $10.0 million, available for us to draw down in three tranches until October 31, 2018, subject to the satisfaction of certain milestones for each tranche. Through the end of the drawdown period on October 31, 2018, we had not drawn down from the facility. The Loan Agreement expired on October 31, 2018. Funding Requirements We expect our expenses to increase substantially in connection with our ongoing activities, particularly as we advance the preclinical activities and clinical trials of our product candidates. Our expenses will also increase as we: • continue our development of our product candidates, including continuing enrollment in our ongoing Phase 2 clinical trial for AVR-RD-01, the ongoing investigator-sponsored clinical trial of AVR-RD-04 and our ongoing clinical trial of AVR-RD-02; • initiate additional clinical trials and preclinical studies for our other current and future product candidates; • seek to identify and develop or in-license or acquire additional product candidates and technologies; • seek to industrialize our ex vivo lentiviral gene therapy approach into a robust, scalable and, if approved, commercially viable process; • seek marketing approvals for our product candidates that successfully complete clinical trials, if any; • establish a sales, marketing and distribution infrastructure to commercialize any product candidates for which we may obtain marketing approval; • hire and retain additional personnel, such as clinical, quality control, commercial and scientific personnel; • expand our infrastructure, office space and facilities to accommodate our growing employee base, including adding equipment and physical infrastructure to support our research and development; and • continue to incur additional public company-related costs. We believe that our existing cash and cash equivalents as of December 31, 2019, together with the estimated net proceeds of $93.5 million from our February 2020 Follow-on Offering, will enable us to fund our operating expenses and capital expenditure requirements into the second quarter of 2022. We have based these estimates on assumptions that may prove to be wrong, and we could utilize our available capital resources sooner than we expect. If we receive regulatory approval for any of our product candidates, we expect to incur significant commercialization expenses related to product manufacturing, sales, marketing and distribution, depending on where we choose to commercialize. Until such time, if ever, that we can generate product revenue sufficient to achieve profitability, we expect to finance our cash needs through a combination of equity offerings, debt financings, collaboration agreements, government and other third-party funding, strategic alliances, licensing arrangements or marketing and distribution arrangements. Debt financing and preferred equity financing, if available, may involve agreements that include covenants limiting or restricting our ability to take specific actions, such as incurring additional debt, making capital expenditures or declaring dividends. If we raise additional funds through government and other third-party funding, collaboration agreements, strategic alliances, licensing arrangements or marketing and distribution arrangements, we may have to relinquish valuable rights to our technologies, future revenue streams, research programs or product candidates or grant licenses on terms that may not be favorable to us. If we are unable to raise additional funds through equity or debt financings when needed, we may be required to delay, limit, reduce or terminate our product development or future commercialization efforts or grant rights to develop and market products or product candidates that we would otherwise prefer to develop and market ourselves. Contractual Obligations and Commitments The following table summarizes our contractual obligations as of December 31, 2019 and the effects that such obligations are expected to have on our liquidity and cash flows in future periods (in thousands): (1) Represents future minimum lease payments under our non-cancelable operating leases for office and laboratory space, which are located in Cambridge, Massachusetts. Those leases will expire from October 2020 to January 2023. The minimum lease payments above do not include any related common area maintenance charges or real estate taxes. We enter into contracts in the normal course of business with CROs, CMOs and other third parties for clinical trials, preclinical research studies and testing and manufacturing services. Payments due upon cancellation consist only of payments for services provided or expenses incurred, including noncancelable obligations of our service providers, up to the date of cancellation. These payments are not included in the preceding table as the amount and timing of such payments are not known. In addition, pursuant to our license agreements with UHN, BioMarin, GenStem and the Lund University rights holders, we are required to make certain milestone and royalty payments to our licensors. See “Business-License Agreements” for additional details regarding our payment obligations to these licensors. Critical Accounting Policies and Significant Judgments and Estimates Our consolidated financial statements are prepared in accordance with generally accepted accounting principles in the United States. The preparation of our consolidated financial statements and related disclosures requires us to make estimates and judgments that affect the reported amounts of assets, liabilities, revenue, costs and expenses, and the disclosure of contingent assets and liabilities in our financial statements. We base our estimates on historical experience, known trends and events and various other factors that we believe are reasonable under the circumstances, the results of which form the basis for making judgments about the carrying values of assets and liabilities that are not readily apparent from other sources. We evaluate our estimates and assumptions on an ongoing basis. Our actual results may differ from these estimates under different assumptions or conditions. While our significant accounting policies are described in more detail in Note 2 to our consolidated financial statements appearing elsewhere in this report, we believe that the following accounting policies are those most critical to the judgments and estimates used in the preparation of our consolidated financial statements. Accrued Research and Development Expenses As part of the process of preparing our consolidated financial statements, we are required to estimate our accrued research and development expenses. This process involves reviewing open contracts and purchase orders, communicating with our personnel to identify services that have been performed on our behalf and estimating the level of service performed and the associated cost incurred for the service when we have not yet been invoiced or otherwise notified of actual costs. The majority of our service providers invoice us in arrears for services performed, on a pre-determined schedule or when contractual milestones are met; however, some require advanced payments. We make estimates of our accrued expenses as of each balance sheet date in the consolidated financial statements based on facts and circumstances known to us at that time. We periodically confirm the accuracy of these estimates with the service providers and make adjustments if necessary. Examples of estimated accrued research and development expenses include fees paid to: • vendors, including central laboratories, in connection with preclinical development activities; • CROs and investigative sites in connection with preclinical and clinical studies; and • CMOs in connection with drug substance and drug product formulation of preclinical and clinical trial materials. We base our expenses related to preclinical studies and clinical trials on our estimates of the services received and efforts expended pursuant to quotes and contracts with multiple research institutions and CROs that conduct and manage preclinical studies and clinical trials on our behalf. The financial terms of these agreements are subject to negotiation, vary from contract to contract and may result in uneven payment flows. There may be instances in which payments made to our vendors will exceed the level of services provided and result in a prepayment of the expense. Payments under some of these contracts depend on factors such as the successful enrollment of patients and the completion of clinical trial milestones. In accruing service fees, we estimate the time period over which services will be performed and the level of effort to be expended in each period. If the actual timing of the performance of services or the level of effort varies from the estimate, we adjust the accrual or the amount of prepaid expenses accordingly. Although we do not expect our estimates to be materially different from amounts actually incurred, our understanding of the status and timing of services performed relative to the actual status and timing of services performed may vary and may result in reporting amounts that are too high or too low in any particular period. To date, there have not been any material adjustments to our prior estimates of accrued research and development expenses. Stock-Based Compensation We measure stock options and other stock-based awards granted to employees and members of our board of directors for their services as directors based on the fair value on the date of the grant and recognize the corresponding compensation expense of those awards over the requisite service period, which is generally the vesting period of the respective award. We have issued stock options, restricted stock and restricted stock units with service-based vesting conditions. Prior to the adoption of Accounting Standards Update (ASU) No. 2018-07, Compensation-Stock Compensation (Topic 718): Improvements to Nonemployee Share-Based Payment Accounting (ASU 2018-07), as discussed in Note 2 to our consolidated financial statements appearing at the end of this document, the measurement date for non-employee awards was generally the date the services are completed, resulting in financial reporting period adjustments to stock-based compensation during the vesting terms for changes in the fair value of the awards. After the adoption of ASU 2018-07, the measurement date for non-employee awards is the later of the adoption date of ASU 2018-07, or the date of grant, without change in the fair value of the award. We estimate the fair value of each stock option grant using the Black-Scholes option-pricing model, which uses as inputs the estimated fair value of our common stock and assumptions we make for the volatility of our common stock, the expected term of our stock options, the risk-free interest rate for a period that approximates the expected term of our stock options and our expected dividend yield. We determined the assumptions for the Black-Scholes option-pricing model as discussed below. Each of these inputs is subjective and generally requires significant judgment to determine. • Fair Value of Our Common Stock. The fair value of our common stock is determined based on the quoted market price of our common stock. Prior to our IPO, our stock was not publicly traded, and therefore we estimated the fair value of our common stock, as discussed in “Determination of the Fair Value of Common Stock” below. • Expected Term. The expected term represents the period that the stock-based awards are expected to be outstanding. The expected term of stock options granted has been determined using the simplified method, which uses the midpoint between the vesting date and the contractual term. • Risk-Free Interest Rate. The risk-free interest rate is based on the U.S. Treasury yield curve in effect at the date of grant for zero-coupon U.S. Treasury constant maturity notes with terms approximately equal to the stock-based award’s expected term. • Expected Volatility. Because we do not have long-term trading history of our common stock, the expected volatility was derived from the average historical stock volatilities of several public companies within our industry that we consider to be comparable to our business over a period equivalent to the expected term of the stock-based awards. • Dividend Rate. The expected dividend is zero as we have not paid and do not anticipate paying any dividends in the foreseeable future. If any of the assumptions used in the Black-Scholes model change significantly, stock-based compensation for future awards may differ materially compared with the awards granted previously. Determination of the Fair Value of Common Stock The fair value of our common stock is determined based on the quoted market price of our common stock. Prior to our IPO, there was no public market for our common stock, and consequently, the estimated fair value of our common stock was determined by our board of directors as of the date of each option grant, with input from management, considering third-party valuations of our common stock as well as our board of directors’ assessment of additional objective and subjective factors that it believed were relevant and which may have changed from the date of the most recent third-party valuation through the date of the grant. These third-party valuations were performed in accordance with the guidance outlined in the American Institute of Certified Public Accountants’ Accounting and Valuation Guide, Valuation of Privately-Held-Company Equity Securities Issued as Compensation. After a public trading market for our common stock was established following the closing of our IPO, it was no longer necessary for our board of directors to estimate the fair market value of our common stock in connection with our accounting for granted equity awards. Valuation of Derivative Liability The fair value of the derivative liability recognized in connection with our stock purchase agreement with UHN was determined based on significant inputs not observable in the market, which represents a Level 3 measurement within the fair value hierarchy. The fair value of the derivative liability was determined using the probability-weighted expected return method, or PWERM, which considered as inputs the type and probability of occurrence of an IPO dilution event, the amount of the payment, the expected timing of an IPO dilution event and a risk-adjusted discount rate. Valuation of Warrant Liability In connection with entering into the Loan Agreement, we agreed to issue a warrant to purchase shares of our Series A preferred stock to the lender. We classified the warrant as a liability on our consolidated balance sheet because the warrant represented a free-standing financial instrument that may have required us to transfer assets upon exercise. The warrant liability was initially recorded at fair value upon the date of the warrant issuance and was subsequently remeasured to fair value at each reporting date. Changes in the fair value of the warrant liability were recognized as a component of other income (expense), net in the consolidated statements of operations. We utilized the Black-Scholes option-pricing model, which incorporates assumptions and estimates, to value the warrant. We assessed these assumptions and estimates on a quarterly basis as additional information impacting the assumptions was obtained. Estimates and assumptions impacting the fair value measurement included the fair value per share of the underlying equity instruments issuable upon exercise of the warrant, the remaining contractual term of the warrant, risk-free interest rate, expected dividend yield and expected volatility of the underlying preferred stock. Prior to our IPO in 2018, we had been a private company and lacked company-specific historical and implied volatility information of our stock. Therefore, we estimated expected stock volatility based on the historical volatility of publicly traded peer companies for a term equal to the remaining contractual term of the warrant. The risk-free interest rate was determined by reference to the U.S. Treasury yield curve for time periods approximately equal to the remaining contractual term of the warrant. We estimated a 0% dividend yield based on the fact that we have never paid or declared dividends. Upon the closing of our IPO, the preferred stock warrant became exercisable for common stock instead of preferred stock. The carrying amount of the warrant to purchase preferred stock as of the date of IPO was transferred to additional paid in capital. No further revaluation was required for the warrant to purchase common stock. Emerging Growth Company Status We are an “emerging growth company,” as defined in the Jumpstart Our Business Startups Act of 2012, or the JOBS Act, and we may take advantage of certain exemptions from various reporting requirements that are applicable to other public companies that are not emerging growth companies. We may take advantage of these exemptions until we are no longer an emerging growth company. Section 107 of the JOBS Act provides that an emerging growth company can take advantage of the extended transition period afforded by the JOBS Act for the implementation of new or revised accounting standards. We have elected to use the extended transition period for complying with new or revised accounting standards and, as a result of this election, our financial statements may not be comparable to companies that comply with public company effective dates. We may take advantage of these exemptions up until the last day of the fiscal year following the fifth anniversary of our IPO or such earlier time that we are no longer an emerging growth company. We would cease to be an emerging growth company if we have more than $1.07 billion in annual revenue, we have more than $700.0 million in market value of our stock held by non-affiliates (and we have been a public company for at least 12 months and have filed one annual report on Form 10-K) or we issue more than $1.0 billion of non-convertible debt securities over a three-year period. Off-Balance Sheet Arrangements We did not have during the periods presented, and we do not currently have, any off-balance sheet arrangements, as defined in the rules and regulations of the Securities and Exchange Commission. Recently Issued Accounting Pronouncements A description of recently issued accounting pronouncements that may potentially impact our financial position and results of operations is disclosed in Note 2 to our audited financial statements appearing elsewhere in this report.

<s>[INST] Overview We are a leading clinicalstage gene therapy company with a mission to free people from a lifetime of genetic disease. Our company is focused on developing potentially curative ex vivo lentiviralbased gene therapies to treat patients with rare diseases following a single dose treatment regimen. Our gene therapies employ hematopoietic stem cells that are harvested from the patient and then modified with a lentiviral vector to insert the equivalent of a functional copy of the gene that is defective in the target disease. We believe that our approach, which is designed to transform stem cells from patients into therapeutic products, has the potential to provide curative benefit for a range of diseases. Our initial focus is on a group of rare genetic diseases referred to as lysosomal diseases, some of which today are primarily managed with enzyme replacement therapies, or ERTs. These lysosomal diseases have wellunderstood biologies, identified patient populations, established standards of care yet with significant unmet needs, and represent large market opportunities with approximately $4.0 billion in worldwide net sales in 2019. Our initial pipeline is comprised of four lentiviralbased gene therapy programs, including AVRRD01 for the treatment of Fabry disease, AVRRD04 for the treatment of cystinosis, AVRRD02 for the treatment of Gaucher disease and AVRRD03 for the treatment of Pompe disease. AVRRD01 is currently being evaluated in an investigatorsponsored Phase 1 clinical trial and a companysponsored Phase 2 clinical trial. Five patients have been dosed in the investigatorsponsored Phase 1 clinical trial of AVRRD01, and enrollment is complete. As of March 6, 2020, four patients have been dosed in our companysponsored Phase 2 clinical trial of AVRRD01, and we are actively recruiting additional potential patients for our currently active sites in Australia, Canada and the United States. AVRRD04 is currently being studied by our collaborators at the University of California, San Diego, or UCSD, in a Phase 1/2 investigatorsponsored clinical trial, and as of March 6, 2020 one patient has been dosed. In January 2020, we announced that we received notice of clearance from the U.S. Food and Drug Administration, or FDA, regarding an Investigational New Drug, or IND, application for AVRRD02, our investigational gene therapy for the treatment of Gaucher disease. The Phase 1/2 clinical trial for AVRRD02 is actively recruiting in Australia and Canada, with additional sites planned in the United States. Our AVRRD03 program for Pompe disease is currently in preclinical development with the first INDenabling preclinical study initiated in 2019. Since our inception in 2015, we have devoted substantially all of our resources to organizing and staffing our company, business planning, raising capital, acquiring or discovering product candidates and securing related intellectual property rights, conducting discovery, research and development activities for our programs and planning for potential commercialization. We do not have any products approved for sale and have not generated any revenue from product sales. To date, we have funded our operations with proceeds from the sales of preferred stock and our initial public offering, or IPO, and we have raised additional capital through an underwritten public offering that closed in July 2019, or the July 2019 FollowOn Offering, and an underwritten public offering that closed in February 2020, or the February 2020 FollowOn Offering. Through December 31, 2019, we had received gross cash proceeds of $87.5 million from sales of our preferred stock, and gross cash proceeds, before deducting underwriting discounts and commissions and expenses, of $114.7 million and $138.3 million from sales of our common stock through our IPO and July 2019 FollowOn Offering, respectively. Since our inception, we have incurred significant operating losses. Our ability to generate product revenue sufficient to achieve profitability will depend heavily on the successful development and eventual commercialization of one or more of our current [/INST] Negative. </s>

PennyMac Financial Services, Inc.

2019-03-05

2018-12-31

Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations Critical Accounting Policies Preparation of financial statements in compliance with accounting principles generally accepted in the United States (“GAAP”) requires us to make estimates that affect the reported amounts of assets and liabilities and the disclosure of contingent assets and liabilities at the date of the financial statements, and revenues and expenses during the reporting period. Certain of these estimates significantly influence the portrayal of our financial condition and results, and they require us to make difficult, subjective or complex judgments. Our critical accounting policies primarily relate to our fair value estimates. Fair Value We group assets measured at or based on fair value in three levels based on the markets in which the assets are traded and the observability of the inputs used to determine fair value. These levels are: (1) Includes assets measured on both a recurring and nonrecurring basis based on the accounting principles applicable to the specific asset or liability and whether we have elected to carry the asset or liability at its fair value. As shown above, our consolidated balance sheet is substantially comprised of assets and liabilities that are measured at or based on their fair values. At December 31, 2018, $5.6 billion or 74% of our total assets were carried at fair value on a recurring basis and $2.3 million (real estate acquired in settlement of loans (“REO”) properties, were carried based on its fair value on a non-recurring basis when fair value indicates evidence of impairment of individual properties. Of these assets carried at or based on fair value, $3.2 billion or 42% of total assets are measured using “Level 3” fair value inputs - significant inputs where there is difficulty in observing the inputs used by market participants in establishing fair value. Changes in inputs to measurement of these assets can have a significant effect on the amounts reported for these items including their reported balances and their effects on our income. As a result of the difficulty in observing certain significant valuation inputs affecting our “Level 3” fair value assets and liabilities, we are required to make judgments regarding these items’ fair values. Different persons in possession of the same facts may reasonably arrive at different conclusions as to the inputs to be applied in valuing these assets and liabilities and their fair values. Such differences may result in significantly different fair value measurements. Likewise, due to the general illiquidity of some of these assets, subsequent transactions may be at values significantly different from those reported. Because the fair value of “Level 3” fair value assets and liabilities are difficult to estimate, our valuation process includes performance of these items’ fair value estimation by specialized staff and significant senior management oversight. We have assigned the responsibility for estimating the fair values of non-interest rate lock commitment (“IRLC”) “Level 3” fair value assets and liabilities to our Financial Analysis and Valuation group (the “FAV group”), which is responsible for valuing and monitoring these items and maintenance of our valuation policies and procedures for non-IRLC assets and liabilities. The FAV group submits the results of its valuations to our senior management valuation committee, which oversees the valuations. During 2018, our senior management valuation committee included the Company’s executive chairman, chief executive, chief financial, chief risk, and deputy chief financial officers. The fair value of our IRLCs is developed by our Capital Markets Risk Management staff and is reviewed by our Capital Markets Operations group. Following is a discussion of our approach to measuring the balance sheet items that are most affected by “Level 3” fair value estimates. Mortgage Loans We carry mortgage loans at their fair values. We recognize changes in the fair value of mortgage loans in current period income as a component of Net gains on mortgage loans held for sale at fair value. How we estimate the fair value of mortgage loans is based on whether the mortgage loans are saleable into active markets with observable fair value inputs. · We categorize mortgage loans that are saleable into active markets as “Level 2” fair value assets. We estimate the fair value of such mortgage loans using their quoted market price or market price equivalent. At December 31, 2018, we held $2.3 billion of such mortgage loans. · We categorize mortgage loans that are not saleable into active markets as “Level 3” fair value assets. “Level 3” fair value mortgage loans arise primarily from two sources: - We may purchase certain delinquent government guaranteed or insured mortgage loans from Ginnie Mae guaranteed securitizations included in our mortgage loan servicing portfolio. Our right to purchase such mortgage loans arises as the result of the borrower’s failure to make payments for three consecutive months preceding the month that we repurchase the mortgage loan. Our ability to purchase delinquent mortgage loans provides us with an alternative to our obligation to continue advancing principal and interest at the coupon rate of the related Ginnie Mae security. To the extent such mortgage loans (“early buyout loans” or “EBO”) have not become saleable into another Ginnie Mae guaranteed security by becoming current either through the borrower’s reperformance or through completion of a modification of the mortgage loan’s terms, we measure such mortgage loans using “Level 3” fair value inputs. - Certain of our mortgage loans may become non-saleable into active markets due to our identification of one or more defects. Because such mortgage loans are generally not saleable into active mortgage markets, we classify them as “Level 3” fair value assets. We use a discounted cash flow model to estimate the fair value of “Level 3” fair value mortgage loans. The significant unobservable inputs used in the fair value measurement of our “Level 3” fair value mortgage loans held for sale are discount rates, home price projections and prepayment speeds. Significant changes in any of those inputs in isolation could result in a significant change to the mortgage loans’ fair value measurement. At December 31, 2018, we held $260.0 million of “Level 3” fair value mortgage loans. Interest Rate Lock Commitments Our net gains on mortgage loans held for sale include our estimates of the gains or losses we expect to realize upon the sale of mortgage loans we have contractually committed to fund or purchase but have not yet funded, purchased or sold. We recognize a substantial portion of our net gains on mortgage loans held for sale at fair value before we fund or purchase the mortgage loans as the result of these commitments. We call these commitments IRLCs. We recognize the fair value of IRLCs at the time we make the commitment to the correspondent seller or mortgage loan applicant and adjust the fair value of such IRLCs as the mortgage loan approaches the point of funding or purchase or the prospective transaction is canceled. We carry IRLCs as either Derivative assets or Derivative liabilities on our consolidated balance sheet. The fair value of an IRLC is transferred to Mortgage loans held for sale at fair value when the mortgage loan is funded or purchased. An active, observable market for IRLCs does not exist. Therefore, we measure the fair value of IRLCs using methods we believe that market participants use in pricing IRLCs. We estimate the fair value of an IRLC based on observable Agency MBS prices, our estimates of the fair value of the MSRs we expect to receive in the sale of the mortgage loans and the probability that we will fund or purchase the mortgage loan (the “pull-through rate”). Pull-through rates and MSR fair values are based on our estimates as these inputs are difficult to observe in the mortgage marketplace. Our estimate of the probability that a mortgage loan will be funded and market interest rates are updated as the mortgage loans move through the funding or purchase process and as mortgage market interest rates change and may result in significant changes in our estimates of the fair value of the IRLCs. Such changes are reflected in the change in fair value of IRLCs which is a component of our Net gains on mortgage loans held for sale at fair value in the period of the change. The financial effects of changes in these inputs are generally inversely correlated. Increasing mortgage interest rates have a positive effect on the fair value of the MSR component of IRLC fair value but increase the pull-through rate for the mortgage loan principal and interest payment cash flow component, which has decreased in fair value. A shift in our assessment of an input to the valuation of IRLCs can have a significant effect on the amount of Net gains on sale of mortgage loans held for sale for the period. We believe that the most significant “Level 3” fair value input to the measurement of IRLCs is the pull-through rate. At December 31, 2018, we held $49.3 million of net IRLC assets at fair value. Following is a quantitative summary of the effect of changes in the pull-through rate input on the fair value of IRLCs at December 31, 2018: (1) The upward shift in input amount on a per-loan basis is limited to the amount of shift required to reach a 100% pull-through rate. The preceding analysis holds constant all of the other inputs to show an estimate of the effect on fair value of a change in the pull-through rate. We expect that in a market shock event, multiple inputs would be affected and the effects of these changes may compound or counteract each other. Therefore the preceding analysis is not a projection of the effects of a shock event or a change in our estimate of an input and should not be relied upon as an earnings projection. Mortgage Servicing Rights MSRs represent the fair value assigned to contracts that obligate us to service the mortgage loans on behalf of the owners of the mortgage loans in exchange for servicing fees and the right to collect certain ancillary income from the borrower. We recognize MSRs at our estimate of the fair value of the contract to service the loans. We include changes in fair value of MSRs in current period income as a component of Amortization, impairment and change in fair value of mortgage servicing rights and mortgage servicing liabilities. During the year ended December 31, 2018, we recognized a $129.4 million net reduction in fair value of MSRs: $303.8 million of the reduction was due to realization of cash flows underlying the fair value of MSR, partially offset by a $174.4 million increase due to changes in inputs used to estimate fair value. We classify MSRs as “Level 3” fair value assets and determine their fair value using a discounted cash flow approach. We believe the most significant “Level 3” fair value inputs to the valuation of MSRs are the pricing spread (used to develop periodic discount rates), prepayment speed and annual per-loan cost of servicing. A shift in the market for MSRs or a change in our assessment of an input to the valuation of MSRs can have a significant effect on their fair value and in our income for the period. The fair value of MSRs that we held at December 31, 2018 was $2.8 billion. Following is a summary of the effect on fair value of MSRs of various changes to these key inputs at December 31, 2018: The preceding analyses hold constant all of the inputs other than the input that is being changed to show an estimate of the effect on fair value of a change in a specific input. We expect that in a market shock event, multiple inputs would be affected and the effects of these changes may compound or counteract each other. Therefore the preceding analyses are not projections of the effects of a shock event or a change in our estimate of an input and should not be relied upon as earnings projections. Excess Servicing Spread Financing We finance a portion of the cost of Agency MSRs that we purchase from non-affiliate sellers through the sale to PMT of the servicing spread in excess of a specified level. We carry our ESS at fair value. Because the ESS is a claim to a portion of the cash flows from MSRs, the valuation of the ESS is similar to that of MSRs. We use the same discounted cash flow approach to measure the ESS and the related MSRs except that certain inputs relating to the cost to service the mortgage loans underlying the MSRs and certain ancillary income are not included in the ESS valuation as these cash flows do not accrue to the holder of the ESS. A shift in the market for, or a change in our assessment of an input to, the valuation of ESS can have a significant effect on the fair value of ESS and in our income for the period. However, we believe that this change will be offset to a great extent by a change in the fair value of the MSRs that the ESS is financing. We record changes in the fair value of ESS in Amortization, impairment and change in fair value of mortgage servicing rights and mortgage servicing liabilities. During the year ended December 31, 2018, we recorded $8.5 million of net increase in fair value of ESS. We believe that the most significant “Level 3” fair value inputs to the valuation of ESS are the pricing spread (used to develop periodic discount rates) and prepayment speed. At December 31, 2018, we carried $216.1 million of ESS at fair value. Following is a summary of the effect on fair value of various changes to these inputs at December 31, 2018: The preceding analyses hold constant all of the inputs other than the input that is being changed to show an estimate of the effect on fair value of a change in that specific input. We expect that in a market shock event, multiple inputs would be affected and the effects of these changes may compound or counteract each other. Therefore the preceding analyses are not projections of the effects of a shock event or a change in our estimate of an input and should not be relied upon as earnings projections. Critical Accounting Policy Not Based on Fair Value- Liability for Losses Under Representations and Warranties We record a provision for losses relating to our representations and warranties as part of our mortgage loan sale transactions and periodically update our estimates of our liability. The method we use to estimate the liability for representations and warranties is a function of the representations and warranties given and considers a combination of factors, including, but not limited to, estimated future default and mortgage loan repurchase rates, the potential severity of loss in the event of default and, if applicable, the probability of reimbursement by the correspondent mortgage loan seller. The level of the liability for losses under representations and warranties is difficult to estimate and requires considerable judgment. The level of mortgage loan repurchase losses is dependent on economic factors, purchaser or insurer loss mitigation strategies, and other external conditions that may change over the lives of the underlying mortgage loans. Our estimate of the liability for representations and warranties is developed by our credit administration staff. The liability estimate is reviewed and approved by our senior management credit committee which includes the senior executives of the Company and of the loan production, loan servicing and credit risk management areas. During the year ended December 31, 2018, we recorded $5.8 million in provision for losses relating to current year mortgage loan sales in Net gain on mortgage loans held for sale at fair value and incurred net losses totaling $50,000. As economic fundamentals change, as purchaser and insurer evaluations of their loss mitigation strategies (including claims under representations and warranties) change and as the mortgage market and general economic conditions affect our correspondent sellers, the level of repurchase activity and ensuing losses will change. As a result of these changes, we may be required to adjust the estimate of our liability for representations and warranties. Such an adjustment may be material to our financial condition and income. During the year ended December 31, 2018, we recorded reductions to our previously recorded representations and warranties liability amounts totaling $4.7 million in Net gain on mortgage loans held for sale at fair value. At December 31, 2018, the balance of our liability for losses under representations and warranties totaled $21.2 million. Accounting Developments Refer to Note 3 - Significant Accounting Policies - Recently Issued Accounting Pronouncement to our consolidated financial statements for a discussion of recent accounting developments and the expected effect on the Company. Results of Operations Our results of operations are summarized below: (1) Primarily represents repricing of Payable to exchanged Private National Mortgage Acceptance Company, LLC unitholders under tax receivable agreement, of which, for 2017, $32.0 million was the result of the change in the federal tax rate under Tax Cuts and Jobs Act of 2017 (the “Tax Act”). Comparison of the years ended December 31, 2018, 2017 and 2016 During the year ended December 31, 2018, we recorded net income of $244.4 million, a decrease of $67.1 million or 22% from 2017. The decrease was primarily due to an increase of $97.4 million in total expense, which was partially offset by an increase of $29.2 million in total net revenue. The increase in total expense was primarily due to expansion of our loan servicing and production businesses. The increase in total net revenue is primarily due to an increase of $139.3 million in Net mortgage loan servicing fees and an increase of $73.2 million in Net interest income, partially offset by decreases of $142.8 million in Net gains on mortgage loans held for sale at fair value, $17.6 million in Mortgage loan origination fees and $25.5 million in Other income. The decrease in our Net gains on mortgage loans held for sale at fair value reflects continued competitive pressures in the mortgage market place arising from the effect of increasing interest rates on borrower demand for mortgage loans. Increasing interest rates also contributed $70.8 million to Net mortgage loan servicing fees in the form of fair value gains net of hedging results during 2018 as compared to 2017. As discussed in Net interest income below, financing incentives contributed $48.1 million and $9.2 million to our pre-tax income during the years ended December 31, 2018, and 2017, respectively. The master repurchase agreement underlying the incentives is subject to a rolling six-month term through August 21, 2019, unless terminated earlier at the option of the lender. We expect that we will cease to accrue the incentives under the repurchase agreement in the second quarter of 2019. While there can be no assurance, we expect that the loss of such incentive income will be partially offset by an improvement in pricing margins. During the year ended December 31, 2017, we recorded net income of $311.5 million, a decrease of $25.5 million or 8% from 2016. The decrease was primarily due to a decrease in Net gains on mortgage loans held for sale at fair value due to decreases in our loan production volume and production profit margins. The decrease in production volume and production profit margins during the year ended December 31, 2017, reflects generally rising interest rates in the mortgage market, which have a negative influence on demand for mortgage lending and causes increased competition for mortgage loans among market participants. The decrease in Net gains on mortgage loans held for sale at fair value was partially offset by an increase in Net mortgage loan servicing fees which reflects both growth in our servicing portfolio and improved fair value adjustments resulting from the more stable interest rates and decreased risk premium for government servicing assets. Net mortgage loan servicing fees Following is a summary of our net mortgage loan servicing fees: Amortization, impairment and change in fair value of mortgage servicing rights and excess servicing spread are summarized below: Following is a summary of our mortgage loan servicing portfolio: Net mortgage loan servicing fees increased $139.3 million and $120.6 million during the years ended December 31, 2018 and 2017, compared to the years ended December 31, 2017 and 2016, respectively. The increase was due to a combination of increased mortgage loan servicing fees resulting from growth in our mortgage loan servicing portfolio and decreased losses in fair value and impairment of MSRs and mortgage servicing liabilities (“MSLs”), net of hedging results, resulting from the effect of generally rising interest rates from 2016. Mortgage loan servicing fees increased $112.0 million and $93.6 million during the years ended December 31, 2018 and 2017, compared to the years ended December 31, 2017 and 2016, respectively, reflecting an increase in our average servicing portfolio of 22% and 25% during the years ended December 31, 2018 and 2017, compared to the years ended December 31, 2017 and 2016, respectively. These increases were moderated by decreasing mortgage loan servicing fees from the Advised Entities due to a reduction in fees related to the servicing of distressed mortgage loans as those loan portfolios liquidated in the case of two of the Investment Funds, and continued to liquidate in the case of PMT. Special servicing activities generate higher revenues on a per-loan basis than prime servicing due to the higher costs we incur to service such loans. Net gains on mortgage loans held for sale at fair value Most of our mortgage loan production consists of government-insured or guaranteed mortgage loans that we source primarily through PMT. PMT is not approved by Ginnie Mae as an issuer of Ginnie Mae-guaranteed securities which are backed by government-insured or guaranteed mortgage loans. We purchase such mortgage loans that PMT acquires through its correspondent production activities and pay PMT a sourcing fee ranging from two to three and one-half basis points on the UPB of such mortgage loans. During the year ended December 31, 2018, we recognized Net gains on mortgage loans held for sale at fair value totaling $249.0 million, compared to $391.8 million and $531.8 million during the years ended December 31, 2017 and 2016, respectively. The decreases in 2018 and 2017 compared to 2017 and 2016 were primarily due to decreases in both loan production volume for our own account and profit margins reflecting the generally rising interest rates in the mortgage market, which has a negative influence on demand for mortgage lending. Reduced demand negatively influences profit margins by causing increased price competition in the acquisition and origination of mortgage loans. Our net gains on mortgage loans held for sale include both cash and non-cash elements. We receive proceeds on sale that include both cash and MSRs. The net gain for the years ended December 31, 2018, 2017 and 2016 included $584.2 million, $563.9 million, and $562.5 million, respectively, in fair value of MSRs received as part of proceeds on sales, net of mortgage servicing liabilities incurred. We also recognize a liability for our estimate of the losses we expect to incur in the future as a result of claims against us in connection with the representations and warranties that we made in the loan sales transactions. The net gain for the years ended December 31, 2018, 2017 and 2016, included net provisions for (reversals of) losses relating to representations and warranties of $1.2 million, $1.6 million, and ($582,000), respectively. Our net gains on mortgage loans held for sale are summarized below: Provision for Losses Under Representations and Warranties We record our estimate of the losses that we expect to incur in the future as a result of claims against us made in connection with the representations and warranties provided to the purchasers and insurers of the mortgage loans we sold in our Net gains on sale of mortgage loans held for sale at fair value. Our agreements with the purchasers and insurers include representations and warranties related to the mortgage loans we sell to purchasers. The representations and warranties require adherence to purchaser and insurer origination and underwriting guidelines, including but not limited to the validity of the lien securing the mortgage loan, property eligibility, borrower credit, income and asset requirements, and compliance with applicable federal, state and local law. In the event of a breach of our representations and warranties, we may be required to either repurchase the mortgage loans with the identified defects or indemnify the purchaser or insurer. In such cases, we bear any subsequent credit loss on the mortgage loans. Our credit loss may be reduced by any recourse we have to correspondent originators that sold such mortgage loans to us and breached similar or other representations and warranties. In such event, we have the right to seek a recovery of related repurchase losses from that correspondent seller. The method used to estimate our losses on representations and warranties is a function of our estimate of future defaults, mortgage loan repurchase rates, the severity of loss in the event of default, if applicable, and the probability of reimbursement by the correspondent mortgage loan seller. We establish a liability at the time mortgage loans are sold and review our liability estimate on a periodic basis. During the years ended December 31, 2018, 2017, and 2016 we recorded provisions for losses under representations and warranties relating to current mortgage loan sales as a component of Net gains on mortgage loans held for sale at fair value totaling $5.8 million, $5.9 million, and $7.1 million, respectively. We also recorded reductions in the liability of $4.7 million, $4.3 million, and $7.7 million, for the years ended December 31, 2018, 2017 and 2016, respectively. The reductions in the liability resulted from previously sold mortgage loans meeting criteria established by the Agencies which exempt them from certain repurchase or indemnification claims. Following is a summary of mortgage loan repurchase activity and the unpaid balance of mortgage loans subject to representations and warranties: During the year ended December 31, 2018, we repurchased mortgage loans with unpaid principal balances totaling $26.0 million and charged $50,000 in net incurred losses relating to repurchases against our liability for representations and warranties. As the outstanding balance of mortgage loans we purchase and sell subject to representations and warranties increases and the loans sold continue to season, we expect that the level of repurchase activity may increase. Mortgage loan origination fees Following is a summary of our mortgage loan origination fees: Mortgage loan origination fees decreased $17.6 million and $6.3 million during the years ended December 31, 2018, and 2017, compared to the years ended December 31, 2017 and 2016, respectively. The decreases were primarily due to decreases in the volume of mortgage loans we produced. Fulfillment fees fron PennyMac Mortgage Investment Trust Following is a summary of our fulfillment fees: Fulfillment fees from PMT represent fees we collect for services we perform on behalf of PMT in connection with the acquisition, packaging and sale of mortgage loans. The fulfillment fees are calculated as a percentage of the UPB of the mortgage loans we fulfill for PMT. Fulfillment fees increased $1.0 million during the year ended December 31, 2018, compared to the year ended December 31, 2017. The increase was primarily due to increased volume of mortgage loans we fulfilled for PMT, partially offset by discretionary reductions in the fulfillment fee rate made to facilitate certain loan acquisition transactions by PMT in a competitive market environment. Fulfillment fees decreased $6.1 million during the year ended December 31, 2017, compared to the year ended December 31, 2016, primarily due to realization of a lower fulfillment fee rate during 2017 compared to 2016 resulting from amendments to the mortgage banking services agreement with PMT. Net Interest Income Net interest income increased $73.2 million during the year ended December 31, 2018 compared to the year ended December 31, 2017. The increase is primarily due to a $38.9 million increase of incentives relating to financing of mortgage loans under a master repurchase agreement and an increase of $37.4 million in the placement fees we receive relating to the custodial funds, reflecting the growth of our servicing portfolio and higher interest rates, as well as an increase in interest income on mortgage loans held for sale. Net interest expense decreased $23.7 million during the year ended December 31, 2017 compared to the year ended December 31, 2016. The decrease was primarily due to an increase in interest income on mortgage loans held for sale as a result of an increase in average mortgage loan inventory and an increase in the placement fees we receive relating to the custodial funds we held, partially offset by an increase in interest expense incurred to fund the growth in our average inventory of mortgage loans held for sale and to finance our MSRs. We entered into a master repurchase agreement in 2017 that provides us with incentives to finance mortgage loans approved for satisfying certain consumer relief characteristics as provided in the agreement. We recorded $48.1 million and $9.2 million of such incentives as reductions of Interest expense during the year ended December 31, 2018 and 2017, respectively. The master repurchase agreement is subject to a rolling six-month term through August 21, 2019, unless terminated earlier at the option of the lender. We expect that we will cease to accrue the incentives under the repurchase agreement in the second quarter of 2019. While there can be no assurance, we expect that the loss of such incentives will be partially offset by an improvement in pricing margins in our Net gains on mortgage loans held for sale at fair value. Management fees and Carried Interest Management fees and Carried Interest are summarized below: Management fees from PMT increased by $1.9 million during the year ended December 31, 2018, compared to the year ended December 31, 2017, primarily reflecting the increase in PMT’s average shareholders’ equity upon which its management fees are based and an increase in performance incentive fees. The performance incentive fees increased $1.1 million during the year ended December 31, 2018, compared to the year ended December 31, 2017, resulting from an increase in PMT’s net income on which incentive fees are based. Management fees from PMT increased $1.9 million during the year ended December 31, 2017, compared to the year ended December 31, 2016, primarily reflecting the increase in PMT’s average shareholders’ equity upon which its base management fee is based. The increase of PMT’s average shareholders’ equity during the year ended December 31, 2017, compared to the year ended December 31, 2016, was primarily due to the issuance of additional equity by PMT in the form of preferred shares. The performance incentive fees increased $304,000 during the year ended December 31, 2017 compared to the year ended December 31, 2016 resulting from an increase in PMT’s net income on which incentive fees are based. Management fees from the Investment Funds decreased $1.0 million and $1.1 million for the years ended December 31, 2018 and December 31, 2017, compared to the years ended December 31, 2017 and December 31, 2016, respectively. The reduction of management fees was anticipated as the Investment Funds completed their liquidation during the year ended December 31, 2018. Change in Fair Value of Investment in and Dividends Received from PMT The results of our holdings of common shares of PMT, which is included in Changes in fair value of investment in, and dividends received from PMT are summarized below: Change in fair value of investment in and dividends received from PMT increased $214,000 during the year ended December 31, 2018 compared to the year ended December 31, 2017 and decreased $106,000 during the year ended December 31, 2017 compared to the year ended December 31, 2016, primarily due to changes in the fair value of our investment in PMT. We held 75,000 common shares of PMT during each of the three years ended December 31, 2018. Other revenues Other revenue decreased $25.5 million for the year ended December 31, 2018, compared to the year ended December 31, 2017. The decrease is primarily due to a decrease of $31.8 million in Revaluation of Payable to exchanged Private National Mortgage Acceptance Company, LLC unitholders under the tax receivable agreement as a result of the reduction in the federal tax rate which was recorded in 2017, partially offset by an increase of $5.1 million in reimbursements from PMT due to our adoption of the Financial Accounting Standard Board’s Accounting Standards Update 2014-09, Revenue from Contracts with Customers (Subtopic 606) using the modified retrospective method effective January 1, 2018. Those reimbursements were included as a reduction of expense in previous years. Other revenue increased $32.8 million during the year ended December 31, 2017 compared to the year ended December 31, 2016. The increase was primarily due to our recording of a $32.0 million Revaluation of Payable to exchanged Private National Mortgage Acceptance Company, LLC unitholders under the tax receivable agreement as a result of the reduction in the federal tax rate. Expenses Compensation Our compensation expense is summarized below: Compensation expense increased $44.5 million during the year ended December 31, 2018, compared to the year ended December 31, 2017. The increase in compensation was primarily due to increased base salaries, taxes and benefits due to increased average head count resulting from the growth in our mortgage banking activities during 2018. Compensation expense increased $16.6 million during the year ended December 31, 2017, compared to the year ended December 31, 2016. The increase was primarily due to an increase in base salaries due to increased average head count during 2017 compared to 2016 resulting from the development of and growth in our mortgage banking segments, partially offset by a decrease in incentive compensation due to lower attainment of profitability targets during 2017 compared to 2016. Servicing Servicing expense increased $19.4 million and $31.8 million in the years ended December 31, 2018 and 2017 compared to the years ended December 31, 2017 and 2016, respectively. The increases were due to growth in our government-insured or guaranteed mortgage servicing portfolio, which includes mortgage loans that are subject to nonreimbursable servicing advance losses, and to our EBO program to purchase defaulted mortgage loans out of Ginnie Mae pools. The EBO program reduces the ongoing cost of servicing defaulted mortgage loans subject to Ginnie Mae MBS when we purchase and either sell the defaulted loans or finance them with debt at interest rates below the Ginnie Mae MBS pass-through rates. While the EBO program reduces the ultimate cost of servicing such mortgage loan pools, it accelerates loss recognition when the mortgage loans are purchased. We recognize expense because purchasing the mortgage loans from their Ginnie Mae pools causes us to write off accumulated non-reimbursable interest advances, net of interest receivable from the mortgage loans’ insurer or guarantor at the debenture rate of interest applicable to the respective mortgage loans. During the year ended December 31, 2018, we purchased $3.0 billion in UPB of EBOs as compared to $2.9 billion for the year ended December 31, 2017 and $1.6 billion for the year ended December 31, 2016. Technology Technology expense increased $8.1 million and $16.7 million in the years ended December 31, 2018 and 2017 compared to the years ended December 31, 2017 and 2016, respectively. The increases were primarily due to growth in loan servicing operations and continued investment in loan production and servicing infrastructure. Occupancy and equipment Occupancy and equipment expenses increased $4.5 million and $5.5 million during the years ended December 31, 2018 and 2017, compared to the years ended December 31, 2017 and 2016, respectively. The increases are primarily attributable to expansion of our facilities to accommodate our growth. Provision for Income Taxes For the years ended December 31, 2018, 2017 and 2016, our effective tax rates were 8.7%, 7.3%, and 12.0%, respectively. The difference between our effective tax rate and the statutory rates was primarily due to the allocation of earnings to the noncontrolling interest unitholders. Pursuant to the Reorganization, the noncontrolling interest unitholders converted their ownership units into our shares and as a result, we were allocated starting on that date and will in the future be allocated 100% of PNMAC earnings that will be subject to corporate federal and state statutory tax rates, which will in turn increase our effective income tax rate. The lower effective tax rate for 2017 also reflects the effect of the repricing of the net deferred tax liability resulting from the change in the federal statutory rate from 35% to 21% under the Tax Act. Balance Sheet Analysis Following is a summary of key balance sheet items as of the dates presented: Total assets increased $110.5 million from $7.4 billion at December 31, 2017 to $7.5 billion at December 31, 2018. The increase was primarily due to an increase of $701.2 million in MSRs reflecting continued additions from our mortgage loan production activities and servicing portfolio acquisitions, partially offset by a decrease of $577.5 million in mortgage loans held for sale at fair value resulting from a reduction in mortgage loan production inventory. Total liabilities increased by $176.4 million from $5.6 billion as of December 31, 2017 to $5.8 billion as of December 31, 2018. The increase was primarily attributable to an increase of $513.6 million in long-term debt primarily due to issuance of notes payable and an increase of $358.5 million in other liabilities primarily due to an increase in income tax payable relating to conversion of the noncontrolling interest in PennyMac to common stockholders’ equity pursuant to the Reorganization, partially offset by a decrease of $513.6 million of short-term debt due to lower production inventory. Cash Flows Our cash flows for the three years ended December 31, 2018 are summarized below: Operating activities Net cash provided by (used in) operating activities totaled $572.4 million, ($883.4) million, and ($938.3) million during the years ended December 31, 2018, 2017, and 2016 respectively. Our cash flows from operating activities are primarily influenced by changes in the levels of our inventory of mortgage loans as shown below: The increase in cash flow from other operating sources during the year ended December 31, 2018, compared to the year ended December 31, 2017, was primarily attributable to our collection of $31.9 million in repurchase agreement derivatives and an increase in net changes in other assets and accounts payable and accrued expenses in the amount of $68.2 million. We expect that we will cease to accrue the incentives under the repurchase agreement in the second quarter of 2019. While there can be no assurance, we expect that the loss of such incentive income will be partially offset by an improvement in pricing margins in our Net gains on mortgage loans held for sale at fair value. Investing activities Net cash used in investing activities was $322.6 million during the year ended December 31, 2018, a decrease of $16.6 million compared to the year ended December 31, 2017. The decrease was primarily due to an $85.6 million increase in cash used in net settlement of derivative financial instruments used to hedge our investment in MSRs and an increase of $49.1 million in purchase of MSRs, partially offset by an increase of $136.4 million in short-term investment cash flows. Net cash used in investing activities was $339.2 million during 2017, an increase of $304.5 million from 2016 due to increased purchases of MSRs during 2017 as compared to 2016. Financing activities Net cash used in financing activities totaled $132.0 million during the year ended December 31, 2018 primarily due to net repurchases of assets sold under agreements to repurchase and mortgage loan participation purchase and sale agreements of $440.9 million, reflecting a reduction in our financing of mortgage loans held for sale, and repayments of excess servicing spread financing of $46.8 million, partially offset by net proceeds from issuance of notes payable of $400 million. Net cash provided by financing activities was $1.2 billion during the year ended December 31, 2017, primarily due to an increase in loans sold under agreements to repurchase and notes payable used to finance the growth in our inventory of mortgage loans held for sale and MSRs. Net cash provided by financing activities was $967.2 million during the year ended December 31, 2016, primarily from net proceeds from sales of assets under agreements to repurchase of $569.5 million, net proceeds from issuances of mortgage loan participation certificates of $436.7 million and net proceeds from advances on notes payable of $89.3 million to finance growth in our inventory of mortgage loans held for sale and investments in MSRs. The increases were partially offset by repayments of ESS totaling $129.0 million. Liquidity and Capital Resources Our liquidity reflects our ability to meet our current obligations (including our operating expenses and, when applicable, the retirement of, and margin calls relating to, our debt, and margin calls relating to hedges on our commitments to purchase or originate mortgage loans and on our MSR investments), fund new originations and purchases, and make investments as we identify them. We expect our primary sources of liquidity to be through cash flows from business activities, proceeds from bank borrowings, proceeds from and issuance of ESS and/or equity or debt offerings. We believe that our liquidity is sufficient to meet our current liquidity needs. Our current borrowing strategy is to finance our assets where we believe such borrowing is prudent, appropriate and available. Our borrowing activities are in the form of sales of assets under agreements to repurchase, sales of mortgage loan participation certificates, ESS financing, notes payable (including a revolving credit agreement) and a capital lease. Most of our borrowings have short-term maturities and provide for terms of approximately one year. Because a significant portion of our current debt facilities consists of short-term borrowings, we expect to renew these facilities in advance of maturity in order to ensure our ongoing liquidity and access to capital or otherwise allow ourselves sufficient time to replace any necessary financing. Our repurchase agreements represent the sales of assets together with agreements for us to buy back the assets at a later date. The table below presents the average outstanding, maximum and ending balances for each of the three years ended December 31, 2018, 2017 and 2016: The differences between the average and maximum daily balances on our repurchase agreements reflect the fluctuations throughout the month of our inventory as we fund and pool mortgage loans for sale in guaranteed mortgage securitizations. Our secured financing agreements at PLS require us to comply with various financial covenants. The most significant financial covenants currently include the following: · positive net income during each calendar quarter; · a minimum in unrestricted cash and cash equivalents of $40 million; · a minimum tangible net worth of $500 million; · a maximum ratio of total liabilities to tangible net worth of 10:1; and · at least one other warehouse or repurchase facility that finances amounts and assets that are similar to those being financed under certain of our existing secured financing agreements. With respect to servicing performed for PMT, PLS is also subject to certain covenants under PMT’s debt agreements. Covenants in PMT’s debt agreements are equally, or sometimes less, restrictive than the covenants described above. In addition to the covenants noted above, PennyMac’s revolving credit agreement and capital lease contain additional financial covenants including, but not limited to, · a minimum of cash equal to the amount borrowed under the revolving credit agreement; · a minimum of unrestricted cash and cash equivalents equal to $25 million; · a minimum of tangible net worth of $500 million; · a minimum asset coverage ratio (the ratio of the total asset amount to the total commitment) of 2.5; and · a maximum ratio of total indebtedness to tangible net worth ratio of 5:1. Although these financial covenants limit the amount of indebtedness that we may incur and affect our liquidity through minimum cash reserve requirements, we believe that these covenants currently provide us with sufficient flexibility to successfully operate our business and obtain the financing necessary to achieve that purpose. Our debt financing agreements also contain margin call provisions that, upon notice from the applicable lender at its option, require us to transfer cash or, in some instances, additional assets in an amount sufficient to eliminate any margin deficit. A margin deficit will generally result from any decline in the market value (as determined by the applicable lender) of the assets subject to the related financing agreement. Upon notice from the applicable lender, we will generally be required to satisfy the margin call on the day of such notice or within one business day thereafter, depending on the timing of the notice. We are also subject to liquidity and net worth requirements established by FHFA for Agency seller/servicers and Ginnie Mae for single-family issuers. FHFA and Ginnie Mae have established minimum liquidity requirements and revised their net worth requirements for their approved non-depository single-family sellers/servicers in the case of Fannie Mae, Freddie Mac, and Ginnie Mae for its approved single-family issuers, as summarized below: · FHFA liquidity requirement is equal to 0.035% (3.5 basis points) of total Agency servicing UPB plus an incremental 200 basis points of the amount by which total nonperforming Agency servicing UPB exceeds 6% of the applicable Agency servicing UPB; allowable assets to satisfy liquidity requirement include cash and cash equivalents (unrestricted), certain investment-grade securities that are available for sale or held for trading including Agency mortgage-backed securities, obligations of Fannie Mae or Freddie Mac, and U.S. Treasury obligations, and unused and available portions of committed servicing advance lines; · FHFA net worth requirement is a minimum net worth of $2.5 million plus 0.25% (25 basis points) of UPB for total 1-4 unit residential mortgage loans serviced and a tangible net worth/total assets ratio greater than or equal to 6%; · Ginnie Mae single-family issuer minimum liquidity requirement is equal to the greater of $1.0 million or 0.10% (10 basis points) of the issuer’s outstanding Ginnie Mae single-family securities, which must be met with cash and cash equivalents; and · Ginnie Mae net worth requirement is equal to $2.5 million plus 0.35% (35 basis points) of the issuer’s outstanding Ginnie Mae single-family obligations. We believe that we are currently in compliance with the applicable Agency requirements. We have purchased portfolios of MSRs and have financed them in part through the sale to PMT of the right to receive ESS. The outstanding amount of the ESS is based on the current fair value of such ESS and amounts received on the underlying mortgage loans. In June 2017, our Board of Directors approved a stock repurchase program that allows us to repurchase up to $50 million of our common stock using open market stock purchases or privately negotiated transactions in accordance with applicable rules and regulations. The stock repurchase program does not have an expiration date and the authorization does not obligate us to acquire any particular amount of common stock. We intend to finance the stock repurchase program through cash on hand. From inception through December 31, 2018, we have repurchased $13.9 million of shares under our stock repurchase program. We continue to explore a variety of means of financing our continued growth, including debt financing through bank warehouse lines of credit, bank loans, repurchase agreements, securitization transactions and corporate debt. However, there can be no assurance as to how much additional financing capacity such efforts will produce, what form the financing will take or whether such efforts will be successful. Off-Balance Sheet Arrangements and Aggregate Contractual Obligations Off-Balance Sheet Arrangements As of December 31, 2018, we have not entered into any off-balance sheet arrangements or guarantees. Contractual Obligations As of December 31, 2018 we had contractual obligations aggregating $7.3 billion, comprised of commitments to purchase and originate mortgage loans, borrowings, and a payable to exchanged Private National Mortgage Acceptance Company, LLC unitholders under a tax receivable agreement. We also lease our office facilities and license certain software to support our loan servicing operations. Payment obligations under these agreements are summarized below: (1) Software licenses include both volume and activity based fees that are dependent on the number of loans serviced during each period and include a base fee of approximately $1.8 million per month. Estimated payments for software licenses above are based on the number of loans currently serviced by us, which totaled approximately 1.5 million at December 31, 2018. Future amounts due may significantly fluctuate based on changes in the number of loans serviced by us. For the year ended December 31, 2018, software license fees totaled $25.4 million. The amount at risk (the fair value of the assets pledged plus the related margin deposit, less the amount advanced by the counterparty and accrued interest) relating to our assets sold under agreements to repurchase is summarized by counterparty below as of December 31, 2018: (1) The borrowing facility with Credit Suisse First Boston Mortgage Capital LLC is in the form of a sale of a variable funding note under an agreement to repurchase. Beneficial interests in the Ginnie Mae MSRs and servicing advances are pledged to the Issuer Trust and together serve as the collateral backing the VFN, 2018-GT1 Notes and 2018-GT2 Notes described in Note 13-Borrowings. 2018-GT1 Notes and 2018-GT2 Notes are included in Notes payable on the Company's consolidated balance sheet. (2) The borrowing facility with Credit Suisse First Boston Mortgage Capital LLC is in the form of an asset sale under an agreement to repurchase. Debt Obligations As described further above in “Liquidity and Capital Resources,” we currently finance certain of our assets through borrowings with major financial institution counterparties in the form of sales of assets under agreements to repurchase, mortgage loan participation purchase and sale agreements, notes payable (including a revolving credit agreement), ESS and a capital lease. The borrower under each of these facilities is PLS or subsidiary Issuer Trust with the exception of the revolving credit agreement, which is classified as a note payable, and the capital lease, in each case where the borrower is PennyMac. All PLS obligations as previously noted are guaranteed by PennyMac. Under the terms of these agreements, PLS is required to comply with certain financial covenants, as described further above in “Liquidity and Capital Resources,” and various non-financial covenants customary for transactions of this nature. As of December 31, 2018, we believe we were in compliance in all material respects with these covenants. The agreements also contain margin call provisions that, upon notice from the applicable lender, require us to transfer cash or, in some instances, additional assets in an amount sufficient to eliminate any margin deficit. Upon notice from the applicable lender, we will generally be required to satisfy the margin call on the day of such notice or within one business day thereafter, depending on the timing of the notice. In addition, the agreements contain events of default (subject to certain materiality thresholds and grace periods), including payment defaults, breaches of covenants and/or certain representations and warranties, cross-defaults, guarantor defaults, servicer termination events and defaults, material adverse changes, bankruptcy or insolvency proceedings and other events of default customary for these types of transactions. The remedies for such events of default are also customary for these types of transactions and include the acceleration of the principal amount outstanding under the agreements and the liquidation by our lenders of the mortgage loans or other collateral then subject to the agreements. The borrowings have maturities as follows: (1) Outstanding indebtedness as of December 31, 2018. (2) Total facility size, committed facility and maturity date include contractual changes through the date of this Report. (3) The borrowing of $140 million with Credit Suisse First Boston Mortgage Capital LLC is in the form of a sale of a variable funding note under an agreement to repurchase up to a maximum of $400 million, less any amount utilized under the Credit Suisse AG note payable facility. All debt financing arrangements that matured between December 31, 2018 and the date of this Report have been renewed or extended and are described in Note 13-Borrowings to the accompanying consolidated financial statements.

<s>[INST] Preparation of financial statements in compliance with accounting principles generally accepted in the United States (“GAAP”) requires us to make estimates that affect the reported amounts of assets and liabilities and the disclosure of contingent assets and liabilities at the date of the financial statements, and revenues and expenses during the reporting period. Certain of these estimates significantly influence the portrayal of our financial condition and results, and they require us to make difficult, subjective or complex judgments. Our critical accounting policies primarily relate to our fair value estimates. Fair Value We group assets measured at or based on fair value in three levels based on the markets in which the assets are traded and the observability of the inputs used to determine fair value. These levels are: (1) Includes assets measured on both a recurring and nonrecurring basis based on the accounting principles applicable to the specific asset or liability and whether we have elected to carry the asset or liability at its fair value. As shown above, our consolidated balance sheet is substantially comprised of assets and liabilities that are measured at or based on their fair values. At December 31, 2018, $5.6 billion or 74% of our total assets were carried at fair value on a recurring basis and $2.3 million (real estate acquired in settlement of loans (“REO”) properties, were carried based on its fair value on a nonrecurring basis when fair value indicates evidence of impairment of individual properties. Of these assets carried at or based on fair value, $3.2 billion or 42% of total assets are measured using “Level 3” fair value inputs significant inputs where there is difficulty in observing the inputs used by market participants in establishing fair value. Changes in inputs to measurement of these assets can have a significant effect on the amounts reported for these items including their reported balances and their effects on our income. As a result of the difficulty in observing certain significant valuation inputs affecting our “Level 3” fair value assets and liabilities, we are required to make judgments regarding these items’ fair values. Different persons in possession of the same facts may reasonably arrive at different conclusions as to the inputs to be applied in valuing these assets and liabilities and their fair values. Such differences may result in significantly different fair value measurements. Likewise, due to the general illiquidity of some of these assets, subsequent transactions may be at values significantly different from those reported. Because the fair value of “Level 3” fair value assets and liabilities are difficult to estimate, our valuation process includes performance of these items’ fair value estimation by specialized staff and significant senior management oversight. We have assigned the responsibility for estimating the fair values of noninterest rate lock commitment (“IRLC”) “Level 3” fair value assets and liabilities to our Financial Analysis and Valuation group (the “FAV group”), which is responsible for valuing and monitoring these items and maintenance of our valuation policies and procedures for nonIRLC assets and liabilities. The FAV group submits the results of its valuations to our senior management valuation committee, which oversees the valuations. During 2018, our senior management valuation committee included the Company’s executive chairman, chief executive, chief financial, chief risk, and deputy chief financial officers. The fair value of our IRLCs is developed by our Capital Markets Risk Management staff and is reviewed by our Capital Markets Operations group. Following is a discussion of our approach to measuring the balance sheet items that are most affected by “Level 3” fair value estimates. Mortgage Loans We carry mortgage loans at their fair values. We recognize changes in the fair value of mortgage loans in current period income as a component of Net gains on mortgage loans held for sale at fair value. How we estimate the fair value of mortgage loans is based on whether the mortgage loans are saleable into active markets with observable fair value inputs. · We categorize mortgage loans that are saleable into active markets as “Level 2” fair value assets. We estimate the fair value of such mortgage loans using their quoted market price or market price equivalent. At December 31, 2018, we held $2.3 billion of such mortgage loans. · We categorize mortgage loans that are not saleable into active markets as “Level 3” fair value [/INST] Positive. </s>

PennyMac Financial Services, Inc.

2020-02-28

2019-12-31

Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations Critical Accounting Policies Preparation of financial statements in compliance with accounting principles generally accepted in the United States (“GAAP”) requires us to make estimates that affect the reported amounts of assets and liabilities and the disclosure of contingent assets and liabilities at the date of the financial statements, and revenues and expenses during the reporting period. Certain of these estimates significantly influence the portrayal of our financial condition and results, and they require us to make difficult, subjective or complex judgments. Our critical accounting policies primarily relate to our fair value estimates. Fair Value We group assets measured at or based on fair value in three levels based on the markets in which the assets are traded and the observability of the inputs used to determine fair value. These levels are: (1) Includes assets measured on both a recurring and nonrecurring basis based on the accounting principles applicable to the specific asset or liability and whether we have elected to carry the asset or liability at its fair value. As shown above, our consolidated balance sheet is substantially comprised of assets and liabilities that are measured at or based on their fair values. At December 31, 2019, $8.1 billion or 79% of our total assets were carried at fair value on a recurring basis and $20.3 million (real estate acquired in settlement of loans (“REO”)), were carried based on fair value on a non-recurring basis when fair value indicates evidence of impairment of individual properties. Of these assets carried at or based on fair value, $3.5 billion or 34% of total assets are measured using “Level 3” fair value inputs - significant inputs where there is difficulty in observing the inputs used by market participants in establishing fair value. Changes in inputs to measurement of these assets can have a significant effect on the amounts reported for these items including their reported balances and their effects on our income. As a result of the difficulty in observing certain significant valuation inputs affecting our “Level 3” fair value assets and liabilities, we are required to make judgments regarding these items’ fair values. Different persons in possession of the same facts may reasonably arrive at different conclusions as to the inputs to be applied in valuing these assets and liabilities and their fair values. Such differences may result in significantly different fair value measurements. Likewise, due to the general illiquidity of some of these assets, subsequent transactions may be at values significantly different from those reported. Because the fair value of “Level 3” fair value assets and liabilities are difficult to estimate, our valuation process includes performance of these items’ fair value estimation by specialized staff and significant senior management oversight. We have assigned the responsibility for estimating the fair values of non-interest rate lock commitment (“IRLC”) “Level 3” fair value assets and liabilities to our Financial Analysis and Valuation group (the “FAV group”), which is responsible for valuing and monitoring these items and maintenance of our valuation policies and procedures for non-IRLC assets and liabilities. The FAV group submits the results of its valuations to our senior management valuation committee, which oversees the valuations. During 2019, our senior management valuation committee included the Company’s executive chairman, chief executive, chief financial, chief risk, and deputy chief financial officers. The fair value of our IRLCs is developed by our Capital Markets Risk Management staff and is reviewed by our Capital Markets Operations group. Following is a discussion of our approach to measuring the balance sheet items that are most affected by “Level 3” fair value estimates. Loans Held for Sale We carry loans at their fair values. We recognize changes in the fair value of loans in current period income as a component of Net gains on loans held for sale at fair value. How we estimate the fair value of loans is based on whether the loans are saleable into active markets with observable fair value inputs. · We categorize loans that are saleable into active markets as “Level 2” fair value assets. We estimate the fair value of such loans using their quoted market price or market price equivalent. At December 31, 2019, we held $4.5 billion of such loans. · We categorize loans that are not saleable into active markets as “Level 3” fair value assets. “Level 3” fair value loans arise primarily from three sources: - We may purchase certain delinquent government guaranteed or insured loans from Ginnie Mae guaranteed securitizations included in our loan servicing portfolio. Our right to purchase such loans arises as the result of the loan being at least three months delinquent when we buy the loan. Our ability to purchase delinquent loans provides us with an alternative to our obligation to continue advancing principal and interest at the coupon rate of the related Ginnie Mae security. To the extent such loans (“early buyout” or “EBO” loans) have not become saleable into another Ginnie Mae guaranteed security by becoming current either through the borrower’s reperformance or through completion of a modification of the loan’s terms, we measure such loans using “Level 3” fair value inputs. At December 31, 2019, we held $374.1 million of such loans. - Certain of our loans may become non-saleable into active markets due to our identification of one or more defects. At December 31 2019, we held $9.2 million of such loans. - We originate home equity loans for sale to PMT. At present, an active, observable market for such loans does not exist. Because such loans are generally not saleable into active markets, we classify them as “Level 3” fair value assets. At December 31, 2019, we held $513,000 of such loans. We use a discounted cash flow model to estimate the fair value of “Level 3” fair value loans. The significant unobservable inputs used in the fair value measurement of our “Level 3” fair value loans held for sale are discount rates, home price projections and prepayment speeds. Significant changes in any of those inputs in isolation could result in a significant change to the loans’ fair value measurement. Interest Rate Lock Commitments Our net gains on loans held for sale include our estimates of the gains or losses we expect to realize upon the sale of loans we have contractually committed to fund or purchase but have not yet funded, purchased or sold. We recognize a substantial portion of our net gains on loans held for sale at fair value before we fund or purchase the loans as the result of these commitments. We call these commitments IRLCs. We recognize the fair value of IRLCs at the time we make the commitment to the correspondent seller, broker or loan applicant and adjust the fair value of such IRLCs as the loan approaches the point of funding or purchase or the prospective transaction is canceled. We carry IRLCs as either Derivative assets or Derivative liabilities on our consolidated balance sheet. The fair value of an IRLC is transferred to Loans held for sale at fair value when the loan is funded or purchased. An active, observable market for IRLCs does not exist. Therefore, we measure the fair value of IRLCs using methods we believe that market participants use in pricing IRLCs. We estimate the fair value of an IRLC based on observable Agency MBS prices, our estimates of the fair value of the MSRs we expect to receive in the sale of the loans and the probability that we will fund or purchase the loan (the “pull-through rate”). Pull-through rates and MSR fair values are based on our estimates as these inputs are difficult to observe in the marketplace. Our estimate of the probability that a loan will be funded and market interest rates are updated as the loans move through the funding or purchase process and as market interest rates change and may result in significant changes in our estimates of the fair value of the IRLCs. Such changes are reflected in the change in fair value of IRLCs which is a component of our Net gains on loans held for sale at fair value in the period of the change. The financial effects of changes in these inputs are generally inversely correlated. Increasing interest rates have a positive effect on the fair value of the MSR component of IRLC fair value but increase the pull-through rate for the loan principal and interest payment cash flow component, which decreases in fair value. A shift in our assessment of an input to the valuation of IRLCs can have a significant effect on the amount of Net gains on loans held for sale at fair value for the period. We believe that the most significant “Level 3” fair value input to the measurement of IRLCs is the pull-through rate. At December 31, 2019, we held $136.7 million of net IRLC assets at fair value. Following is a quantitative summary of the effect of changes in the pull-through rate input on the fair value of IRLCs at December 31, 2019: (1) The upward shift in input amount on a per-loan basis is limited to the amount of shift required to reach a 100% pull-through rate. The preceding analysis holds constant all of the other inputs to show an estimate of the effect on fair value of a change in the pull-through rate. We expect that in a market shock event, multiple inputs would be affected and the effects of these changes may compound or counteract each other. Therefore the preceding analysis is not a projection of the effects of a shock event or a change in our estimate of an input and should not be relied upon as an earnings projection. Mortgage Servicing Rights MSRs represent the fair value assigned to contracts that obligate us to service the mortgage loans on behalf of the owners of the mortgage loans in exchange for servicing fees and the right to collect certain ancillary income from the borrower. We recognize MSRs at our estimate of the fair value of the contract to service the loans. We include changes in fair value of MSRs in current period income as a component of Net loan servicing fees-Amortization, impairment and change in fair value of mortgage servicing rights and mortgage servicing liabilities. Both our estimate of the change in fair value attributable to realization of cash flows and of the change in fair value are affected by changes in market inputs are affected by changes in inputs. During the year ended December 31, 2019, we recognized a $1.0 billion net reduction in fair value of MSRs: $455.5 million of the reduction was due to realization of cash flows underlying the fair value of MSR and a $550.7 million of the reduction was due to changes in market inputs. We classify MSRs as “Level 3” fair value assets and determine their fair value using a discounted cash flow approach. We believe the most significant “Level 3” fair value inputs to the valuation of MSRs are the pricing spread (used to develop periodic discount rates), prepayment speed and annual per-loan cost of servicing. A shift in the market for MSRs or a change in our assessment of an input to the valuation of MSRs can have a significant effect on their fair value and in our income for the period. The fair value of MSRs that we held at December 31, 2019 was $2.9 billion. Following is a summary of the effect on fair value of MSRs of various changes to these key inputs at December 31, 2019: The preceding analyses hold constant all of the inputs other than the input that is being changed to show an estimate of the effect on fair value of a change in a specific input. We expect that in a market shock event, multiple inputs would be affected and the effects of these changes may compound or counteract each other. Therefore the preceding analyses are not projections of the effects of a shock event or a change in our estimate of an input and should not be relied upon as earnings projections. Excess Servicing Spread Financing We finance a portion of the cost of Agency MSRs that we purchase from non-affiliate sellers through the sale to PMT of the servicing spread in excess of a specified level. We carry our ESS at fair value. Because the ESS is a claim to a portion of the cash flows from MSRs, the valuation of the ESS is similar to that of MSRs. We use the same discounted cash flow approach to measure the ESS and the related MSRs except that certain inputs relating to the cost to service the mortgage loans underlying the MSRs and certain ancillary income are not included in the ESS valuation as these cash flows do not accrue to the holder of the ESS. A shift in the market for, or a change in our assessment of an input to, the valuation of ESS can have a significant effect on the fair value of ESS and in our income for the period. However, we believe that this change will be offset to a great extent by a change in the fair value of the MSRs that the ESS is financing. We record changes in the fair value of ESS in Net loan servicing fees-Change in fair value of excess servicing spread payable to PennyMac Mortgage Investment Trust. During the year ended December 31, 2019, we recorded $9.3 million of net gains due to changes in fair value of ESS. We believe that the most significant “Level 3” fair value inputs to the valuation of ESS are the pricing spread (used to develop periodic discount rates) and prepayment speed. At December 31, 2019, we carried $178.6 million of ESS at fair value. Following is a summary of the effect on fair value of various changes to these inputs at December 31, 2019: The preceding analyses hold constant all of the inputs other than the input that is being changed to show an estimate of the effect on fair value of a change in that specific input. We expect that in a market shock event, multiple inputs would be affected and the effects of these changes may compound or counteract each other. Therefore the preceding analyses are not projections of the effects of a shock event or a change in our estimate of an input and should not be relied upon as earnings projections. Critical Accounting Policy Not Based on Fair Value- Liability for Losses Under Representations and Warranties We record a provision for losses relating to our representations and warranties as part of our loan sale transactions and periodically update our estimates of our liability. The method we use to estimate the liability for representations and warranties is a function of the representations and warranties given and considers a combination of factors, including, but not limited to, estimated future default and loan repurchase rates, the potential severity of loss in the event of default and, if applicable, the probability of reimbursement by the correspondent loan seller. The level of the liability for losses under representations and warranties is difficult to estimate and requires considerable judgment. The level of loan repurchase losses is dependent on economic factors, purchaser or insurer loss mitigation strategies, and other external conditions that may change over the lives of the underlying loans. Our estimate of the liability for representations and warranties is developed by our credit administration staff. The liability estimate is reviewed and approved by our senior management credit committee which includes the senior executives of the Company and of the loan production, loan servicing and credit risk management areas. During the year ended December 31, 2019, we recorded $8.4 million in provision for losses relating to current year loan sales in Net gain on loans held for sale at fair value and incurred net losses totaling $209,000. As economic fundamentals change, as purchaser and insurer evaluations of their loss mitigation strategies (including claims under representations and warranties) change and as the mortgage market and general economic conditions affect our correspondent sellers, the level of repurchase activity and ensuing losses will change. As a result of these changes, we may be required to adjust the estimate of our liability for representations and warranties. Such an adjustment may be material to our financial condition and income. During the year ended December 31, 2019, we recorded reductions to our previously recorded representations and warranties liability amounts totaling $7.9 million in Net gain on loans held for sale at fair value. At December 31, 2019, the balance of our liability for losses under representations and warranties totaled $21.4 million. Accounting Developments Refer to Note 3 - Significant Accounting Policies - Recently Issued Accounting Pronouncements to our consolidated financial statements for a discussion of recent accounting developments and the expected effect on the Company. Results of Operations Our results of operations are summarized below: (1) Primarily represents Repricing of payable to exchanged Private National Mortgage Acceptance Company, LLC unitholders under tax receivable agreement, of which, for 2017, $32.0 million was the result of the change in the federal tax rate under the Tax Act. Comparison of the years ended December 31, 2019, 2018 and 2017 During the year ended December 31, 2019, we recorded net income of $393.0 million, an increase of $148.5 million, or 61%, from 2018. The increase is due to an increase of $492.8 million in total net revenue, partially offset by an increase of $231.0 million in total expenses and $113.2 million in provision for income taxes. The increase in total revenue was primarily due to an increase of $476.5 million in Net gains on loans held for sale at fair value, $79.3 million in Fulfillment fees from PennyMac Mortgage Invest Trust, and $72.5 million in Loan origination fees resulting from higher production volume and improved profit margins, which was partially offset by a decrease of $151.7 million in Net loan servicing fees primarily attributable to the effect of lower interest rates on the fair value of our MSRs that resulted in fair value losses net of hedging results compared to the year ended December 31, 2018. The increase in total expenses was primarily due to increases in loan origination and compensation expenses, reflecting the continuing growth of our mortgage banking activities. The provision for income taxes increased significantly as a result of the Reorganization which was completed in late 2018. During the year ended December 31, 2018, we recorded net income of $244.4 million, a decrease of $67.1 million or 22% from 2017. The decrease was primarily due to an increase of $97.4 million in total expense, which was partially offset by an increase of $29.2 million in total net revenue. The increase in total expense was primarily due to expansion of our loan servicing and production businesses. The increase in total net revenue was primarily due to an increase of $139.3 million in Net loan servicing fees and an increase of $73.2 million in Net interest income, partially offset by decreases of $142.8 million in Net gains on loans held for sale at fair value, $17.6 million in Loan origination fees and $31.8 million in Repricing of payable to exchanged Private National Mortgage Acceptance Company, LLC unitholders under tax receivable agreement. The decrease in our Net gains on loans held for sale at fair value reflected continued competitive pressures in the mortgage market place arising from the effect of then-increasing interest rates on borrower demand for mortgage loans. Increasing interest rates also contributed $70.8 million to Net loan servicing fees in the form of fair value gains net of hedging results during 2018 as compared to 2017. Net gains on loans held for sale at fair value During the year ended December 31, 2019, we recognized Net gains on loans held for sale at fair value totaling $725.5 million, compared to $249.0 million and $391.8 million during the years ended December 31, 2018 and 2017, respectively. The increase in 2019 compared to 2018 was primarily due to an increase in loan production volume and improved profit margins in our mortgage production business, reflecting increased demand for mortgage loans during 2019 as compared to 2018. The increase in demand for mortgage loans during 2019 as compared to 2018 is attributable primarily to the decrease in market interest rates that prevailed during 2019 compared to 2018. The decreases in 2018 compared to 2017 was primarily due to decreases in both loan production volume for our own account and profit margins reflecting the effect of then-generally rising interest rates in the mortgage market, which has a negative influence on demand for mortgage lending. Reduced demand negatively influences profit margins by causing increased price competition in the acquisition and origination of mortgage loans. Our net gains on loans held for sale are summarized below: Our gain on sale of loans held for sale includes both cash and non-cash elements. We receive proceeds on sale that include our estimate of the fair value of MSRs and we incur liabilities for mortgage servicing liabilities (which represent the fair value of the costs we expect to incur in excess of the fees we receive for early buyout of delinquent loans we have resold) and for the fair value of our estimate of the losses we expect to incur relating to the representations and warranties we provide in our loan sale transactions. Non-cash elements of gain on sale of loans The MSRs, mortgage servicing liabilities (“MSLs”), and liability for representations and warranties we recognize represent our estimate of the fair value of future benefits and costs we will realize for years in the future. These estimates represented approximately 125% of our gain on sale of loans at fair value for the year ended December 31, 2019, as compared to 225% and 143% for the years ended December 31, 2018 and 2017, respectively. How we measure and update our measurements of MSRs and MSLs is detailed in Note 6 - Fair value - Valuation Techniques and Inputs to the consolidated financial statements included in this Annual Report. Our agreements with the purchasers and insurers include representations and warranties related to the loans we sell. The representations and warranties require adherence to purchaser and insurer origination and underwriting guidelines, including but not limited to the validity of the lien securing the loan, property eligibility, borrower credit, income and asset requirements, and compliance with applicable federal, state and local law. In the event of a breach of our representations and warranties, we may be required to either repurchase the loans with the identified defects or indemnify the purchaser or insurer. In such cases, we bear any subsequent credit loss on the loans. Our credit loss may be reduced by any recourse we have to correspondent originators that sold such loans to us and breached similar or other representations and warranties. In such event, we have the right to seek a recovery of related repurchase losses from that correspondent seller. The method used to estimate our losses on representations and warranties is a function of our estimate of future defaults, loan repurchase rates, the severity of loss in the event of default, if applicable, and the probability of reimbursement by the correspondent loan seller. We establish a liability at the time loans are sold and review our liability estimate on a periodic basis. During the years ended December 31, 2019, 2018, and 2017 we recorded provisions for losses under representations and warranties relating to current loan sales as a component of Net gains on loans held for sale at fair value totaling $8.4 million, $5.8 million, and $5.9 million, respectively. We also recorded reductions in the liability relating to previously sold loans of $7.9 million, $4.7 million, and $4.3 million, for the years ended December 31, 2019, 2018 and 2017, respectively. The reductions in the liability relating to previously sold loans resulted from those loans meeting performance criteria established by the Agencies which significantly limits the likelihood of certain repurchase or indemnification claims. Following is a summary of mortgage loan repurchase activity and the unpaid balance of mortgage loans subject to representations and warranties: During the year ended December 31, 2019, we repurchased loans with unpaid principal balances totaling $18.7 million and charged $209,000 in net incurred losses relating to repurchases against our liability for representations and warranties. As the credit criteria relating to loans we originate and sell change, as the outstanding balance of loans we purchase and sell subject to representations and warranties increases and as the loans sold continue to season, we expect that the level of repurchase activity and corresponding losses may increase. The level of the liability for losses under representations and warranties is difficult to estimate and requires considerable judgment. The level of loan repurchase losses is dependent on economic factors, purchaser or insurer loss mitigation strategies, and other external conditions that may change over the lives of the underlying loans. Our estimate of the liability for representations and warranties is developed by our credit administration staff and approved by our senior management credit committee which includes our senior executives and senior management in our loan production, loan servicing and credit risk management groups. Our representations and warranties are generally not subject to stated limits of exposure. However, we believe that the current UPB of loans sold by us and subject to representation and warranty liability to date represents the maximum exposure to repurchases related to representations and warranties. Loan origination fees Following is a summary of our loan origination fees: Loan origination fees increased $72.5 million during the year ended December 31, 2019 compared to the year ended December 31, 2018, and the increase was primarily due to an increase in the volume of loans we produced. Loan origination fees decreased $17.6 million during the years ended December 31, 2018 compared to the year ended December 31, 2017, and the decrease was primarily due to decreases in the volume of loans we produced. Fulfillment fees fron PennyMac Mortgage Investment Trust Following is a summary of our fulfillment fees: Fulfillment fees from PMT represent fees we collect for services we perform on behalf of PMT in connection with the acquisition, packaging and sale of loans. The fulfillment fees are calculated as a percentage of the UPB of the loans we fulfill for PMT. Fulfillment fees increased $79.3 million and $1.0 million during the years ended December 31, 2019 and 2018, compared to the years ended December 31, 2018 and 2017, respectively. The increases were primarily due to increased volume of loans we fulfilled for PMT, partially offset by an increase in discretionary reductions in the fulfillment fee rate during the years ended December 31, 2019 and 2018 compared to the respective prior years. Net loan servicing fees Following is a summary of our net loan servicing fees: Amortization, impairment and change in fair value of mortgage servicing rights and excess servicing spread financing net of hedging results are summarized below: Following is a summary of our loan servicing portfolio: Net loan servicing fees decreased $151.7 million during the year ended December 31, 2019 compared to the year ended December 31, 2018. The decrease was primarily due to an increase of $338.0 million in losses in fair value of MSR, MSLs and excess servicing spread financing, net of hedging results, compared to the year ended December 31, 2018, resulting from the effect of decreasing interest rates on mortgage servicing asset and liability fair values. The increased losses were partially offset by an increase of $186.2 million in loan servicing fees, resulting from an increase of 24% in our average servicing portfolio for the year ended December 31, 2019 compared to the year ended December 31, 2018. Net loan servicing fees increased $139.3 million during the year ended December 31, 2018, compared to the year ended December 31, 2017. The increase was due to a combination of an increase of $112.0 million of mortgage loan servicing fees, resulting from growth in our loan servicing portfolio and a decrease of $27.3 million in fair value losses and impairment of MSRs and MSL, net of hedging results, resulting from the effect of generally rising interest rates during 2017. Net Interest Income Net interest income increased $4.9 million during the year ended December 31, 2019 compared to the year ended December 31, 2018. The increase was primarily due to: · an increase of $56.3 million in placement fees we receive relating to custodial funds that we manage, reflecting the growth of our servicing portfolio and net interest income relating to growth in our average inventory of loans held for sale, partially offset by · a $33.4 million decrease in the financing incentives we received from one of our lenders for financing mortgage loans approved for satisfying certain consumer relief characteristics; and · a $22.7 million increase in interest shortfall on repayment of loans serviced for Agency securitizations. When a borrower repays a loan, we are responsible for paying the full month’s interest to the holders of the Agency securities that are backed by the loan regardless of when in the month the borrower repays the loan. The increase in refinancing activity in our MSR portfolio caused the increase in the interest shortfall. Net interest income increased $73.2 million during the year ended December 31, 2018 compared to the year ended December 31, 2017. The increase is primarily due to a $38.9 million increase of incentives relating to financing of mortgage loans under the master repurchase agreement described below and an increase of $37.4 million in the placement fees we received relating to the custodial funds that we manage, reflecting the growth of our servicing portfolio and higher placement fee rates, as well as an increase in interest income on loans held for sale. We entered into a master repurchase agreement in 2017 that provided us with incentives to finance mortgage loans approved for satisfying certain consumer relief characteristics as provided in the agreement. We recorded $14.7 million, $48.1 million and $9.2 million of such incentives as reductions of Interest expense during the years ended December 31, 2019, 2018 and 2017, respectively. The master repurchase agreement expired on August 21, 2019. Management fees and Carried Interest Management fees and Carried Interest are summarized below: Management fees from PMT increased by $12.0 million during the year ended December 31, 2019, compared to the year ended December 31, 2018, reflecting the combined effect of the performance incentive fees arising from PMT’s increased profitability and the increase in PMT’s average shareholders’ equity upon which its management fees are based. The increase in average shareholders’ equity was primarily due to the issuance of new common shares by PMT during the year ended December 31, 2019. Management fees from PMT increased by $1.9 million during the year ended December 31, 2018, compared to the year ended December 31, 2017, primarily reflecting the increase in PMT’s average shareholders’ equity upon which its management fees are based and an increase in performance incentive fees. Performance incentive fees increased $1.1 million during the year ended December 31, 2018, compared to the year ended December 31, 2017, resulting from an increase in PMT’s net income on which incentive fees are based. Change in Fair Value of Investment in and Dividends Received from PMT The results of our holdings of common shares of PMT, which is included in Changes in fair value of investment in, and dividends received from PMT are summarized below: Change in fair value of investment in and dividends received from PMT increased $84,000 during the year ended December 31, 2019, compared to the year ended December 31, 2018, and increased $214,000 during the year ended December 31, 2018, compared to the year ended December 31, 2017, due to changes in the fair value of our investment in PMT. We held 75,000 common shares of PMT during each of the three years ended December 31, 2019. Other revenues Other revenue decreased $1.2 million for the year ended December 31, 2019, compared to the year ended December 31, 2018. The decrease was primarily due to a decrease of $747,000 in Repricing of Payable to exchanged Private National Mortgage Acceptance Company, LLC unitholders under the tax receivable agreement as a result of a smaller change in tax rate in 2019 compared to 2018. Other revenue decreased $25.5 million for the year ended December 31, 2018, compared to the year ended December 31, 2017. The decrease was primarily due to a decrease of $31.8 million in Repricing of payable to exchanged Private National Mortgage Acceptance Company, LLC unitholders under the tax receivable agreement as a result of the reduction in the federal tax rate which was recognized in 2017, partially offset by an increase of $5.1 million in reimbursements from PMT due to our adoption of the Financial Accounting Standard Board’s Accounting Standards Update 2014-09, Revenue from Contracts with Customers (Subtopic 606) using the modified retrospective method effective January 1, 2018. Under Accounting Standard Update 2014-09, reimbursements must be accounted for as revenue. Those reimbursements were included as a reduction of expense in previous years. Expenses Compensation Our compensation expense is summarized below: Compensation expense increased $100.2 million during the year ended December 31, 2019, compared to the year ended December 31, 2018. The increase in compensation was primarily due to increases in incentive compensation resulting from performance-based incentives in our mortgage banking business and higher than expected attainment of profitability targets along with increases in base salaries, taxes and benefits due to increased average head count resulting from the growth in our mortgage banking activities during 2019. Compensation expense increased $44.5 million during the year ended December 31, 2018, compared to the year ended December 31, 2017. The increase in compensation was primarily due to increased base salaries, taxes and benefits due to increased average head count resulting from the growth in our mortgage banking activities during 2018. Servicing Servicing expense increased $27.6 million and $19.4 million in the years ended December 31, 2019 and 2018 compared to the years ended December 31, 2018 and 2017, respectively. The increases were due to growth in our government-insured or guaranteed mortgage servicing portfolio, which includes loans that are subject to nonreimbursable servicing advance losses, and to our EBO program to purchase defaulted loans from Ginnie Mae pools. During the year ended December 31, 2019, we purchased $4.4 billion in UPB of EBO loans as compared to $3.0 billion for the year ended December 31, 2018 and $2.9 billion for the year ended December 31, 2017. The EBO program reduces the ongoing cost of servicing defaulted mortgage loans subject to Ginnie Mae MBS when we purchase and either sell the defaulted loans or finance them with debt at interest rates below the Ginnie Mae MBS pass-through rates. While the EBO program reduces the ultimate cost of servicing such mortgage loan pools, it accelerates loss recognition when the mortgage loans are purchased. We recognize expense because purchasing the mortgage loans from their Ginnie Mae pools causes us to write off accumulated non-reimbursable interest advances, net of interest receivable from the mortgage loans’ insurer or guarantor at the debenture rate of interest applicable to the respective mortgage loans. Technology Technology expense increased $7.8 million and $8.1 million in the years ended December 31, 2019 and 2018 compared to the years ended December 31, 2018 and 2017, respectively. The increases were primarily due to growth in our loan servicing operations and continued investment in our loan production and servicing infrastructure. Occupancy and equipment Occupancy and equipment expenses increased $1.8 million and $4.5 million during the years ended December 31, 2019 and 2018, compared to the years ended December 31, 2018 and 2017, respectively. The increases are primarily attributable to expansion of our facilities to accommodate our growth. Provision for Income Taxes For the years ended December 31, 2019, 2018 and 2017, our effective tax rates were 25.8%, 8.7%, and 7.3%, respectively. The difference in prior years between our effective tax rate and the statutory rates was primarily due to the allocation of earnings to the noncontrolling interest unitholders. Pursuant to the Reorganization, the noncontrolling interest unitholders converted their ownership units into our shares and as a result, we were allocated starting on that date and will in the future be allocated 100% of PNMAC earnings that will be subject to corporate federal and state statutory tax rates, which has in turn increased our effective income tax rate. Balance Sheet Analysis Following is a summary of key balance sheet items as of the dates presented: Total assets increased $2.7 billion from $7.5 billion at December 31, 2018 to $10.2 billion at December 31, 2019. The increase was primarily due to an increase of $2.4 billion in loans held for sale at fair value resulting from an increase in loan production inventory and $106.2 million in MSRs reflecting continued additions from our loan production activities and servicing portfolio acquisitions. Total liabilities increased by $2.3 billion from $5.8 billion as of December 31, 2018 to $8.1 billion as of December 31, 2019. The increase was primarily attributable to an increase of $2.3 billion in borrowings required to finance a larger inventory of loans held for sale combined with a $91.3 million increase in other liabilities due to recognition of operating lease liabilities effective January 1, 2019, as the result of our adoption of the Financial Accounting Standards Board’s Accounting Standards Update 2016-02, Leases (Topic 842), which requires us to recognize our contractual lease rights and obligations on our consolidated balance sheet. Cash Flows Our cash flows for the three years ended December 31, 2019 are summarized below: Operating activities Net cash (used in) provided by operating activities totaled ($2.2) billion, $572.4 million, and ($883.4) million during the years ended December 31, 2019, 2018, and 2017 respectively. Our cash flows from operating activities are primarily influenced by changes in the levels of our inventory of loans held for sale as shown below: Cash provided by other operating sources for the year ended December 31, 2019 was consistent with the year ended December 31, 2018. The increase in cash flow from other operating sources during the year ended December 31, 2018, compared to the year ended December 31, 2017, was primarily attributable to our collection of $31.9 million in repurchase agreement derivatives and an increase in operating cash flows arising from net changes in other assets and accounts payable and accrued expenses in the amount of $68.2 million. The master repurchase agreement expired on August 21, 2019. Investing activities Net cash provided by investing activities was $148.8 million during the year ended December 2019, primarily comprised of $366.1 million in net settlement of derivative financial instruments used to hedge our investment in MSRs, partially offset by $227.4 million used in purchase of MSRs. Net cash used in investing activities was $322.6 million and $339.2 million during the years ended December 31, 2018, and 2017, respectively, primarily comprised of cash used in purchase of MSRs and net settlements of derivative financial instruments used to hedge our investment in MSRs. Financing activities Net cash provided by financing activities totaled $2.1 billion during the year ended December 31, 2019 which was primarily to finance the growth in our inventory of mortgage loans held for sale and our investments in MSR. Net cash used in financing activities totaled $132.0 million during the year ended December 31, 2018 which was primarily due to net repurchases of assets sold under agreements to repurchase and mortgage loan participation purchase and sale agreements of $440.9 million, reflecting a reduction in our financing of loans held for sale, and repayments of excess servicing spread financing of $46.8 million, partially offset by net proceeds from issuance of notes payable secured by of $400 million. Net cash provided by financing activities was $1.2 billion during the year ended December 31, 2017, primarily due to an increase in loans sold under agreements to repurchase and notes payable used to finance the growth in our inventory of loans held for sale and MSRs. Liquidity and Capital Resources Our liquidity reflects our ability to meet our current obligations (including our operating expenses and, when applicable, the retirement of, and margin calls relating to, our debt, and margin calls relating to hedges on our commitments to purchase or originate mortgage loans and on our MSR investments), fund new originations and purchases, and make investments as we identify them. We expect our primary sources of liquidity to be through cash flows from business activities, proceeds from bank borrowings, proceeds from and issuance of ESS and/or equity or debt offerings. We believe that our liquidity is sufficient to meet our current liquidity needs and make distributions to our shareholders. Our current borrowing strategy is to finance our assets where we believe such borrowing is prudent, appropriate and available. Our borrowing activities are in the form of sales of assets under agreements to repurchase, sales of mortgage loan participation certificates, ESS financing, notes payable (including a revolving credit agreement) and a capital lease. Most of our borrowings have short-term maturities and provide for terms of approximately one year. Because a significant portion of our current debt facilities consists of short-term borrowings, we expect to renew these facilities in advance of maturity in order to ensure our ongoing liquidity and access to capital or otherwise allow ourselves sufficient time to replace any necessary financing. Our repurchase agreements represent the sales of assets together with agreements for us to buy back the assets at a later date. The table below presents the average outstanding, maximum and ending balances for each of the three years ended December 31, 2019, 2018 and 2017: The differences between the average and maximum daily balances on our repurchase agreements reflect the fluctuations throughout the month of our inventory as we fund and pool mortgage loans for sale in guaranteed mortgage securitizations. Our secured financing agreements at PLS require us to comply with various financial covenants. The most significant financial covenants currently include the following: · positive net income during each calendar quarter; · a minimum in unrestricted cash and cash equivalents of $40 million; · a minimum tangible net worth of $500 million; · a maximum ratio of total liabilities to tangible net worth of 10:1; and · at least one other warehouse or repurchase facility that finances amounts and assets that are similar to those being financed under certain of our existing secured financing agreements. With respect to servicing performed for PMT, PLS is also subject to certain covenants under PMT’s debt agreements. Covenants in PMT’s debt agreements are equally, or sometimes less, restrictive than the covenants described above. In addition to the covenants noted above, PennyMac’s revolving credit agreement and capital lease contain additional financial covenants including, but not limited to, · a minimum of cash equal to the amount borrowed under the revolving credit agreement; · a minimum of unrestricted cash and cash equivalents equal to $25 million; · a minimum of tangible net worth of $500 million; · a minimum asset coverage ratio (the ratio of the total asset amount to the total commitment) of 2.5; and · a maximum ratio of total indebtedness to tangible net worth ratio of 5:1. Although these financial covenants limit the amount of indebtedness that we may incur and affect our liquidity through minimum cash reserve requirements, we believe that these covenants currently provide us with sufficient flexibility to successfully operate our business and obtain the financing necessary to achieve that purpose. Our debt financing agreements also contain margin call provisions that, upon notice from the applicable lender at its option, require us to transfer cash or, in some instances, additional assets in an amount sufficient to eliminate any margin deficit. A margin deficit will generally result from any decline in the market value (as determined by the applicable lender) of the assets subject to the related financing agreement. Upon notice from the applicable lender, we will generally be required to satisfy the margin call on the day of such notice or within one business day thereafter, depending on the timing of the notice. We are also subject to liquidity and net worth requirements established by FHFA for Agency seller/servicers and Ginnie Mae for single-family issuers. FHFA and Ginnie Mae have established minimum liquidity requirements and revised their net worth requirements for their approved non-depository single-family sellers/servicers or issuers as summarized below: · FHFA liquidity requirement is equal to 0.035% (3.5 basis points) of total Agency servicing UPB plus an incremental 200 basis points of the amount by which total nonperforming Agency servicing UPB exceeds 6% of the applicable Agency servicing UPB; allowable assets to satisfy liquidity requirement include cash and cash equivalents (unrestricted), certain investment-grade securities that are available for sale or held for trading including Agency mortgage-backed securities, obligations of Fannie Mae or Freddie Mac, and U.S. Treasury obligations, and unused and available portions of committed servicing advance lines; · FHFA net worth requirement is a minimum net worth of $2.5 million plus 0.25% (25 basis points) of UPB for total 1-4 unit residential mortgage loans serviced and a tangible net worth/total assets ratio greater than or equal to 6%; · Ginnie Mae single-family issuer minimum liquidity requirement is equal to the greater of $1.0 million or 0.10% (10 basis points) of the issuer’s outstanding Ginnie Mae single-family securities, which must be met with cash and cash equivalents; and · Ginnie Mae net worth requirement is equal to $2.5 million plus 0.35% (35 basis points) of the issuer’s outstanding Ginnie Mae single-family obligations. We believe that we are currently in compliance with the applicable Agency requirements. We have purchased portfolios of MSRs and have financed them in part through the sale to PMT of the right to receive ESS. The outstanding amount of the ESS is based on the current fair value of such ESS and amounts received on the underlying mortgage loans. In June 2017, our Board of Directors approved a stock repurchase program that allows us to repurchase up to $50 million of our common stock using open market stock purchases or privately negotiated transactions in accordance with applicable rules and regulations. The stock repurchase program does not have an expiration date and the authorization does not obligate us to acquire any particular amount of common stock. We intend to finance the stock repurchase program through cash on hand. From inception through December 31, 2019, we have repurchased $14.9 million of shares under our stock repurchase program. We continue to explore a variety of means of financing our continued growth, including debt financing through bank warehouse lines of credit, bank loans, repurchase agreements, securitization transactions and corporate debt. However, there can be no assurance as to how much additional financing capacity such efforts will produce, what form the financing will take or whether such efforts will be successful. Off-Balance Sheet Arrangements and Aggregate Contractual Obligations Off-Balance Sheet Arrangements As of December 31, 2019, we have not entered into any off-balance sheet arrangements or guarantees. Contractual Obligations As of December 31, 2019 we had contractual obligations aggregating $13.7 billion, comprised of commitments to purchase and originate loans, borrowings, and a payable to exchanged Private National Mortgage Acceptance Company, LLC unitholders under a tax receivable agreement. We also lease our office facilities. Payment obligations under these agreements are summarized below: Debt Obligations As described further above in “Liquidity and Capital Resources,” we currently finance certain of our assets through borrowings with major financial institution counterparties in the form of sales of assets under agreements to repurchase, mortgage loan participation purchase and sale agreements, notes payable (including a revolving credit agreement), ESS and a capital lease. The borrower under each of these facilities is PLS or subsidiary Issuer Trust with the exception of the revolving credit agreement, which is classified as a note payable, and the capital lease, in each case where the borrower is PennyMac. All PLS obligations as previously noted are guaranteed by PennyMac. Under the terms of these agreements, PLS is required to comply with certain financial covenants, as described further above in “Liquidity and Capital Resources,” and various non-financial covenants customary for transactions of this nature. As of December 31, 2019, we believe we were in compliance in all material respects with these covenants. The agreements also contain margin call provisions that, upon notice from the applicable lender, require us to transfer cash or, in some instances, additional assets in an amount sufficient to eliminate any margin deficit. Upon notice from the applicable lender, we will generally be required to satisfy the margin call on the day of such notice or within one business day thereafter, depending on the timing of the notice. In addition, the agreements contain events of default (subject to certain materiality thresholds and grace periods), including payment defaults, breaches of covenants and/or certain representations and warranties, cross-defaults, guarantor defaults, servicer termination events and defaults, material adverse changes, bankruptcy or insolvency proceedings and other events of default customary for these types of transactions. The remedies for such events of default are also customary for these types of transactions and include the acceleration of the principal amount outstanding under the agreements and the liquidation by our lenders of the mortgage loans or other collateral then subject to the agreements. The borrowings have maturities as follows: (1) Outstanding indebtedness as of December 31, 2019. (2) Total facility size, committed facility and maturity date include contractual changes through the date of this Report. (3) The total credit facility from Credit Suisse is $1.5 billion. The borrowing of $100 million with Credit Suisse First Boston Mortgage Capital LLC is in the form of a sale of a variable funding note under an agreement to repurchase up to a maximum of $400 million, less any amount utilized under the Credit Suisse AG note payable and an agreement to repurchase relating to the financing of Fannie Mae MSRs. The amount at risk (the fair value of the assets pledged plus the related margin deposit, less the amount advanced by the counterparty and accrued interest) relating to our assets sold under agreements to repurchase is summarized by counterparty below as of December 31, 2019: (1) The borrowing facility with Credit Suisse First Boston Mortgage Capital LLC is in the form of a sale of a variable funding note under an agreement to repurchase. (2) The borrowing facility with Credit Suisse First Boston Mortgage Capital LLC is in the form of an asset sale under an agreement to repurchase. All debt financing arrangements that matured between December 31, 2019 and the date of this Report have been renewed or extended and are described in Note 13-Borrowings to the accompanying consolidated financial statements.

<s>[INST] Preparation of financial statements in compliance with accounting principles generally accepted in the United States (“GAAP”) requires us to make estimates that affect the reported amounts of assets and liabilities and the disclosure of contingent assets and liabilities at the date of the financial statements, and revenues and expenses during the reporting period. Certain of these estimates significantly influence the portrayal of our financial condition and results, and they require us to make difficult, subjective or complex judgments. Our critical accounting policies primarily relate to our fair value estimates. Fair Value We group assets measured at or based on fair value in three levels based on the markets in which the assets are traded and the observability of the inputs used to determine fair value. These levels are: (1) Includes assets measured on both a recurring and nonrecurring basis based on the accounting principles applicable to the specific asset or liability and whether we have elected to carry the asset or liability at its fair value. As shown above, our consolidated balance sheet is substantially comprised of assets and liabilities that are measured at or based on their fair values. At December 31, 2019, $8.1 billion or 79% of our total assets were carried at fair value on a recurring basis and $20.3 million (real estate acquired in settlement of loans (“REO”)), were carried based on fair value on a nonrecurring basis when fair value indicates evidence of impairment of individual properties. Of these assets carried at or based on fair value, $3.5 billion or 34% of total assets are measured using “Level 3” fair value inputs significant inputs where there is difficulty in observing the inputs used by market participants in establishing fair value. Changes in inputs to measurement of these assets can have a significant effect on the amounts reported for these items including their reported balances and their effects on our income. As a result of the difficulty in observing certain significant valuation inputs affecting our “Level 3” fair value assets and liabilities, we are required to make judgments regarding these items’ fair values. Different persons in possession of the same facts may reasonably arrive at different conclusions as to the inputs to be applied in valuing these assets and liabilities and their fair values. Such differences may result in significantly different fair value measurements. Likewise, due to the general illiquidity of some of these assets, subsequent transactions may be at values significantly different from those reported. Because the fair value of “Level 3” fair value assets and liabilities are difficult to estimate, our valuation process includes performance of these items’ fair value estimation by specialized staff and significant senior management oversight. We have assigned the responsibility for estimating the fair values of noninterest rate lock commitment (“IRLC”) “Level 3” fair value assets and liabilities to our Financial Analysis and Valuation group (the “FAV group”), which is responsible for valuing and monitoring these items and maintenance of our valuation policies and procedures for nonIRLC assets and liabilities. The FAV group submits the results of its valuations to our senior management valuation committee, which oversees the valuations. During 2019, our senior management valuation committee included the Company’s executive chairman, chief executive, chief financial, chief risk, and deputy chief financial officers. The fair value of our IRLCs is developed by our Capital Markets Risk Management staff and is reviewed by our Capital Markets Operations group. Following is a discussion of our approach to measuring the balance sheet items that are most affected by “Level 3” fair value estimates. Loans Held for Sale We carry loans at their fair values. We recognize changes in the fair value of loans in current period income as a component of Net gains on loans held for sale at fair value. How we estimate the fair value of loans is based on whether the loans are saleable into active markets with observable fair value inputs. · We categorize loans that are saleable into active markets as “Level 2” fair value assets. We estimate the fair value of such loans using their quoted market price or market price equivalent. At December 31, 2019, we held $4.5 billion of such loans. · We categorize loans that are not saleable into active markets as “Level 3” fair value assets. “Level 3” fair value loans arise primarily from three sources: We may purchase certain delinquent government guaranteed or [/INST] Positive. </s>

PermRock Royalty Trust

2019-04-01

2018-12-31

Item 7. Trustee’s Discussion and Analysis of Financial Condition and Results of Operations Overview PermRock Royalty Trust, a Delaware statutory trust formed in November 2017 by Boaz Energy, completed its initial public offering in May 2018. The Trust’s only asset and source of income is the Net Profits Interest, which entitles the Trust to receive 80% of the net profits from oil and natural gas production from the Underlying Properties. The Net Profits Interest is passive in nature and neither the Trust nor the Trustee has any management control over or responsibility for costs relating to the operation of the Underlying Properties. Although the Trust was formed on November 22, 2017, the conveyance of the Net Profits Interest did not occur until May 4, 2018, with an effective date of January 1, 2018, and no proceeds were received by the Trust from Boaz Energy during the three-month period ended March 31, 2018. As a result, the Trust did not recognize any income or make any distributions during the three-month period ended March 31, 2018. The Trust is required to make monthly cash distributions of substantially all of its monthly cash receipts, after deduction of fees and expenses for the administration of the Trust and any cash reserves, to holders of its Trust units as of the applicable record date on or before the 10th business day after the record date. The Net Profits Interest is entitled to a share of the profits from and after January 1, 2018 attributable to production occurring on or after such date. The Trust is not subject to any pre-set termination provisions based on a maximum volume of oil or natural gas to be produced or the passage of time. The amount of Trust revenues and cash distributions to Trust unitholders depends on, among other things: • volumes produced; • wellhead prices; • price differentials; • production and development costs; • potential reductions or suspensions of production; and • the amount and timing of Trust administrative expenses. Boaz Energy typically receives payment for oil production 30 to 60 days after it is produced and for natural gas production 60 to 90 days after it is produced. 2018 Recap and 2019 Outlook In 2018, Boaz Energy participated in the drilling of 23 new wells operated by others in the Permian Platform area and two new wells in the Permian Shelf. Boaz Energy has continued to optimize waterfloods in the Permian Clearfork and Permian Shelf through the use of conformance technology. In 2019, Boaz Energy plans to streamline existing waterflood operations, convert additional wells to injection wells where prudent, drill one to two new operated wells and continue to participate in Permian Platform drilling proposed by non-operating partners. Results of Operations The Trust was formed on November 22, 2017. In connection with the closing of the initial public offering, on May 4, 2018, Boaz Energy contributed the Net Profits Interest to the Trust in exchange for 12,165,732 Trust units. The Net Profits Interest entitles the Trust to receive 80% of the net profits from the sale and production of oil and natural gas attributable to the Underlying Properties that are produced during the term of the Conveyance. The Net Profits Interest is passive in nature and neither the Trust nor the Trustee has any control over, or responsibility for, costs relating to the operation of the Underlying Properties. Based on 12,165,732 Trust units outstanding at each date listed below, the per unit distributions during the year ended December 31, 2018 were as follows: Computation of Income from the Net Profits Interest Received by the Trust In connection with the closing of the initial public offering in May 2018, Boaz Energy contributed the Net Profits Interest to the Trust in exchange for 12,165,732 newly issued Trust units. The Net Profits Interest entitles the Trust to receive 80% of the net profits attributable to Boaz Energy’s interest from the sale of oil and natural gas production from the Underlying Properties. The Trust’s income from the Net Profits Interest consists of monthly net profits attributable to income from the Underlying Properties. Because of the interval between the time of production and receipt of net profits income by the Trust, the Trust recognizes production during the month in which the related net profits income is paid to the Trust. Net profits income for the calendar year ended December 31, 2018, was based on production for the period between January 2018 and October 2018. The table below outlines the computation of income from the Net Profits Interest received by the Trust derived from the excess of revenues over direct operating expenses of the Underlying Properties for the year ended December 31, 2018: (1) Sales volumes for natural gas include NGLs. (2) Represents “gross profits” as described in “Computation of Net Profits.” (3) Reflects gross cash impact of settlement of derivative contracts relating to production. Important factors used in calculating the Trust’s net profits income include the volumes of oil and gas produced from the Underlying Properties and the realized prices received for the sale of those minerals, including natural gas liquids, as well as lease operating expenses, production, ad valorem and other taxes, development expenses and the Trust’s general and administrative expenses. In future years, a comparison between the current year’s net profits income and the previous year’s net profits income will be included. Derivative Contracts Income from the Net Profits Interest is exposed to fluctuations in energy prices in the normal scope of business. To mitigate the negative effects of a possible decline in oil prices on distributable income to the Trust, Boaz Energy entered into derivative put option contracts with respect to approximately 100% of expected oil production attributable to the Net Profits Interest during the remainder of 2018 and 76% of such production during 2019. These derivative contracts consist of put option contracts with strike prices of $60 per barrel in 2018 and $50 per barrel in 2019. Boaz Energy believes that these put option contracts provide downside protection to the Trust in the event spot prices for crude oil decline below the applicable strike price, while still allowing the Trust to benefit from increasing crude oil prices. If prices for crude oil as quoted on NYMEX decline below the applicable strike prices, Boaz Energy could exercise its put option and receive payment generally equal to the difference between the applicable strike price and the market price for crude oil at the time of exercise, multiplied by the notional quantity of crude oil hedged under the applicable put option contract being exercised. After December 31, 2019, none of the production attributable to the Underlying Properties will be hedged. Liquidity and Capital Resources The Trust’s principal sources of liquidity and capital are cash flow generated from the Net Profits Interest and borrowings, if any, to fund administrative expenses. The Trust’s primary uses of cash are distributions to Trust unitholders, payment of Trust administrative expenses, including, if applicable, any reserves established by the Trustee for future liabilities. Administrative expenses include the Trustee and Delaware Trustee fees, accounting, engineering, legal, tax advisory and other professional fees, and Form 1099 preparation and distribution expenses. The Trust is also responsible for paying other expenses incurred as a result of being a publicly traded entity, including costs associated with annual, quarterly and current reports to the SEC, NYSE listing fees, independent auditor fees and registrar and transfer agent fees. If the Trustee determines that cash on hand and cash to be received in respect of the Net Profits Interest are, or will be, insufficient to cover the Trust’s liabilities and expenses, the Trustee may cause the Trust to borrow funds to pay liabilities of the Trust. Pursuant to the Trust Agreement, the Trustee is authorized to retain cash from the distributions it receives (i) in an amount not to exceed $1.0 million at any one time to be used by the Trust in the event that its cash on hand (including available cash reserves) is not sufficient to pay ordinary course administrative expenses as they become due, however until May 31, 2019, the Trustee shall not retain any cash from monthly distributions pursuant to this clause and (ii) in such amounts as the Trustee in its discretion deems appropriate to pay for future liabilities of the Trust. Boaz Energy has provided the Trust with a $1.0 million Letter of Credit (the “Letter of Credit”) that may be drawn by the Trust to pay its administrative expenses. Commencing in the monthly period ending May 31, 2019 and continuing until the reserve described in clause (i) equals or exceeds $1.0 million, the Trustee will retain cash from distributions in such amount as the Trustee determines but not less than $25,000 per month or more than $100,000 per month. At such time as such reserve equals or exceeds $1.0 million, the Trustee is required to release the Letter of Credit. If the Trustee causes the Trust to borrow funds, or if the Trustee draws on the Letter of Credit being provided by Boaz Energy, the Trust unitholders will not receive distributions until the borrowed funds or the amount drawn, as applicable, are repaid. Off-Balance Sheet Arrangements As of December 31, 2018, the Trust had no off-balance sheet arrangements. New Accounting Pronouncements As the Trust’s financial statements are prepared on the modified cash basis, most accounting pronouncements are not applicable to the Trust’s financial statements. No new accounting pronouncements have been adopted or issued that would impact the financial statements of the Trust. Critical Accounting Policies and Estimates The Trust uses the modified cash basis of accounting to report Trust receipts of the Net Profits Interest and payments of expenses incurred. The Net Profits Interest represents the right to receive revenues (oil and natural gas sales), less direct operating expenses (lease operating expenses and severance and ad valorem taxes) and development expenses of the Underlying Properties, multiplied by 80%, plus any payments received in connection with the settlement of certain derivative contracts. Cash distributions of the Trust are made based on the amount of cash received by the Trust pursuant to terms of the Conveyance creating the Net Profits Interest. The financial statements of the Trust, as prepared on a modified cash basis, reflect the Trust’s assets, liabilities, Trust corpus, earnings and distributions as follows: • Income from the Net Profits Interest is recorded when distributions are received by the Trust; • Distributions to Trust unitholders are recorded when declared by the Trust; • Trust general and administrative expenses (which includes the Trustee’s fees as well as accounting, engineering, legal, tax advisory and other professional fees) are recorded when paid; • Cash reserves for Trust expenses may be established by the Trustee for certain expenditures that would not be recorded as contingent liabilities under accounting principles generally accepted in the United States of America (“GAAP”); • Amortization of the investment in the Net Profits Interest is calculated on a unit-of-production basis and is charged directly to Trust corpus, and such amortization does not affect distributions from the Trust; and • The Trust’s investment in the Net Profits Interest is periodically assessed to determine whether its aggregate value has been impaired below its total capitalized cost basis and, if an impairment loss is indicated by the carrying amount of the assets exceeding the sum of the undiscounted expected future net cash flows, then an impairment loss is recognized for the amount by which the carrying amount of the asset exceeds its estimated fair value. The financial statements of the Trust are prepared on a modified cash basis of accounting, which is considered to be the most meaningful basis of preparation for a royalty trust because monthly distributions to the Trust unitholders are based on net cash receipts. Although this basis of accounting is permitted for royalty trusts by the SEC, the financial statements of the Trust differ from financial statements prepared in accordance with GAAP because net profits income is not accrued in the month of production, expenses are not recognized when incurred and cash reserves may be established for certain contingencies that would not be recorded in GAAP financial statements. This comprehensive basis of accounting other than GAAP corresponds to the accounting permitted for royalty trusts by the SEC as specified by Staff Accounting Bulletin Topic 12:E, Financial Statements of Royalty Trusts. The preparation of financial statements requires the Trust to make estimates and assumptions that affect the reported amounts of assets and liabilities and the reported amounts of revenues and expenses during the reporting period. Actual results could differ from those estimates. Oil and Natural Gas Reserves. The proved oil and natural gas reserves for the Underlying Properties are estimated by independent petroleum engineers. Reserve engineering is a subjective process that is dependent upon the quality of available data and the interpretation thereof. Estimates by different engineers often vary, sometimes significantly. In addition, physical factors such as the results of drilling, testing and production subsequent to the date of an estimate, as well as economic factors such as changes in product prices, may justify revision of such estimates. Because proved reserves are required to be estimated using prices at the date of the evaluation, estimated reserve quantities can be significantly impacted by changes in product prices. Accordingly, oil and natural gas quantities ultimately recovered and the timing of production may be substantially different from original estimates. The Financial Accounting Standards Board requires supplemental disclosures for oil and gas producers based on a standardized measure of discounted future net cash flows relating to proved oil and natural gas reserve quantities. Under this disclosure, future cash inflows are computed by applying the average prices during the 12-month period prior to fiscal year-end, determined as an unweighted arithmetic average of the first-day-of-the-month benchmark price for each month within such period, unless prices are defined by contractual arrangements, excluding escalations based upon future conditions. Future price changes are only considered to the extent provided by contractual arrangements in existence at year-end. The standardized measure of discounted future net cash flows is achieved by using a discount rate of 10% a year to reflect the timing of future cash flows relating to proved oil and natural gas reserves. Changes in any of these assumptions, including consideration of other factors, could have a significant impact on the standardized measure. The standardized measure does not necessarily result in an estimate of the current fair market value of proved reserves. Amortization of Net Profits Interest. The Trust calculates amortization of the Net Profits Interest in oil and natural gas properties on a unit-of-production basis based on the Underlying Properties’ production and reserves. The reserves upon which the amortization rate is based are quantity estimates which are subject to numerous uncertainties inherent in the estimation of proved reserves. The volumes considered to be commercially recoverable fluctuate with changes in prices and operating costs. These estimates are expected to change as additional information becomes available in the future. Downward revisions in proved reserves may result in an increased rate of amortization. Amortization is recorded on sales volumes paid by the Trust during the relevant period and is charged directly to the Trust corpus balance. As a result, amortization does not affect the cash earnings of the Trust. Impairment of Net Profits Interest. The Net Profits Interest in oil and natural gas properties is periodically assessed for impairment whenever events or circumstances indicate that the current fair value based on expected future cash flows of the Underlying Properties may be less than the carrying value of the Net Profits Interest. During the year ended December 31, 2018, the Trust did not recognize any impairment of the Net Profits Interest. Future downward revisions in actual production volumes relative to current forecasts, higher than expected operating costs, or lower than anticipated market pricing could result in recognition of impairment in future periods. Refer to Note 2 to the financial statements included in Item 8 of this report for the Trust’s significant accounting policies.

<s>[INST] PermRock Royalty Trust, a Delaware statutory trust formed in November 2017 by Boaz Energy, completed its initial public offering in May 2018. The Trust’s only asset and source of income is the Net Profits Interest, which entitles the Trust to receive 80% of the net profits from oil and natural gas production from the Underlying Properties. The Net Profits Interest is passive in nature and neither the Trust nor the Trustee has any management control over or responsibility for costs relating to the operation of the Underlying Properties. Although the Trust was formed on November 22, 2017, the conveyance of the Net Profits Interest did not occur until May 4, 2018, with an effective date of January 1, 2018, and no proceeds were received by the Trust from Boaz Energy during the threemonth period ended March 31, 2018. As a result, the Trust did not recognize any income or make any distributions during the threemonth period ended March 31, 2018. The Trust is required to make monthly cash distributions of substantially all of its monthly cash receipts, after deduction of fees and expenses for the administration of the Trust and any cash reserves, to holders of its Trust units as of the applicable record date on or before the 10th business day after the record date. The Net Profits Interest is entitled to a share of the profits from and after January 1, 2018 attributable to production occurring on or after such date. The Trust is not subject to any preset termination provisions based on a maximum volume of oil or natural gas to be produced or the passage of time. The amount of Trust revenues and cash distributions to Trust unitholders depends on, among other things: volumes produced; wellhead prices; price differentials; production and development costs; potential reductions or suspensions of production; and the amount and timing of Trust administrative expenses. Boaz Energy typically receives payment for oil production 30 to 60 days after it is produced and for natural gas production 60 to 90 days after it is produced. 2018 Recap and 2019 Outlook In 2018, Boaz Energy participated in the drilling of 23 new wells operated by others in the Permian Platform area and two new wells in the Permian Shelf. Boaz Energy has continued to optimize waterfloods in the Permian Clearfork and Permian Shelf through the use of conformance technology. In 2019, Boaz Energy plans to streamline existing waterflood operations, convert additional wells to injection wells where prudent, drill one to two new operated wells and continue to participate in Permian Platform drilling proposed by nonoperating partners. Results of Operations The Trust was formed on November 22, 2017. In connection with the closing of the initial public offering, on May 4, 2018, Boaz Energy contributed the Net Profits Interest to the Trust in exchange for 12,165,732 Trust units. The Net Profits Interest entitles the Trust to receive 80% of the net profits from the sale and production of oil and natural gas attributable to the Underlying Properties that are produced during the term of the Conveyance. The Net Profits Interest is passive in nature and neither the Trust nor the Trustee has any control over, or responsibility for, costs relating to the operation of the Underlying Properties. Based on 12,165,732 Trust units outstanding at each date listed below, the per unit distributions during the year ended December 31, 2018 were as follows: Computation of Income from the Net Profits Interest Received by the Trust In connection with the closing of the initial public offering in May 2018, Boaz Energy contributed the Net Profits Interest to the Trust in exchange for 12,165,732 newly issued Trust units. The Net Profits Interest entitles the Trust to receive 80% of the net profits attributable to Boaz Energy’s interest from the sale of oil and natural gas production from the Underlying Properties. The Trust’s income from the Net Profits Interest consists of monthly net profits attributable to income from the Underlying Properties. Because of the interval between [/INST] Positive. </s>

PermRock Royalty Trust

2020-03-30

2019-12-31

Item 7. Trustee’s Discussion and Analysis of Financial Condition and Results of Operations Overview PermRock Royalty Trust, a Delaware statutory trust formed in November 2017 by Boaz Energy, completed its initial public offering in May 2018. The Trust’s only asset and source of income is the Net Profits Interest, which entitles the Trust to receive 80% of the net profits from oil and natural gas production from the Underlying Properties. The Net Profits Interest is passive in nature and neither the Trust nor the Trustee has any management control over or responsibility for costs relating to the operation of the Underlying Properties. Although the Trust was formed on November 22, 2017, the conveyance of the Net Profits Interest did not occur until May 4, 2018, with an effective date of January 1, 2018, and no proceeds were received by the Trust from Boaz Energy during the three-month period ended March 31, 2018. As a result, the Trust did not recognize any income or make any distributions during the three-month period ended March 31, 2018. The Trust is required to make monthly cash distributions of substantially all of its monthly cash receipts, after deduction of fees and expenses for the administration of the Trust and any cash reserves, to holders of its Trust units as of the applicable record date on or before the 10th business day after the record date. The Net Profits Interest is entitled to a share of the profits attributable to production. Boaz Energy typically receives payment for oil production 30 to 60 days after it is produced and for natural gas production 60 to 90 days after it is produced. The Trust is not subject to pre-set termination provisions based on a maximum volume of oil or natural gas to be produced or the passage of time. The amount of Trust revenues and cash distributions to Trust unitholders depends on, among other things: · volumes produced; · wellhead prices; · price differentials; · production and development costs; · potential reductions or suspensions of production; and · the amount and timing of Trust administrative expenses. Oil prices have declined sharply during the first quarter of 2020 in response to the economic effects of the recent announcement of Saudi Arabia’s abandonment of output restraints and the COVID-19 pandemic. Continued low oil and gas prices on production from the Underlying Properties could cause (i) a reduction in the amount of net proceeds to which the Trust is entitled, which could materially reduce or completely eliminate the amount of cash available for distribution to Trust unitholders and (ii) a reduction in the amount of oil and natural gas that are economic to produce from the Underlying Properties. As discussed below, all derivative contracts expired as of December 31, 2019 and the terms of the Conveyance prohibit Boaz Energy from entering into new hedging arrangements. Consequently, the amount of cash contributions to the Trust are subject to even greater fluctuation after December 31, 2019. 2019 Recap and 2020 Outlook In 2019, Boaz Energy optimized waterflood operations, converted additional wells to injection wells where prudent and continued to participate in Permian Platform drilling proposed by non-operating partners. Boaz Energy completed two new wells operated by Boaz Energy in the Permian Clearfork area in 2019. The first was completed in August 2019 and came on-line in September 2019. The second new well reached total depth and came on-line in December 2019. In 2020, Boaz Energy plans to implement a new waterflood in the Permian Platform area and optimize revenue on the Underlying Properties. RESULTS OF OPERATIONS Distributable Income Years Ended December 31, 2019 and 2018 The decrease in net profits income was primarily due to decreased oil and natural gas prices and increased development costs. See “Computation of Income from the Net Profits Interest Received by the Trust” below. Interest Income. Interest income increased slightly for the year ended December 31, 2019, as compared to the prior year, primarily due to cash reserves beginning in May 2019, and also due to the increased number of days invested in 2019 compared to 2018 when the Trust’s IPO was completed in May 2018 resulting in only seven months for interest income in the year ended December 31, 2018. General and Administrative Expenditures. General and administrative expenditures increased for the year ended December 31, 2019, as compared to the prior year, primarily because the Trust’s IPO was completed in May 2018 resulting in only seven months of general and administrative expenditures in the year ended December 31, 2018. Cash Reserves. Pursuant to the Trust Agreement, the Trustee was authorized to begin retaining cash reserves for administrative expenses beginning in May 2019; therefore, no cash reserves were recorded for the year ended December 31, 2018. Based on 12,165,732 Trust units outstanding at each date listed below, the per unit distributions during the year ended December 31, 2019 were as follows: Computation of Income from the Net Profits Interest Received by the Trust The table below outlines the computation of income from the Net Profits Interest received by the Trust for the years ended December 31, 2019 and 2018: ------- (1) Annual sales volumes for 2019 reflect production volumes for November 2018 through October 2019. Because the Trust’s first distribution in May 2018 reflected production from January and February of 2018, annual sales volumes for 2018 reflect production volumes for January 2018 through October 2018. (2) Sales volumes for natural gas include NGLs. (3) In calculating the previously reported monthly distribution for May 2019, Boaz Energy included a one-time severance tax refund of $0.29 million on its Terry County Clearfork waterflood. Boaz Energy has advised that the Texas Comptroller of Public Accounts denied the claim for that severance tax refund, and that Plains Pipeline, the purchaser of the production subject to that severance tax, offset the amount of the refunded severance tax against the payments otherwise due to Boaz Energy for the purchase of oil and gas during the month of June 2019. Boaz Energy nevertheless processed cash flows for the month of June as though Plains Pipeline had made payment in full for June 2019 and calculated the Net Profits Interest accordingly, such that Boaz Energy bore the cost of that severance tax pending the outcome of an administrative hearing on the controversy. On February 10, 2020 the claim for the severance tax refund was approved. The reduction in severance tax attributable to the Terry County Clearfork waterflood will continue to be applicable. (4) Reflects gross cash proceeds from settlement of derivative contracts relating to production as discussed in Note 7 to consolidated financial statements and elsewhere in this Annual Report. (5) Boaz Energy is entitled under the Conveyance to reserve up to $3 million from the net profits for certain taxes and development expenses. Boaz Energy held back $553,000 net to the Trust in 2019. Those accumulated reserves were subsequently expended as development costs in 2019 and therefore, the capital reserve net activity for 2019 is $0. (6) Boaz Energy advanced $822,000 net to the Trust to cover capital costs of a new well to be operated by Boaz Energy in Terry County as described in Note 4 to consolidated financial statements. Years Ended December 31, 2019 and 2018 Important factors used in calculating the Trust’s net profits income include the volumes of oil and gas produced from the Underlying Properties and the realized prices received for the sale of those minerals, including natural gas liquids, as well as direct operating and development expenses. Sales Volumes Oil. Oil sales volumes increased for the year ended December 31, 2019 as compared to the prior year. This was primarily due to the two additional production months included in the calculations for the year ended December 31, 2019 as compared to the prior year. Natural Gas. Natural gas sales volumes increased for the year ended December 31, 2019 as compared to the prior year. This was primarily due to the two additional production months included in the calculations for the year ended December 31, 2019 as compared to the prior year. Sales Prices Oil. The average realized oil price per Bbl decreased for the year ended December 31, 2019 as compared to the prior year. The average realized oil price per Bbl for the year ended December 31, 2019 is primarily related to production from November 2018 through October 2019, when the average NYMEX price was $55.96 per Bbl. Natural Gas. The average realized natural gas price per Mcf decreased for the year ended December 31, 2019 as compared to the prior year. The average realized natural gas price per Mcf for the year ended December 31, 2019 is primarily related to production from November 2018 through October 2019, when the average NYMEX price was $2.81 per Mcf. Boaz Energy reports that its natural gas pricing was affected in the Permian Basin where robust drilling activities have resulted in an oversupply of ethane and other natural gas liquids produced in conjunction with the oil and natural gas produced in those activities, requiring Boaz Energy to incur costs to dispose of those excess natural gas liquids. Costs Direct Operating Expenses. Direct operating expenses increased for the year ended December 31, 2019 as compared to the prior year primarily due to the two additional production months included in the calculations for the year ended December 31, 2019 as compared to the prior year, as well as increased marketing costs attendant to the sale of ethane and other natural gas liquids during the second half of 2019. Lease Operating Expenses. Lease operating expenses increased for the year ended December 31, 2019 as compared to the prior year primarily due to the two additional production months included in the calculations for the year ended December 31, 2019 as compared to the prior year. In addition, Boaz Energy reported that it was more active in conducting workovers during 2019. Severance and Ad Valorem Taxes. Severance and ad valorem taxes decreased for the year ended December 31, 2019 as compared to the prior year primarily due to the severance tax refund discussed in footnote (3) above. Development Expenses Related to the Underlying Properties. Development expenses related to the Underlying Properties increased for the year ended December 31, 2019 as compared to the prior year because of an increase in development activity during the year ended December 31, 2019, including two new wells in 2019, injector cleanouts and preparations for planned waterflooding. The increase was also because of the timing of the Conveyance and the Trust’s IPO in May 2018, which caused fewer months to be included in the 2018 calculations. Other Expenses. Other expenses increased for the year ended December 31, 2019 as compared to the prior year, primarily because of two additional months being used in the calculation for 2019. Capital Reserve and Operator Advance. Boaz Energy is entitled under the Conveyance to reserve up to $3 million from the net profits for certain taxes and development expenses. Boaz Energy held back $553,000 net to the Trust in 2019. Those accumulated reserves were expended in 2019 for development costs of a new well to be operated by Boaz Energy in Terry County, as well as an additional $822,000 net to the Trust of funds advanced by Boaz Energy in 2019. Boaz Energy reported that the advancement would be recouped in the calculation of the Net Profits Interest in 2020. As of March 20, 2020, Boaz Energy reported that $742,000 had been recouped and that it anticipates the balance of $80,000 net to the Trust will be recouped in development expenses over the next one to two months. Derivative Contracts Income from the Net Profits Interest is exposed to fluctuations in energy prices in the normal scope of business. To mitigate the negative effects of a possible decline in oil prices on distributable income to the Trust, Boaz Energy entered into derivative put option contracts with respect to approximately 100% of expected oil production attributable to the Net Profits Interest during 2018 and 76% of such production during 2019. These derivative contracts consisted of put option contracts with strike prices of $60 per barrel in 2018 and $50 per barrel in 2019. Boaz Energy believes that these put option contracts provided downside protection to the Trust in the event spot prices for crude oil declined below the applicable strike price, while still allowing the Trust to benefit from increasing crude oil prices. If prices for crude oil as quoted on NYMEX declined below the applicable strike prices, Boaz Energy could exercise its put option and would receive payment generally equal to the difference between the applicable strike price and the market price for crude oil at the time of exercise, multiplied by the notional quantity of crude oil hedged under the applicable put option contract being exercised. These contracts expired as of December 31, 2019, and after December 31, 2019, Boaz Energy no longer hedges any of the production attributable to the Underlying Properties. Liquidity and Capital Resources The Trust’s principal sources of liquidity and capital are cash flow generated from the Net Profits Interest and borrowings, if any, to fund administrative expenses. The Trust’s primary uses of cash are distributions to Trust unitholders, payment of Trust administrative expenses, including, if applicable, any reserves established by the Trustee for future liabilities. Administrative expenses include the Trustee and Delaware Trustee fees, accounting, engineering, legal, tax advisory and other professional fees, and tax reporting and distribution expenses. The Trust is also responsible for paying other expenses incurred as a result of being a publicly traded entity, including costs associated with annual, quarterly and current reports to the SEC, New York Stock Exchange listing fees, independent auditor fees and registrar and transfer agent fees. If the Trustee determines that cash on hand and cash to be received in respect of the Net Profits Interest are, or will be, insufficient to cover the Trust’s liabilities and expenses, the Trustee may cause the Trust to borrow funds to pay liabilities of the Trust. Pursuant to the Trust Agreement, the Trustee is authorized beginning May 2019 to retain cash from the distributions it receives (i) in an amount not to exceed $1.0 million at any one time to be used by the Trust in the event that its cash on hand (including available cash reserves) is not sufficient to pay ordinary course administrative expenses as they become due and (ii) in such amounts as the Trustee in its discretion deems appropriate to pay for future liabilities of the Trust. Boaz Energy provided the Trust with a $1.0 million Letter of Credit that could be drawn by the Trust to pay its administrative expenses. The Trustee continues to retain cash from distributions in such amount as the Trustee determines but not less than $25,000 per month or more than $100,000 per month until the reserve described in clause (i) equals or exceeds $1.0 million, at which time, the Trustee is required to release the Letter of Credit. As of December 31, 2019, the Trustee had retained $600,000 in cash reserves, and as of March 19, 2020, the Trustee had retained $900,000 in cash reserves. The Trustee expects to have retained an aggregate of $1.0 million before the end of April 2020. As of March 19, 2020, the Letter of Credit, which will expire on May 2, 2020, has been decreased by the amount of the $900,000 cash reserves, and the current available amount of the Letter of Credit now totals $100,000. If the Trustee causes the Trust to borrow funds, or if the Trustee draws on the Letter of Credit being provided by Boaz Energy, the Trust unitholders will not receive distributions until the borrowed funds or the amount drawn, as applicable, are repaid. Boaz Energy Capital Expenditure Budget Boaz Energy’s estimated 2020 capital budget for the Underlying Properties is $2 million, of which approximately $800,000 has been expended as of March 30, 2020. Based on current oil and gas prices, there are no significant capital projects planned for the remainder of 2020. The majority of what has been spent so far in 2020 is attributable to properties not operated by Boaz Energy. Boaz Energy anticipates some capital expenditure on waterflood projects and workovers in Crane County which is included in the $2 million estimate. The estimate is subject to change based on, among other things, changes in the price of oil and natural gas, including the impact of the COVID-19 outbreak on such prices, Boaz Energy’s actual capital requirements, the pace of regulatory approvals and the mix of projects. Boaz Energy’s capital expenditure by the end of 2019 was updated to $7.0 million. Off-Balance Sheet Arrangements As of December 31, 2019, the Trust had no off-balance sheet arrangements. New Accounting Pronouncements As the Trust’s financial statements are prepared on the modified cash basis, most accounting pronouncements are not applicable to the Trust’s financial statements. No new accounting pronouncements have been adopted or issued that would impact the financial statements of the Trust. Critical Accounting Policies and Estimates The Trust uses the modified cash basis of accounting to report Trust receipts of the Net Profits Interest and payments of expenses incurred. The Net Profits Interest represents the right to receive revenues (oil and natural gas sales), less direct operating expenses (lease operating expenses and severance and ad valorem taxes) and development expenses of the Underlying Properties, multiplied by 80%, plus any payments received in connection with the settlement of certain derivative contracts. Cash distributions of the Trust are made based on the amount of cash received by the Trust pursuant to terms of the Conveyance creating the Net Profits Interest. The financial statements of the Trust, as prepared on a modified cash basis, reflect the Trust’s assets, liabilities, Trust corpus, earnings and distributions as follows: · Income from the Net Profits Interest is recorded when distributions are received by the Trust; · Distributions to Trust unitholders are recorded when declared by the Trust; · Trust general and administrative expenses (which includes the Trustee’s fees as well as accounting, engineering, legal, tax advisory and other professional fees) are recorded when paid; · Cash reserves for Trust expenses may be established by the Trustee for certain expenditures that would not be recorded as contingent liabilities under accounting principles generally accepted in the United States of America (“GAAP”); · Amortization of the investment in the Net Profits Interest is calculated on a unit-of-production basis and is charged directly to Trust corpus, and such amortization does not affect distributions from the Trust; and · The Trust’s investment in the Net Profits Interest is periodically assessed to determine whether its aggregate value has been impaired below its total capitalized cost basis and, if an impairment loss is indicated by the carrying amount of the assets exceeding the sum of the undiscounted expected future net cash flows, then an impairment loss is recognized for the amount by which the carrying amount of the asset exceeds its estimated fair value. The financial statements of the Trust are prepared on a modified cash basis of accounting, which is considered to be the most meaningful basis of preparation for a royalty trust because monthly distributions to the Trust unitholders are based on net cash receipts. Although this basis of accounting is permitted for royalty trusts by the SEC, the financial statements of the Trust differ from financial statements prepared in accordance with GAAP because net profits income is not accrued in the month of production, expenses are not recognized when incurred and cash reserves may be established for certain contingencies that would not be recorded in GAAP financial statements. This comprehensive basis of accounting other than GAAP corresponds to the accounting permitted for royalty trusts by the SEC as specified by Staff Accounting Bulletin Topic 12:E, Financial Statements of Royalty Trusts. The preparation of financial statements requires the Trust to make estimates and assumptions that affect the reported amounts of assets and liabilities and the reported amounts of revenues and expenses during the reporting period. Actual results could differ from those estimates. Oil and Natural Gas Reserves. The proved oil and natural gas reserves for the Underlying Properties are estimated by independent petroleum engineers. Reserve engineering is a subjective process that is dependent upon the quality of available data and the interpretation thereof. Estimates by different engineers often vary, sometimes significantly. In addition, physical factors such as the results of drilling, testing and production subsequent to the date of an estimate, as well as economic factors such as changes in product prices, may justify revision of such estimates. Because proved reserves are required to be estimated using prices at the date of the evaluation, estimated reserve quantities can be significantly impacted by changes in product prices. Accordingly, oil and natural gas quantities ultimately recovered and the timing of production may be substantially different from original estimates. The Financial Accounting Standards Board requires supplemental disclosures for oil and gas producers based on a standardized measure of discounted future net cash flows relating to proved oil and natural gas reserve quantities. Under this disclosure, future cash inflows are computed by applying the average prices during the 12-month period prior to fiscal year-end, determined as an unweighted arithmetic average of the first-day-of-the-month benchmark price for each month within such period, unless prices are defined by contractual arrangements, excluding escalations based upon future conditions. Future price changes are only considered to the extent provided by contractual arrangements in existence at year-end. The standardized measure of discounted future net cash flows is achieved by using a discount rate of 10% a year to reflect the timing of future cash flows relating to proved oil and natural gas reserves. Changes in any of these assumptions, including consideration of other factors, could have a significant impact on the standardized measure. The standardized measure does not necessarily result in an estimate of the current fair market value of proved reserves. Amortization of Net Profits Interest. The Trust calculates amortization of the Net Profits Interest in oil and natural gas properties on a unit-of-production basis based on the Underlying Properties’ production and reserves. The reserves upon which the amortization rate is based are quantity estimates which are subject to numerous uncertainties inherent in the estimation of proved reserves. The volumes considered to be commercially recoverable fluctuate with changes in prices and operating costs. These estimates are expected to change as additional information becomes available in the future. Downward revisions in proved reserves may result in an increased rate of amortization. Amortization is recorded on sales volumes paid by the Trust during the relevant period and is charged directly to the Trust corpus balance. As a result, amortization does not affect the cash earnings of the Trust. Impairment of Net Profits Interest. The Net Profits Interest in oil and natural gas properties is periodically assessed for impairment whenever events or circumstances indicate that the current fair value based on expected future cash flows of the Underlying Properties may be less than the carrying value of the Net Profits Interest. During the year ended December 31, 2019, the Trust did not recognize any impairment of the Net Profits Interest. Future downward revisions in actual production volumes relative to current forecasts, higher than expected operating costs, or lower than anticipated market pricing could result in recognition of impairment in future periods. Refer to Note 2 to the financial statements included in Item 8 of this report for the Trust’s significant accounting policies.

<s>[INST] PermRock Royalty Trust, a Delaware statutory trust formed in November 2017 by Boaz Energy, completed its initial public offering in May 2018. The Trust’s only asset and source of income is the Net Profits Interest, which entitles the Trust to receive 80% of the net profits from oil and natural gas production from the Underlying Properties. The Net Profits Interest is passive in nature and neither the Trust nor the Trustee has any management control over or responsibility for costs relating to the operation of the Underlying Properties. Although the Trust was formed on November 22, 2017, the conveyance of the Net Profits Interest did not occur until May 4, 2018, with an effective date of January 1, 2018, and no proceeds were received by the Trust from Boaz Energy during the threemonth period ended March 31, 2018. As a result, the Trust did not recognize any income or make any distributions during the threemonth period ended March 31, 2018. The Trust is required to make monthly cash distributions of substantially all of its monthly cash receipts, after deduction of fees and expenses for the administration of the Trust and any cash reserves, to holders of its Trust units as of the applicable record date on or before the 10th business day after the record date. The Net Profits Interest is entitled to a share of the profits attributable to production. Boaz Energy typically receives payment for oil production 30 to 60 days after it is produced and for natural gas production 60 to 90 days after it is produced. The Trust is not subject to preset termination provisions based on a maximum volume of oil or natural gas to be produced or the passage of time. The amount of Trust revenues and cash distributions to Trust unitholders depends on, among other things: · volumes produced; · wellhead prices; · price differentials; · production and development costs; · potential reductions or suspensions of production; and · the amount and timing of Trust administrative expenses. Oil prices have declined sharply during the first quarter of 2020 in response to the economic effects of the recent announcement of Saudi Arabia’s abandonment of output restraints and the COVID19 pandemic. Continued low oil and gas prices on production from the Underlying Properties could cause (i) a reduction in the amount of net proceeds to which the Trust is entitled, which could materially reduce or completely eliminate the amount of cash available for distribution to Trust unitholders and (ii) a reduction in the amount of oil and natural gas that are economic to produce from the Underlying Properties. As discussed below, all derivative contracts expired as of December 31, 2019 and the terms of the Conveyance prohibit Boaz Energy from entering into new hedging arrangements. Consequently, the amount of cash contributions to the Trust are subject to even greater fluctuation after December 31, 2019. 2019 Recap and 2020 Outlook In 2019, Boaz Energy optimized waterflood operations, converted additional wells to injection wells where prudent and continued to participate in Permian Platform drilling proposed by nonoperating partners. Boaz Energy completed two new wells operated by Boaz Energy in the Permian Clearfork area in 2019. The first was completed in August 2019 and came online in September 2019. The second new well reached total depth and came online in December 2019. In 2020, Boaz Energy plans to implement a new waterflood in the Permian Platform area and optimize revenue on the Underlying Properties. RESULTS OF OPERATIONS Distributable Income Years Ended December 31, 2019 and 2018 The decrease in net profits income was primarily due to decreased oil and natural gas prices and increased development costs. See “Computation of Income from the Net Profits Interest Received by the Trust” below. Interest Income. Interest income increased slightly for the year ended December 31, 2019, as compared to the prior year, primarily due to cash reserves beginning in May 2019, and also due to the increased number of days invested [/INST] Negative. </s>

Pure Acquisition Corp.

2019-02-08

2018-12-31

Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations. This Annual Report on Form 10-K includes forward-looking statements. We have based these forward-looking statements on our current expectations and projections about future events. These forward-looking statements are subject to known and unknown risks, uncertainties and assumptions about us that may cause our actual results, levels of activity, performance or achievements to be materially different from any future results, levels of activity, performance or achievements expressed or implied by such forward-looking statements. In some cases, you can identify forward-looking statements by terminology such as “may”, “should”, “could”, “would”, “expect”, “plan”, “anticipate”, “believe”, “estimate”, “continue”, or the negative of such terms or other similar expressions. Factors that might cause or contribute to such a discrepancy include, but are not limited to, those described in our other Securities and Exchange (“SEC”) filings. References to “we”, “us”, “our” or the “Company” are to Pure Acquisition Corp. Our actual results may differ materially from those anticipated in these forward-looking statements as a result of many factors, including those set forth under “Special Note Regarding Forward-Looking Statements,” “Item 1A. Risk Factors” and elsewhere in this Annual Report on Form 10-K. The following discussion and analysis of the Company’s financial condition and results of operations should be read in conjunction with our audited financial statements and the notes related thereto which are included in “Item 8. Financial Statements and Supplementary Data” of this Annual Report on Form 10-K. Overview We are a blank check company incorporated as a Delaware corporation and formed for the purpose of effecting a merger, share exchange, asset acquisition, stock purchase, recapitalization, reorganization or other similar business combination with one or more businesses or entities (“Business Combination”). We intend to focus our search for target businesses in the energy industry with an emphasis on opportunities in the upstream oil and gas industry in North America where our management team’s networks and experience are suited, although our efforts to identify a prospective target business is not just limited to a particular industry or geographic region. On April 17, 2018 (the “IPO Closing Date”), we consummated our initial public offering (the “Public Offering”) of 41,400,000 units (the “Units”), including 5,400,000 Units sold to cover over-allotments, at a price of $10.00 per Unit resulting in gross proceeds of $414,000,000. HighPeak Pure Acquisition, LLC (our “Sponsor”) purchased an aggregate of 10,280,000 private placement warrants at a purchase price of $1.00 per private placement warrant, or $10,280,000 in the aggregate, in a private placement (the “Private Placement Warrants”). On the IPO Closing Date, a portion of the proceeds from our Public Offering and the sale of our Private Placement Warrants in the aggregate amount of $414,000,000 was placed in a U.S.-based trust account at J.P. Morgan, N.A. maintained by Continental Stock Transfer & Trust Company, acting as trustee, for the benefit of our public stockholders (the “Trust Account”). On April 12, 2018, HighPeak Energy Partners, LP ("HighPeak LP"), an affiliate of our Sponsor, entered into a forward purchase agreement with us that provides for the purchase by HighPeak LP of an aggregate of up to 15,000,000 shares of our Class A common stock and 7,500,000 warrants for $10.00 per forward purchase unit, for an aggregate purchase price of up to $150,000,000 in a private placement that will close simultaneously with the closing of our initial Business Combination (the “Forward Purchase Securities”). HighPeak LP is a limited partnership affiliated with our Sponsor. The forward purchase warrants will have the same terms as the Private Placement Warrants so long as they are held by HighPeak LP, its affiliates or its permitted transferees, and the forward purchase shares are identical to the shares of Class A common stock included in the Units sold in the Public Offering, except the forward purchase shares are subject to transfer restrictions and certain registration rights, as described in the forward purchase agreement. HighPeak LP's commitment under the forward purchase agreement may be reduced under certain circumstances as described in the agreement. We are currently in the process of identifying suitable targets for an initial Business Combination. We intend to close our initial Business Combination using cash from the proceeds of the Public Offering, the sale of the Private Placement Warrants, the private placement of Forward Purchase Securities and from additional issuances, if any, or our capital stock, debt or a combination of cash, stock and debt. We are pursuing acquisition opportunities and, at any given time, may be in various stages of due diligence or preliminary discussions with respect to a number of potential acquisitions. From time to time, we many enter into non-binding letters of intent. We are not currently subject to any definitive agreement with respect to any Business Combination. However, we cannot assure you we will be able to identify any suitable target candidates or, if identified, be able to complete the acquisition of such candidates on favorable terms or at all. Results of Operations We have neither engaged in any significant operations nor generated any operating revenue. Our only activities from inception through the year ended December 31, 2018 have been related to our formation and the Public Offering. Although we have not generated operating revenue, we have generated non-operating income in the form of interest income on cash and cash equivalents. We expect to incur increased expenses as a result of being a public company (for legal, financial reporting, accounting and auditing compliance), as well as costs in the pursuit of an acquisition target. For the period from Inception to December 31, 2018, we earned net income of $4,275,271, which consisted of interest income on cash and cash equivalents held in the Trust Account net of operating costs, administrative service fees and income tax provision. Liquidity and Capital Resources Until the consummation of the Public Offering, our only source of liquidity was an initial sale of shares of Class B common stock, par value $0.0001 per share, which are convertible to shares of our Class A commons stock upon completion of an initial Business Combination, (the “Founders’ Shares”), to the Sponsor and the proceeds of a $200,000 loan from our Sponsor. At the IPO Closing Date, the Company repaid the Sponsor $200,000 in settlement of the outstanding loan in full. On the IPO Closing Date, we consummated the Public Offering of 41,400,000 Units, including 5,400,000 Units sold to cover the over-allotments at a price of $10.00 per Unit resulting in gross proceeds from the Public Offering of $414,000,000. Our Sponsor purchased an aggregate of 10,280,000 Private Placement Warrants at a purchase price of $1.00 per Private Placement Warrant, or $10,280,000 in the aggregate. On the IPO Closing Date, proceeds of $414,000,000 were deposited in a U.S.-based trust account at J.P. Morgan, N.A. maintained by Continental Stock Transfer & Trust Company, acting as trustee, for the benefit of our public stockholders. Of the gross proceeds received from the Public Offering and the sale of the Private Placement Warrants not deposited into the Trust Account, $8,280,000 was used to pay underwriting discounts and commissions in the Public Offering, $200,000 was used to repay the loan from the Sponsor in full and the balance was reserved to pay accrued offering and formation expenses; and prospective acquisition business, technical, legal and accounting due diligence expenses; and continuing general and administrative expenses. We had cash of $734,894 and $25,000 at December 31, 2018 and December 31, 2017, respectively. In addition, interest income from the Trust Account may be released to us for any amounts necessary to pay (i) the Company's income and other tax obligations, (ii) payment of $10,000 per month to our Sponsor or one of its affiliates, for up to 18 months, for office space, utilities and secretarial and administrative support commencing on April 13, 2018, the date of listing of our securities on the Nasdaq, and (iii) our liquidation expenses if the Company is unable to consummate a Business Combination within the required time period (up to a maximum of $50,000). The Company has 18 months from the IPO Closing Date to complete its initial Business Combination. If the Company is unable to complete the initial Business Combination within 18 months from the IPO Closing Date, the Company must: (i) cease all operations except for the purpose of winding up, (ii) as promptly as reasonably possible but not more than ten business days thereafter, redeem the Public Shares, at a per-share price, payable in cash, equal to the aggregate amount then on deposit in the Trust Account, including interest (which interest shall be net of taxes payable and up to $50,000 for dissolution expenses) divided by the number of then outstanding Public Shares, which redemption will completely extinguish public stockholders' rights as stockholders (including the right to receive further liquidation distributions, if any), subject to applicable law, and (iii) as promptly as reasonably possible following such redemption, subject to the approval of the Company's remaining stockholders and the Company's Board of Directors, dissolve and liquidate, subject in the case of clauses (ii) and (iii) to the Company's obligations under Delaware law to provide for claims of creditors and the requirements of other applicable law. This mandatory liquidation and subsequent dissolution of the Company if an initial Business Combination is not completed within the required time raises substantial doubt about the Company’s ability to continue as a going concern. No adjustments have been made to the carrying amounts of assets or liabilities should the Company be required to liquidate after 18 months from the IPO Closing Date. In the event of such liquidation, it is possible the per share value of the residual assets remaining available for distribution (including the Trust Account assets) will be less than the offering price per Unit in the Public Offering. Off-Balance Sheet Financing Arrangements We have no obligations, assets or liabilities which would be considered off-balance sheet arrangements as of December 31, 2018. We do not participate in transactions that create relationships with unconsolidated entities or financial partnerships, often referred to as variable interest entities, which would have been established for the purpose of facilitating off-balance sheet arrangements. We have not entered into any off-balance sheet financing arrangements, established any special purpose entities, guaranteed any debt or commitments of other entities, or entered into any non-financial agreements involving assets as of December 31, 2018. Contractual Obligations At December 31, 2018 and December 31, 2017, we did not have any long-term debt, capital lease obligations, operating lease obligations or long-term liabilities. On April 12, 2018, we entered into an administrative services agreement pursuant to which we agreed to pay our Sponsor or one of its affiliates a total of $10,000 per month for office space, utilities, secretarial support and administrative services. During 2018, the Company paid $80,000 to an affiliate of our Sponsor, with funds received from the Trust Account, for administrative services. Upon completion of the initial Business Combination or our liquidation, we will cease paying these monthly fees. On April 12, 2018, we engaged Oppenheimer & Co. Inc. and EarlyBirdCapital severally as advisors in connection with a potential Business Combination to assist us in arranging meetings with our stockholders to discuss the potential Business Combination and the target business’ attributes, introduce us to potential investors interested in purchasing our securities, assist us in obtaining stockholder approval for the Business Combination and assist us with the preparation of our press releases and public filings in connection with the Business Combination. We will pay Oppenheimer & Co. Inc. and EarlyBirdCapital a cash fee for such services in an amount equal to 3.5% of the gross proceeds of the Public Offering (exclusive of any applicable finders’ fees which may become payable) upon the consummation of our initial Business Combination. Pursuant to the terms of the Business Combination marketing agreement, no fee will be due if we do not complete an initial Business Combination. Critical Accounting Policies Basis of Presentation The accompanying financial statements and related disclosures of the Company have been prepared in accordance with accounting principles generally accepted in the United States of America ("U.S. GAAP") and pursuant to the accounting and disclosure rules and regulations of the SEC, and reflect all adjustments, consisting only of normal recurring adjustments, which are, in the opinion of management, necessary for a fair presentation of the financial position as of December 31, 2018 and the results of operations and cash flows for the period presented. Emerging growth company The Company is an "emerging growth company," as defined in Section 2(a) of the Securities Act of 1933, as amended, (the "Securities Act"), as modified by the Jumpstart our Business Startups Act of 2012, (the "JOBS Act"), and it may take advantage of certain exemptions from various reporting requirements applicable to other public companies that are not emerging growth companies including, but not limited to, not being required to comply with the auditor attestation requirements of Section 404 of the Sarbanes- Oxley Act, reduced disclosure obligations regarding executive compensation in its periodic reports and proxy statements, and exemptions from the requirements of holding a nonbinding advisory vote on executive compensation and stockholder approval of any golden parachute payments not previously approved. Further, Section 102(b)(1) of the JOBS Act exempts emerging growth companies from being required to comply with new or revised financial accounting standards until private companies (that is, those that have not had a Securities Act registration statement declared effective or do not have a class of securities registered under the Exchange Act) are required to comply with the new or revised financial accounting standards. The JOBS Act provides a company can elect to opt out of the extended transition period and comply with the requirements that apply to non-emerging growth companies but any such election to opt out is irrevocable. The Company has elected not to opt out of such extended transition period which means when a standard is issued or revised and it has different application dates for public or private companies, the Company, as an emerging growth company, can adopt the new or revised standard at the time private companies adopt the new or revised standard. This may make comparison of the Company's financial statements with another public company which is neither an emerging growth company nor an emerging growth company which has opted out of using the extended transition period difficult or impossible because of the potential differences in accounting standards used. Net Income Per Common Share Net income per common share is computed by dividing net income by the weighted average number of common shares outstanding for the period. The Company has not considered the effect of the Warrants sold in the Public Offering and Private Placement Warrants to purchase 20,700,000 and 10,280,000 shares of the Company’s Class A common stock, respectively, in the calculation of diluted income per share, since their inclusion would be anti-dilutive. The Company’s statement of operations includes a presentation of net income per share for common shares subject to redemption in a manner similar to the two-class method of net income per share. Net income per common share for basic and diluted for Class A common stock is calculated by dividing the interest income earned on the Trust Account, net of applicable administrative fees, franchise taxes and income taxes, by the weighted average number of Class A common stock since issuance. Net loss per common share for basic and diluted for Class B common stock is calculated by dividing the net loss, which excludes income attributable to Class A common stock, by the weighted average number of Class B common stock outstanding for the period. Cash and cash equivalents The Company considers all short-term investments with an original maturity of three months or less when purchased to be cash equivalents. The Company did not have any cash equivalents as of December 31, 2018 or December 31, 2017. Cash and Marketable Securities held in the Trust Account The amounts held in the Trust Account represent proceeds from the Public Offering and the private placement of Private Placement Warrants of $414,000,000 which were invested in permitted United States “government securities” within the meaning of Section 2(a)(16) of the Investment Company Act of 1940, as amended (the “Investment Company Act”), having a maturity of 180 days or less, or in money market funds meeting certain conditions under Rule 2a-7 under the Investment Company Act (“Permitted Investments”) and are classified as restricted assets because such amounts can only be used by the Company in connection with the consummation of an initial Business Combination. As of December 31, 2018, cash and Permitted Investments held in the Trust Account had a fair value of $418,727,517. For the twelve months ended December 31, 2018, investments held in the Trust Account generated interest income of $5,777,767. During 2018, the Company paid $970,000 to the IRS, with funds received from the Trust Account, for estimated federal income taxes. During 2018, the Company paid $80,000 to an affiliate of our Sponsor, with funds received from the Trust Account, for administrative services. Redeemable Common Stock All of our 41,400,000 Public Shares contain a redemption feature which allows for the redemption of Class A Common Stock under the Company’s liquidation or tender offer/stockholder approval provisions. In accordance with FASB ASC 480, redemption provisions not solely within the control of the Company require the security to be classified outside of permanent equity. Ordinary liquidation events, which involve the redemption and liquidation of all of the entity’s equity instruments, are excluded from the provisions of FASB ASC 480. Although the Company has not specified a maximum redemption threshold, its second amended and restated certificate of incorporation provides that in no event will the Company redeem its Public Shares in an amount that would cause its net tangible assets to be less than $5,000,001. The Company recognizes changes in redemption value immediately as they occur and will adjust the carrying value of the security at the end of each reporting period. Increases or decreases in the carrying number of redeemable shares of Class A Common Stock shall be affected by charges against additional paid-in capital. Accordingly, at December 31, 2018, all of the 41,400,000 shares of Class A Common Stock included in the Units were classified outside of permanent equity at approximately $10.00 per share. Concentration of credit risk Financial instruments that potentially subject the Company to concentration of credit risk consist of a cash account in a financial institution which, at times may exceed the Federal depository insurance coverage of $250,000. At December 31, 2018, the Company had not experienced losses on this account and management believes the Company is not exposed to significant risks on such account. Use of estimates The preparation of the financial statements in conformity with U.S. GAAP requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of expenses during the reporting period. Actual results could differ from those estimates. Fair value of financial instruments The fair value of the Company's assets and liabilities, which qualify as financial instruments under ASC Topic 820, "Fair Value Measurements and Disclosures", approximates the carrying amounts represented in the accompanying balance sheets, primarily due to their short-term nature. Offering Costs The Company complies with the requirements of FASB ASC 340-10-S99-1 and SEC Staff Accounting Bulletin (“SAB”) Topic 5A - “Expenses of Offering”. Offering costs of $9,506,582 consisting principally of underwriting discounts of $8,280,000 and $1,226,582 of professional, printing, filing, regulatory and other costs incurred through the date of the financial statements directly related to the preparation of the Public Offering were charged to stockholders' equity upon completion of the Public Offering (See Note 3). Income taxes The Company follows the asset and liability method for accounting for income taxes under FASB ASC 740 "Income Taxes." Deferred tax assets and liabilities are recognized for the estimated future tax consequences attributable to differences between the financial statements carrying amounts of existing assets and liabilities and their respective tax bases. Deferred tax assets and liabilities are measured using enacted tax rates expected to apply to taxable income in the years in which those temporary differences are expected to be recovered or settled. The effect on deferred tax assets and liabilities of a change in tax rates is recognized in income in the period that included the enactment date. Valuation allowances are established, when necessary, to reduce deferred tax assets to the amount expected to be realized. FASB ASC 740 prescribes a recognition threshold and a measurement attribute for financial statement recognition and measurement of tax positions taken or expected to be taken in a tax return. For those benefits to be recognized, a tax position must be more likely than not to be sustained upon examination by taxing authorities. The Company recognizes accrued interest and penalties related to unrecognized tax benefits as income tax expense. There were no unrecognized tax benefits and no amounts accrued for interest and penalties as of December 31, 2018 and December 31, 2017. The Company is currently not aware of any issues under review that could result in significant payments, accruals or material deviation from its position. The Company is subject to income tax examinations by major taxing authorities since inception. On December 22, 2017, the U.S. Tax Cuts and Jobs Act of 2017 (“Tax Reform”) was signed into law. As a result of Tax Reform, the U.S. statutory tax rate was lowered from 35% to 21% effective January 1, 2018, among other changes. FASB ASC 740 requires companies to recognize the effect of tax law changes in the period of enactment; therefore, the Company was required to revalue its deferred tax assets and liabilities at December 31, 2017 at the new rate. The SEC issued Staff Accounting Bulletin No. 118 (“SAB 118”) to address the application of U.S. GAAP in situations when a registrant does not have the necessary information available, prepared or analyzed (including computations) in reasonable detail to complete the accounting for certain tax effects of Tax reform. Related Parties The Company follows subtopic ASC 850-10 for the identification of related parties and disclosure of related party transactions. Pursuant to Section 850-10-20, the related parties include: (a) affiliates of the Company (“Affiliate” means, with respect to any specified person, any other person that, directly or indirectly through one or more intermediaries, controls, is controlled by or is under common control with such person, as such terms are used in and construed under Rule 405 under the Securities Act); (b) entities for which investments in their equity securities would be required, absent the election of the fair value option under the Fair Value Option Subsection of Section 825-10-15, to be accounted for by the equity method by the investing entity; (c) trusts for the benefit of employees, such as pension and profit-sharing thrust that are managed by or under the trusteeship of management; (d) principal owners of the Company; (e) management of the Company; (f) other parties with which the Company may deal if one party controls or can significantly influence the management or operating policies of the other to an extent that one of the transacting parties might be prevented from fully pursuing its own separate interests; and (g) other parties that can significantly influence the management or operating policies of the transacting parties or that have an ownership interest in one of the transacting parties and can significantly influence the other to an extent that one or more of the transacting parties might be prevented from fully pursuing its own separate interests. Recent Accounting Pronouncements In August 2018, the SEC adopted the final rule under SEC Release No. 33-10532, “Disclosure Update and Simplification,” amending certain disclosure requirements that were redundant, duplicative, overlapping, outdated or superseded. In addition, the amendments expanded the disclosure requirements on the analysis of stockholders’ equity for interim financial statements. Under the amendments, an analysis of changes in each caption of stockholders’ equity presented in the balance sheet must be provided in a note or separate statement. The analysis should present a reconciliation of the beginning balance to the ending balance of each period for which a statement of comprehensive income is required to be filed. This final rule is effective on November 5, 2018. The Company anticipates its first presentation of changes in stockholders’ equity will be included in its Form 10-Q for the quarter ended March 31, 2019. The Company has evaluated other recently issued, but not yet effective, accounting pronouncements and does not believe they would have a material effect on the Company's financial statements. Subsequent Events The Company evaluates subsequent events and transactions that occur after the balance sheet date for potential recognition or disclosure. Any material events that occur between the balance sheet date and the date the financial statements were issued are disclosed as subsequent events, while the financial statements are adjusted to reflect any conditions that existed at the balance sheet date.

<s>[INST] The following discussion and analysis of the Company’s financial condition and results of operations should be read in conjunction with our audited financial statements and the notes related thereto which are included in “Item 8. Financial Statements and Supplementary Data” of this Annual Report on Form 10K. Overview We are a blank check company incorporated as a Delaware corporation and formed for the purpose of effecting a merger, share exchange, asset acquisition, stock purchase, recapitalization, reorganization or other similar business combination with one or more businesses or entities (“Business Combination”). We intend to focus our search for target businesses in the energy industry with an emphasis on opportunities in the upstream oil and gas industry in North America where our management team’s networks and experience are suited, although our efforts to identify a prospective target business is not just limited to a particular industry or geographic region. On April 17, 2018 (the “IPO Closing Date”), we consummated our initial public offering (the “Public Offering”) of 41,400,000 units (the “Units”), including 5,400,000 Units sold to cover overallotments, at a price of $10.00 per Unit resulting in gross proceeds of $414,000,000. HighPeak Pure Acquisition, LLC (our “Sponsor”) purchased an aggregate of 10,280,000 private placement warrants at a purchase price of $1.00 per private placement warrant, or $10,280,000 in the aggregate, in a private placement (the “Private Placement Warrants”). On the IPO Closing Date, a portion of the proceeds from our Public Offering and the sale of our Private Placement Warrants in the aggregate amount of $414,000,000 was placed in a U.S.based trust account at J.P. Morgan, N.A. maintained by Continental Stock Transfer & Trust Company, acting as trustee, for the benefit of our public stockholders (the “Trust Account”). On April 12, 2018, HighPeak Energy Partners, LP ("HighPeak LP"), an affiliate of our Sponsor, entered into a forward purchase agreement with us that provides for the purchase by HighPeak LP of an aggregate of up to 15,000,000 shares of our Class A common stock and 7,500,000 warrants for $10.00 per forward purchase unit, for an aggregate purchase price of up to $150,000,000 in a private placement that will close simultaneously with the closing of our initial Business Combination (the “Forward Purchase Securities”). HighPeak LP is a limited partnership affiliated with our Sponsor. The forward purchase warrants will have the same terms as the Private Placement Warrants so long as they are held by HighPeak LP, its affiliates or its permitted transferees, and the forward purchase shares are identical to the shares of Class A common stock included in the Units sold in the Public Offering, except the forward purchase shares are subject to transfer restrictions and certain registration rights, as described in the forward purchase agreement. HighPeak LP's commitment under the forward purchase agreement may be reduced under certain circumstances as described in the agreement. We are currently in the process of identifying suitable targets for an initial Business Combination. We intend to close our initial Business Combination using cash from the proceeds of the Public Offering, the sale of the Private Placement Warrants, the private placement of Forward Purchase Securities and from additional issuances, if any, or our capital stock, debt or a combination of cash, stock and debt. We are pursuing acquisition opportunities and, at any given time, may be in various stages of due diligence or preliminary discussions with respect to a number of potential acquisitions. From time to time, we many enter into nonbinding letters of intent. We are not currently subject to any definitive agreement with respect to any Business Combination. However, we cannot assure you we will be able to identify any suitable target candidates or, if identified, be able to complete the acquisition of such candidates on favorable terms or at all. Results of Operations [/INST] Positive. </s>

Pure Acquisition Corp.

2020-03-13

2019-12-31

Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations This Annual Report on Form 10-K includes forward-looking statements. We have based these forward-looking statements on our current expectations and projections about future events. These forward-looking statements are subject to known and unknown risks, uncertainties and assumptions about us that may cause our actual results, levels of activity, performance or achievements to be materially different from any future results, levels of activity, performance or achievements expressed or implied by such forward-looking statements. In some cases, you can identify forward-looking statements by terminology such as “may,” “should,” “could,” “would,” “expect,” “plan,” “anticipate,” “believe,” “estimate,” “continue,” or the negative of such terms or other similar expressions. Factors that might cause or contribute to such a discrepancy include, but are not limited to, those described in our other SEC filings. References to “we,” “us,” “our,” “Pure,” or the “Company” are to Pure Acquisition Corp. Our actual results may differ materially from those anticipated in these forward-looking statements as a result of many factors, including those set forth under “Special Note Regarding Forward-Looking Statements,” “Item 1A. Risk Factors” and elsewhere in this Annual Report on Form 10-K. The following discussion and analysis of the Company’s consolidated financial condition and results of operations should be read in conjunction with our audited consolidated financial statements attached hereto and the notes related thereto which are included in “Item 8. Financial Statements and Supplementary Data.” of this Annual Report on Form 10-K. Overview We are a blank check company incorporated on November 13, 2017 as a Delaware corporation and formed for the purpose of effecting a merger, share exchange, asset acquisition, stock purchase, recapitalization, reorganization or similar business combination with one or more target businesses (a “Business Combination”) with a focus on a target business in the energy industry, and an emphasis on opportunities in the upstream oil and gas industry in North America where our management team’s collective networks and experience are suited. We have neither engaged in any operations nor generated any operating revenue to date. Based on our business activities, the Company is a “shell company” as defined under the Exchange Act because we have no operations and nominal assets consisting almost entirely of cash. In connection with the formation of the Company, a total of 10,062,500 shares of Class B common stock were sold to our Sponsor at a price of approximately $0.002 per share for an aggregate of $25,000 (the “Founders’ Shares”). In March 2018, our Sponsor returned to us, at no cost, an aggregate of 1,437,500 Founders’ Shares, which we cancelled, leaving an aggregate of 8,625,000 Founders’ Shares outstanding. In March 2018, our Sponsor transferred 40,000 Founders’ Shares to each of our three independent director nominees resulting in a total of 120,000 Founders’ Shares transferred to our independent director nominees. In April 2018, we effected a stock dividend of 0.2 shares of Class B common stock for each outstanding share of Class B common stock, resulting in our Sponsor and independent director nominees holding an aggregate of 10,350,000 Founders’ Shares. At December 31, 2019, our Sponsor and our three independent directors (the “Initial Stockholders”) held, collectively, 10,350,000 Founders’ Shares. On April 17, 2018 (the “IPO Closing Date”), the Company consummated its initial public offering (“Public Offering”) of 41,400,000 units, representing a complete exercise of the over-allotment option, at a purchase price of $10.00 per unit generating gross proceeds of $414,000,000 before underwriting discounts and expenses. Each unit consists of one share of Class A common stock (“Public Share”) of the Company at $0.0001 par value and one half of one warrant (a “Unit”). Each whole warrant entitles the holder to purchase one share of Class A common stock at a price of $11.50 (a “Warrant”). Only whole Warrants may be exercised and no fractional Warrants will be issued upon separation of the Units and only whole Warrants may be traded. Each Warrant will become exercisable on the later of 30 days after the completion of an initial Business Combination or 12 months from the IPO Closing Date and will expire on the fifth anniversary of our completion of an initial Business Combination, or earlier upon redemption or liquidation. Alternatively, if we do not complete a Business Combination by May 21, 2020, the Warrants will expire at the end of such period. If we are unable to deliver registered shares of Class A common stock to the holder upon exercise of Warrants issued in connection with the 41,400,000 Units during the exercise period, the Warrants will expire, except to the extent they may be exercised on a cashless basis in the circumstances described in the agreement governing the Warrants. On the IPO Closing Date, our Sponsor purchased from us an aggregate of 10,280,000 private placement warrants at $1.00 per private placement warrant for a total purchase price of $10,280,000 in a private placement (the “Private Placement Warrants”). Each Private Placement Warrant is exercisable to purchase one share of our Class A common stock at a price of $11.50 and are not redeemable so long as they are held by the initial purchasers of the Private Placement Warrants or their permitted transferees. We received gross proceeds from the Public Offering and the sale of the Private Placement Warrants of $414,000,000 and $10,280,000, respectively, for an aggregate of $424,280,000. We deposited $414,000,000 of the gross proceeds in a trust account with Continental Stock Transfer and Trust Company (the “Trust Account”). The proceeds held in the Trust Account will be invested only in U.S. government treasury bills with a maturity of one hundred eighty (180) days or less or in money market funds that meet certain conditions under Rule 2a-7 under the Investment Act of 1940 and invest only in direct U.S. government obligations. At the IPO Closing Date, the remaining $10,280,000 was held outside of the Trust Account, of which $8,280,000 was used to pay underwriting discounts and $200,000 was used to repay notes payable to our Sponsor with the balance reserved to pay accrued offering and formation costs, business, legal and accounting due diligence on prospective acquisitions and continuing general and administrative expenses. A portion of interest income on the funds held in the Trust Account has been and will continue to be released to us to pay our tax obligations and up to $10,000 per month for office space, utilities and secretarial and administrative support. On April 12, 2018, HPEP I, an affiliate of our Sponsor, entered into a forward purchase agreement (the “Forward Purchase Agreement”) with us that provides for the purchase by HPEP I of an aggregate of up to 15,000,000 shares of our Class A common stock (the “forward purchase shares”) and up to 7,500,000 warrants (the “forward purchase warrants,” and together with the forward purchase shares, the “forward purchase units”) for $10.00 per forward purchase unit, for an aggregate purchase price of up to $150,000,000 in a private placement that will close simultaneously with the closing of our initial Business Combination (collectively, the “Forward Purchase Securities”). On February 6, 2020 as part of an amendment to the HPK Business Combination Agreement (the “HPK Amendment”), the parties to the BCA Amendment revised the form of Forward Purchase Agreement (the “A&R Forward Purchase Agreement”) to be entered into to, among other things, (i) extend the date by which the Business Combination must be completed from February 21, 2020 to May 21, 2020, (ii) reflect that the A&R Forward Purchase Agreement may be assigned by HPEP I to third parties, in addition to its affiliates and we will assign our rights and obligations under the Forward Purchase Agreement to HighPeak Energy, Inc., a Delaware corporation and our wholly owned subsidiary (“HighPeak Energy”), (iii) permit any affiliates of Sponsor who become purchasers under the A&R Forward Purchase Agreement to subsequently terminate the A&R Forward Purchase Agreement upon written notice to HighPeak Energy, (iv) provide for the purchasers under the A&R Forward Purchase Agreement to elect to purchase Forward Purchase Units (as defined in the form of A&R Forward Purchase Agreement) thereunder, provided that the number of Forward Purchase Units to be issued and sold thereunder does not exceed the maximum amounts specified therein, which such number of warrants to be issued and sold thereunder were reduced from up to 7,500,000 warrants to up to 5,000,000 warrants, (v) permit the purchasers thereunder that are affiliates of Sponsor to take certain actions without the consent of any unrelated third party purchasers and (vi) expressly state that the purchasers under the A&R Forward Purchase Agreement will have several and not joint liability. At the closing, the warrants if sold pursuant to the Forward Purchase Agreement (the “Forward Purchase Warrants”) will have the same terms as the Private Placement Warrants so long as they are held by the purchasers under the A&R Forward Purchase Agreement, their affiliates or their permitted transferees, and the Forward Purchase Shares are identical to the shares of Class A common stock included in the Units sold in the Public Offering, except the Forward Purchase Shares will, when issued, be subject to transfer restrictions and certain registration rights, as described in the A&R Forward Purchase Agreement. On May 25, 2018, we announced the holders of our Units may elect to separately trade the Public Shares and Warrants included in the Units commencing on May 29, 2018. Our Units, Class A common stock and Warrants currently trade on the Nasdaq under the symbols “PACQU,” “PACQ” and “PACQW,” respectively. On October 10, 2019, Pure’s stockholders approved an extension of the date by which Pure must consummate an Initial Business Combination from October 17, 2019, to February 21, 2020 (the “February Extension”). Pure requested the February Extension in order to complete an initial Business Combination. In connection with the February Extension, 3,594,000 shares of Class A common stock were redeemed by the Company, for a total value of $36,823,301 on October 11, 2019 and 248,000 public warrants were tendered and accepted for payment on October 16, 2019 by an affiliate of our Sponsor. Pure agreed to deposit into the Trust Account an amount equal to $0.033 for each share of Class A common stock issued in the Public Offering that was not redeemed in connection with the stockholder vote to approve the February Extension for each month (commencing on October 17, 2019 and on the 17th day of each subsequent calendar month) that is needed by Pure to complete the initial Business Combination from October 17, 2019 until the February Extended Date. Further, Pure’s Sponsor has agreed to loan, or cause an affiliate to loan, Pure or one of Pure’s subsidiaries an amount equal to $0.033 for each share of Class A common stock issued in our Public Offering that was not redeemed in connection with the stockholder vote to approve the February Extension for each month (commencing on October 17, 2019 and on the 17th day of each subsequent calendar month through February 21, 2020) that is needed by Pure to complete the Initial Business Combination from October 17, 2019 until February 21, 2020. On November 27, 2019, Pure and HighPeak Energy entered into the HPK Business Combination Agreement, by and among Pure, HighPeak Energy, MergerSub, the HPK Contributors and, solely for the limited purposes specified therein, the HPK Representative, pursuant to which, among other things and subject to the terms and conditions contained therein, at the HPK Closing (a) MergerSub will merge with and into Pure, with Pure surviving as a wholly owned subsidiary of HighPeak Energy, (b) each outstanding share of Class A common stock and Class B common stock of Pure will be converted into the right to receive one share of HighPeak Energy common stock, other than certain shares held by Pure’s Sponsor that will be forfeited prior to the merger, (c) the HPK Contributors will (A) contribute their limited partner interests in HPK LP to HighPeak Energy in exchange for HighPeak Energy common stock for total consideration of 71,150,000 shares of HighPeak Energy common stock, subject to the adjustments as described in the HPK Business Combination Agreement, and the general partner interest in HPK LP to either HighPeak Energy or a wholly owned subsidiary of HighPeak Energy in exchange for no consideration, and (B) directly or indirectly contribute certain loans with respect to which Pure or HighPeak Energy is the obligor, in exchange for shares of HighPeak Energy common stock, (d) all Sponsor Loans, if any, will be cancelled in connection with the closing of the HPK Business Combination Agreement, and (e) following the consummation of the transactions contemplated by the Grenadier Contribution Agreement (as defined below) for total consideration of approximately $465 million in cash, 15,760,000 shares of HighPeak Energy common stock and 2,500,000 warrants to purchase HighPeak Energy common stock at the Closing, subject to adjustments, HighPeak Energy will cause HPK LP to merge with and into Pure with all interests in HPK LP being cancelled for no consideration. On November 27, 2019, HighPeak Assets II and Grenadier entered into a contribution agreement (the “Grenadier Contribution Agreement”), by and among Grenadier, HighPeak Assets II, Pure and HighPeak Energy, pursuant to which, among other things and subject to the terms and conditions contained therein, Grenadier agreed to extend the outside date under the Grenadier Contribution Agreement to February 24, 2020 and HighPeak Assets II has agreed to acquire the Grenadier Assets from Grenadier in exchange for cash, shares of HighPeak Energy common stock and warrants to purchase shares of HighPeak Energy common stock, which transactions are currently expected to occur following HighPeak Energy’s indirect acquisition of HighPeak Assets II pursuant to the HPK Business Combination Agreement. On February 6, 2020, (a) the Company and the other parties to the HPK Business Combination Agreement entered into an amendment to the HPK Business Combination Agreement (the “HPK Amendment”) and the Company, the other parties to the Grenadier Contribution Agreement and, solely for the limited purposes specified therein, the HPK Contributors and HPK Representative entered into an amendment to the Grenadier Contribution Agreement (the “Grenadier Amendment” and together with the HPK Amendment, the “Business Combination Agreement Amendments”). The Business Combination Agreement Amendments, collectively, among other things, (i) extend the date by which the transactions contemplated thereby must be consummated to May 21, 2020, (ii) account for additional Sponsor Loans being made in connection with such extension, (iii) permit HPEP I to assign the Forward Purchase Agreement (as defined in the accompanying proxy statement) to third parties in addition to its affiliates, and for any affiliates of the Sponsor that become parties to the Forward Purchase Agreement Amendment (as defined in the accompanying proxy statement) to terminate the Forward Purchase Agreement Amendment upon written notice, (iv) remove certain restrictions on and obligations of Pure and HighPeak Energy with respect to the Forward Purchase Agreement and Forward Purchase Agreement Amendment that were otherwise imposed by the Grenadier Contribution Agreement, (v) conform the method by which Available Liquidity (as defined in the Grenadier Contribution Agreement) will be calculated to the corresponding calculation method to be employed under the HPK Business Combination Agreement, (vi) permit Grenadier to terminate the Grenadier Contribution Agreement in the event of a payment default with respect to a Second Extension Payment (as defined below), (vii) make certain other updates to representations, definitions, schedules and other matters as further described in the accompanying proxy statement and in the Business Combination Agreement Amendments and (viii) provide the required party consents under each Business Combination Agreement to the amendments contemplated by each of the Business Combination Agreement Amendments. In connection with the entrance into the Grenadier Amendment, the Company, HighPeak Energy, HighPeak Assets II and the HPK Contributors agreed to jointly and severally pay to Grenadier an aggregate amount equal to $15 million (the “Second Extension Payment”), which is to be paid in four installments of varying amounts due by each of the date of execution of the Grenadier Amendment, February 21, 2020, March 23, 2020 and April 21, 2020. The Second Extension Payment will not be credited against the cash price to be paid to Grenadier upon the closing of the transactions contemplated by the Grenadier Contribution Agreement and the obligation to pay the Second Extension Payment will survive any termination of the Grenadier Contribution Agreement in advance of any such closing. For more information regarding the HighPeak Business Combination and the Business Combination Agreement Amendments, please read the registration statement on Form S-4, including the related proxy statement/prospectus incorporated therein, originally filed with the U.S. Securities and Exchange Commission (the “SEC”) by HighPeak Energy on December 2, 2019, and as amended on January 10, 2020 (the “Registration Statement”), and the Current Report on Form 8-K filed with the SEC on February 7, 2020, including the complete text of the Business Combination Agreement and the Business Combination Agreement Amendments. On February 20, 2020, Pure’s stockholders approved an extension of the date by which Pure must consummate an Initial Business Combination from February 21, 2020, to May 21, 2020 (the “Extended Date”). Pure requested the extension to provide additional time to complete an Initial Business Combination. In connection with the extension, 2,189,801 shares of Class A common stock were redeemed, for a total value of $22,811,431on February 21, 2020. Pure agreed to deposit into the Trust Account an amount equal to $0.033 for each share of Class A common stock issued in the Public Offering that was not redeemed in connection with the stockholder vote to approve the May Extension for each month (commencing on March 17, 2020 and on the 17th day of each subsequent calendar month) that is needed by Pure to complete the initial Business Combination from February 21, 2020 until the Extended Date. Further, Pure’s Sponsor has agreed to loan, or cause an affiliate to loan, Pure or one of Pure’s subsidiaries an amount equal to $0.033 for each share of Class A common stock issued in the IPO that was not redeemed in connection with the stockholder vote to approve the extension for each month (commencing on March 17, 2020 and on the 17th day of each subsequent calendar month) that is needed by Pure to complete the Initial Business Combination from February 21, 2020 until the Extended Date. Results of Operations We have neither engaged in any significant operations nor generated any operating revenue. Our only activities from Inception through December 31, 2019 have been related to our formation and the Public Offering. Although we have not generated operating revenue, we have generated non-operating income in the form of interest income on cash and cash equivalents. We expect to incur increased expenses as a result of being a public company (for legal, financial reporting, accounting and auditing compliance), as well as costs in the pursuit of an acquisition target. For the year ended December 31, 2019, we earned net income of $3,785,174, which primarily consisted of interest income on cash and cash equivalents held in the Trust Account partially offset by (i) expenses related to the business combination of $2,903,814, (ii) tax expenses of $1,930,172 and (iii) administrative expenses of $120,000. For the year ended December 31, 2018, we earned net income of $4,275,271, which primarily consisted of interest income on cash and cash equivalents held in the Trust Account partially offset by tax expenses of $1,327,759, expenses related to the business combination of $88,737 and administrative expenses of $86,000. The increase in expenses related to the Business Combination was primarily related to our entry into the HPK Business Combination Agreement and the agreements contemplated thereby. Liquidity and Capital Resources Until the consummation of our Public Offering, our only source of liquidity was an initial sale of the Founders’ Shares to our Sponsor and the proceeds of a $200,000 loan from our Sponsor. At the IPO Closing Date, we repaid our Sponsor $200,000 in settlement of the outstanding loan in full. On the IPO Closing Date, we consummated our Public Offering of 41,400,000 Units, including 5,400,000 Units sold to cover the over-allotments, at a price of $10.00 per Unit resulting in gross proceeds from our Public Offering of $414,000,000. Our Sponsor purchased an aggregate of 10,280,000 Private Placement Warrants at a purchase price of $1.00 per Private Placement Warrant, or $10,280,000 in the aggregate. On the IPO Closing Date, proceeds of $414,000,000 were deposited in a U.S.-based trust account at J.P. Morgan, N.A. maintained by Continental Stock Transfer & Trust Company, acting as trustee, for the benefit of our public stockholders. Of the gross proceeds received from the Public Offering and the sale of the Private Placement Warrants not deposited into the Trust Account, $8,280,000 was used to pay underwriting discounts and commissions in the Public Offering, $200,000 was used to repay the loan from the Sponsor in full and the balance was reserved to pay accrued offering and formation expenses; and prospective acquisition business, technical, legal and accounting due diligence expenses; and continuing general and administrative expenses. On October 16, 2019, we entered into a promissory note with HighPeak Energy Holdings, LLC, a Delaware corporation and affiliate of our Sponsor (“Holdings”), to borrow up to $7.0 million. On February 14, 2020, we entered into an amended and restated promissory note with Holdings to borrow up to $11.0 million. No interest will accrue on the unpaid balance of the promissory note. The entire unpaid balance of the promissory note shall become payable on the earlier of (i) May 31, 2020 or (ii) the date on which we consummate a business combination. The balance outstanding on the promissory note at December 31, 2019 was $4,192,794. We had cash on hand of $179,515 and $734,894 at December 31, 2019 and December 31, 2018, respectively. In addition, interest income from the Trust Account may be released to us for any amounts necessary (i) to pay the Company’s income and other tax obligations, (ii) for payment of $10,000 per month to our Sponsor or one of its affiliates, until the Extended Date, for office space, utilities and secretarial and administrative support commencing on April 13, 2018, the date of listing of our securities on the Nasdaq, and (iii) for our liquidation expenses if the Company is unable to consummate a Business Combination within the required time period (up to a maximum of $50,000). We have until the Extended Date to complete an initial Business Combination. If we are not able to complete an initial Business Combination by the Extended Date, the Company must: (i) cease all operations except for the purpose of winding up, (ii) as promptly as reasonably possible but not more than ten (10) business days thereafter, redeem the Public Shares, at a per-share price, payable in cash, equal to the aggregate amount then on deposit in the Trust Account, including interest (which interest shall be net of taxes payable and up to $50,000 for dissolution expenses) divided by the number of then outstanding Public Shares, which redemption will completely extinguish public stockholders’ rights as stockholders (including the right to receive further liquidation distributions, if any), subject to applicable law, and (iii) as promptly as reasonably possible following such redemption, subject to the approval of our remaining stockholders and our board of directors, dissolve and liquidate, subject in the case of clauses (ii) and (iii) to the Company’s obligations under Delaware law to provide for claims of creditors and the requirements of other applicable law. This mandatory liquidation and subsequent dissolution of the Company if an initial Business Combination is not completed by the close of business on May 21, 2020 raises substantial doubt about the Company’s ability to continue as a going concern. No adjustments have been made to the carrying amounts of assets or liabilities should the Company be required to liquidate after the Extended Date. In the event of such liquidation, it is possible the per share value of the residual assets remaining available for distribution (including the Trust Account assets) will be less than the offering price per Unit in the Public Offering. Off-Balance Sheet Financing Arrangements We have no obligations, assets or liabilities which would be considered off-balance sheet arrangements as of December 31, 2019. We do not participate in transactions that create relationships with unconsolidated entities or financial partnerships, often referred to as variable interest entities, which would have been established for the purpose of facilitating off-balance sheet arrangements. We have not entered into any off-balance sheet financing arrangements, guaranteed any debt or commitments of other entities, or entered into any non-financial agreements involving assets as of December 31, 2019. Contractual Obligations At December 31, 2019 and December 31, 2018, we did not have any long-term debt, capital lease obligations, operating lease obligations or long-term liabilities. On April 12, 2018, we entered into an administrative services agreement pursuant to which we agreed to pay our Sponsor or one of its affiliates a total of $10,000 per month for office space, utilities, secretarial support and administrative services. The Company paid $120,000 and $86,000 to an affiliate of our Sponsor during 2019 and 2018 respectively, with funds received from the Trust Account, for administrative services. Upon completion of the initial Business Combination or our liquidation, we will cease paying these monthly fees. On April 12, 2018, we engaged Oppenheimer & Co. Inc. and EarlyBirdCapital severally as advisors in connection with a potential Business Combination to assist us in arranging meetings with our stockholders to discuss the potential Business Combination and the target business’ attributes, introduce us to potential investors interested in purchasing our securities, assist us in obtaining stockholder approval for the Business Combination and assist us with the preparation of our press releases and public filings in connection with the Business Combination. Pursuant to the engagement letter, we will pay Oppenheimer & Co. Inc. and EarlyBirdCapital a cash fee for such services in an amount equal to 3.5% of the gross proceeds of the Public Offering (exclusive of any applicable finders’ fees which may become payable) upon the consummation of our initial Business Combination. Pursuant to the terms of the Business Combination marketing agreement we entered with Oppenheimer & Co. Inc. and EarlyBirdCapital, no fee will be due if we do not complete an initial Business Combination. On October 16, 2019, we entered into a promissory note with HighPeak Energy Holdings, LLC, a Delaware corporation and affiliate of our Sponsor (“Holdings”), to borrow up to $7.0 million. On February 14, 2020, we entered into an amended and restated promissory note with Holdings to borrow up to $11.0 million. No interest will accrue on the unpaid balance of the promissory note. The entire unpaid balance of the promissory note shall become payable on the earlier of (i) May 31, 2020 or (ii) the date on which we consummate a business combination. The balance outstanding on the promissory note at December 31, 2019 was $4,192,794. Critical Accounting Policies Principles of Consolidation The consolidated financial statements include the accounts of the Company and its wholly owned subsidiaries since their formation. All material intercompany balances and transactions have been eliminated. Certain reclassifications have been made to prior period amounts to conform to the current period’s presentation. Basis of Presentation The accompanying consolidated financial statements and related notes of the Company have been prepared in accordance with U.S. GAAP and pursuant to the accounting and disclosure rules and regulations of the SEC, and reflect all adjustments, which are, in the opinion of management, necessary for a fair presentation of the consolidated financial position as of December 31, 2019 and 2018 and the consolidated results of operations and cash flows for the years ended December 31, 2019 and 2018. Emerging Growth Company The Company is an “emerging growth company,” as defined in Section 2(a) of the Securities Act, as modified by the JOBS Act, and it may take advantage of certain exemptions from various reporting requirements applicable to other public companies that are not emerging growth companies including, but not limited to, not being required to comply with the auditor attestation requirements of Section 404 of the Sarbanes- Oxley Act, reduced disclosure obligations regarding executive compensation in its periodic reports and proxy statements, and exemptions from the requirements of holding a nonbinding advisory vote on executive compensation and stockholder approval of any golden parachute payments not previously approved. Further, Section 102(b)(1) of the JOBS Act exempts emerging growth companies from being required to comply with new or revised financial accounting standards until private companies (that is, those that have not had a Securities Act registration statement declared effective or do not have a class of securities registered under the Exchange Act) are required to comply with the new or revised financial accounting standards. The JOBS Act provides a company can elect to opt out of the extended transition period and comply with the requirements that apply to non-emerging growth companies but any such election to opt out is irrevocable. The Company has elected not to opt out of such extended transition period which means when a standard is issued or revised and it has different application dates for public or private companies, the Company, as an emerging growth company, can adopt the new or revised standard at the time private companies adopt the new or revised standard. This may make comparison of the Company’s consolidated financial statements with another public company which is neither an emerging growth company nor an emerging growth company which has opted out of using the extended transition period difficult or impossible because of the potential differences in accounting standards used. Net Income (Loss) Per Common Share Net income (loss) per common share is computed by dividing net income by the weighted average number of common shares outstanding for the period. The Company has not considered the effect of the warrants sold in our Public Offering and Private Placement Warrants to purchase 20,700,000 and 10,280,000 shares of Class A common stock, respectively, in the calculation of diluted income per share, since their inclusion would be anti-dilutive. The Company’s consolidated statements of operations include a presentation of income per share for common shares subject to redemption similar to the two-class method of income per share. Net income per common share for basic and diluted for Class A common stock is calculated by dividing the interest income earned on the Trust Account, net of applicable administrative fees, franchise taxes and income taxes, by the weighted average number of Class A common stock since issuance. The 2019 weighted average shares outstanding calculation includes effect of the 3,594,000 shares of Class A common stock which were redeemed in October 2019. Net loss per common share for basic and diluted for Class B common stock is calculated by dividing the net loss, which excludes income attributable to Class A common stock, by the weighted average number of Class B common stock outstanding for the period. Cash and Cash Equivalents The Company considers all short-term investments with an original maturity of three months or less when purchased to be cash equivalents. The Company did not have any cash equivalents as of December 31, 2019 and 2018. Cash and Marketable Securities Held in the Trust Account The amounts held in the Trust Account represent proceeds from the Public Offering and the private placement of Private Placement Warrants and equaled $391,997,362 and $418,727,517 as of December 31, 2019 and 2018, respectively after considering a distribution of $36,823,301 to redeem 3,594,000 shares during 2019 in connection with the extension in which the Company’s stockholders extended the period in which the Company must consummate its Business Combination from October 17, 2019 to February 21, 2020. Funds held in the Trust Account were invested in permitted United States “government securities” within the meaning of Section 2(a)(16) of the Investment Company Act of 1940, as amended (the “Investment Company Act”), having a maturity of 180 days or less, or in money market funds meeting certain conditions under Rule 2a-7 under the Investment Company Act (“Permitted Investments”) and are classified as restricted assets because such amounts can only be used by the Company in connection with the consummation of an initial Business Combination. In connection with the extension to February 21, 2020, the Company agreed to contribute $0.033 to the Trust Account for each outstanding share of the Company’s Class A common stock commencing October 17, 2019 and for each subsequent calendar month that is needed by the Company to complete a Business Combination. Pursuant to this agreement, the Company deposited $3,742,794 into the Trust Account during 2019. Pursuant to said extension and the subsequent extension in February 2020, the Company will continue to deposit $0.033 per outstanding share of Class A common stock that was not redeemed in connection with the stockholder vote to approve the Extension into the Trust Account for each calendar month needed by the Company to complete a Business Combination until the Extended Date. As of December 31, 2019, cash and Permitted Investments held in the Trust Account had a fair value of $391,964,540. For the year ended December 31, 2019, investments held in the Trust Account generated interest income of $8,739,160. During 2019, the Company paid $2,041,000 to the IRS for estimated federal income taxes, $260,630 to the State of Delaware for franchise taxes and $120,000 to an affiliate of our Sponsor for administrative services with funds received from the Trust Account. On October 11, 2019, 3,594,000 shares of Class A common stock were redeemed for $36,823,301 in connection with an extension approved by our stockholders to extend the time by which we must complete the Business Combination to February 21, 2020. On February 20, 2020, 2,189,801 shares of Class A common stock were redeemed for $22,811,431 in connection with an extension approved by our stockholders to extend the time by which we must complete the Business Combination to May 21, 2020. As of December 31, 2018, cash and Permitted Investments held in the Trust Account had a fair value of $418,727,517. For the year ended December 31, 2018, investments held in the Trust Account generated interest income of $5,777,767. During 2018, the Company paid $970,000 to the IRS for estimated federal income taxes and $80,000 to an affiliate of our Sponsor for administrative services, with funds received from the Trust Account. Redeemable Common Stock As discussed in Note 1 - Description of Organization and Business Development, all of the 37,806,000 Public Shares as of December 31, 2019 contain a redemption feature which allows for the redemption of each share of Class A common stock under the Company’s liquidation or tender offer/stockholder approval provisions. In accordance with FASB ASC 480, redemption provisions not solely within the control of the Company require the security to be classified outside of permanent equity. Ordinary liquidation events, which involve the redemption and liquidation of all of the entity’s equity instruments, are excluded from the provisions of FASB ASC 480. Although the Company has not specified a maximum redemption threshold, the Company’s Charter provides that in no event will the Company redeem its Public Shares in an amount that would cause its net tangible assets to be less than $5,000,001. On February 20, 2020, Pure’s stockholders approved an extension of the date by which Pure must consummate an initial Business Combination from February 21, 2020 to May 21, 2020, In connection with this extension, 2,189,801 shares of Class A common stock were redeemed for a total value of $22,811,431 on February 21, 2020 from the Trust Account. The Company recognizes changes in redemption value immediately as they occur and will adjust the carrying value of the security at the end of each reporting period. Increases or decreases in the carrying number of redeemable shares of Class A common stock shall be affected by charges against additional paid in capital. Accordingly, at December 31, 2019, 37,725,710 shares of the outstanding 37,806,000 shares of Class A common stock included in the Units were classified outside of permanent equity at $10.10 per share. The shares of Class A common stock outstanding at December 31, 2019 include the effect of the 3,594,000 shares of Class A common stock redeemed in October 2019. At December 31, 2018, all 41,400,000 shares outstanding of Class A common stock included in the Units were classified outside of permanent equity at $10.00 per share. Concentration of Credit Risk Financial instruments that potentially subject the Company to concentration of credit risk consist of a cash account in a financial institution which, at times may exceed the Federal depository insurance coverage of $250,000. At December 31, 2019, the Company had not experienced losses on this account and management believes the Company is not exposed to significant risks on such account. Use of Estimates The preparation of the consolidated financial statements in conformity with U.S. GAAP requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the consolidated financial statements and the reported amounts of expenses during the reporting period. Actual results could differ from those estimates. Fair Value of Financial Instruments The fair value of the Company’s assets and liabilities, which qualify as financial instruments under ASC Topic 820, “Fair Value Measurements and Disclosures,” approximates the carrying amounts represented in the accompanying balance sheets, primarily due to their short-term nature. Offering Costs The Company complies with the requirements of FASB ASC 340-10-S99-1 and SEC Staff Accounting Bulletin (“SAB”) Topic 5A - “Expenses of Offering.” Offering costs of $9,506,582 consisting principally of underwriting discounts of $8,280,000 and $1,226,582 of professional, printing, filing, regulatory and other costs directly related to the preparation of our Public Offering were charged to stockholders’ equity upon completion of our Public Offering (See Note 3 - Public Offering and Private Placement). Income Taxes The Company follows the asset and liability method for accounting for income taxes under FASB ASC 740 “Income Taxes.” Deferred tax assets and liabilities are recognized for the estimated future tax consequences attributable to differences between the consolidated financial statements carrying amounts of existing assets and liabilities and their respective tax bases. Deferred tax assets and liabilities are measured using enacted tax rates expected to apply to taxable income in the years in which those temporary differences are expected to be recovered or settled. The effect on deferred tax assets and liabilities of a change in tax rates is recognized in income in the period that included the enactment date. Valuation allowances are established, when necessary, to reduce deferred tax assets to the amount expected to be realized. FASB ASC 740 prescribes a recognition threshold and a measurement attribute for financial statement recognition and measurement of tax positions taken or expected to be taken in a tax return. For those benefits to be recognized, a tax position must be more likely than not to be sustained upon examination by taxing authorities. The Company recognizes accrued interest and penalties related to unrecognized tax benefits as income tax expense. There were no unrecognized tax benefits and no amounts accrued for interest and penalties as of December 31, 2019 and 2018. The Company is currently not aware of any issues under review that could result in significant payments, accruals or material deviation from its position. The Company is subject to income tax examinations by major taxing authorities since inception. On December 22, 2017, the U.S. Tax Cuts and Jobs Act of 2017 (“Tax Reform”) was signed into law. As a result of Tax Reform, among other changes, the U.S. statutory corporate tax rate was lowered from 35% to 21% effective January 1, 2018. FASB ASC 740 requires companies to recognize the effect of tax law changes in the period of enactment; therefore, the Company was required to revalue its deferred tax assets and liabilities at December 31, 2017 at the new statutory rate. Management did not recognize any material change in the value of our deferred tax assets and liabilities as a result of Tax Reform. State Franchise Taxes The Company is incorporated in the state of Delaware and is subject to Delaware state franchise tax which is computed based on an analysis of both authorized shares and total gross assets. The Company has liabilities on the accompanying balance sheets for accrued Delaware state franchise taxes of $84,214 and $144,845 as of December 31, 2019 and 2018, respectively. On the accompanying income statements, the Company incurred Delaware franchise tax expense of $200,100 and $144,845 for the years ended December 31, 2019 and 2018, respectively. The Company paid the State of Delaware $260,730 and zero dollars during 2019 and 2018, respectively, for Delaware franchise taxes. Related Parties The Company follows FASB subtopic ASC 850-10 for the identification of related parties and disclosure of related party transactions. Pursuant to ASC Section 850-10-20, the related parties include: (a) affiliates of the Company (“Affiliate” means, with respect to any specified person, any other person that, directly or indirectly through one or more intermediaries, controls, is controlled by or is under common control with such person, as such terms are used in and construed under Rule 405 under the Securities Act); (b) entities for which investments in their equity securities would be required, absent the election of the fair value option under the Fair Value Option Subsection of Section 825-10-15, to be accounted for by the equity method by the investing entity; (c) trusts for the benefit of employees, such as pension and profit-sharing thrust that are managed by or under the trusteeship of management; (d) principal owners of the Company; (e) management of the Company; (f) other parties with which the Company may deal if one party controls or can significantly influence the management or operating policies of the other to an extent that one of the transacting parties might be prevented from fully pursuing its own separate interests; and (g) other parties that can significantly influence the management or operating policies of the transacting parties or that have an ownership interest in one of the transacting parties and can significantly influence the other to an extent that one or more of the transacting parties might be prevented from fully pursuing its own separate interests. Recent Accounting Pronouncements The Company has evaluated recently issued, but not yet effective, accounting pronouncements and does not believe they would have a material effect on the Company’s consolidated financial statements. Subsequent Events The Company evaluates subsequent events and transactions that occur after the balance sheet date for potential recognition or disclosure. Any material events that occur between the balance sheet date and the date the consolidated financial statements were issued are disclosed as subsequent events, while the consolidated financial statements are adjusted to reflect any conditions that existed at the balance sheet date. Subsequent to December 31, 2019, the Company’s stockholders approved the May Extension, the Company was a party to and/or entered into the Business Combination Agreement Amendments and agreed to additional Sponsor Loans and the Second Extension Payment all of which have been discussed earlier.

<s>[INST] The following discussion and analysis of the Company’s consolidated financial condition and results of operations should be read in conjunction with our audited consolidated financial statements attached hereto and the notes related thereto which are included in “Item 8. Financial Statements and Supplementary Data.” of this Annual Report on Form 10K. Overview We are a blank check company incorporated on November 13, 2017 as a Delaware corporation and formed for the purpose of effecting a merger, share exchange, asset acquisition, stock purchase, recapitalization, reorganization or similar business combination with one or more target businesses (a “Business Combination”) with a focus on a target business in the energy industry, and an emphasis on opportunities in the upstream oil and gas industry in North America where our management team’s collective networks and experience are suited. We have neither engaged in any operations nor generated any operating revenue to date. Based on our business activities, the Company is a “shell company” as defined under the Exchange Act because we have no operations and nominal assets consisting almost entirely of cash. In connection with the formation of the Company, a total of 10,062,500 shares of Class B common stock were sold to our Sponsor at a price of approximately $0.002 per share for an aggregate of $25,000 (the “Founders’ Shares”). In March 2018, our Sponsor returned to us, at no cost, an aggregate of 1,437,500 Founders’ Shares, which we cancelled, leaving an aggregate of 8,625,000 Founders’ Shares outstanding. In March 2018, our Sponsor transferred 40,000 Founders’ Shares to each of our three independent director nominees resulting in a total of 120,000 Founders’ Shares transferred to our independent director nominees. In April 2018, we effected a stock dividend of 0.2 shares of Class B common stock for each outstanding share of Class B common stock, resulting in our Sponsor and independent director nominees holding an aggregate of 10,350,000 Founders’ Shares. At December 31, 2019, our Sponsor and our three independent directors (the “Initial Stockholders”) held, collectively, 10,350,000 Founders’ Shares. On April 17, 2018 (the “IPO Closing Date”), the Company consummated its initial public offering (“Public Offering”) of 41,400,000 units, representing a complete exercise of the overallotment option, at a purchase price of $10.00 per unit generating gross proceeds of $414,000,000 before underwriting discounts and expenses. Each unit consists of one share of Class A common stock (“Public Share”) of the Company at $0.0001 par value and one half of one warrant (a “Unit”). Each whole warrant entitles the holder to purchase one share of Class A common stock at a price of $11.50 (a “Warrant”). Only whole Warrants may be exercised and no fractional Warrants will be issued upon separation of the Units and only whole Warrants may be traded. Each Warrant will become exercisable on the later of 30 days after the completion of an initial Business Combination or 12 months from the IPO Closing Date and will expire on the fifth anniversary of our completion of an initial Business Combination, or earlier upon redemption or liquidation. Alternatively, if we do not complete a Business Combination by May 21, 2020, the Warrants will expire at the end of such period. If we are unable to deliver registered shares of Class A common stock to the holder upon exercise of Warrants issued in connection with the 41,400,000 Units during the exercise period, the Warrants will expire, except to the extent they may be exercised on a cashless basis in the circumstances described in the agreement governing the Warrants. On the IPO Closing Date, our Sponsor purchased from us an aggregate of 10,280,00 [/INST] Positive. </s>

Select Interior Concepts, Inc.

2019-03-15

2018-12-31

Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS The following information should be read in conjunction with Item 6. “Selected Financial Data” above and the accompanying consolidated financial statements and related notes included in this Annual Report. The following discussion may contain forward-looking statements that reflect our plans, estimates, and beliefs. Our actual results could differ materially from those discussed in these forward-looking statements. Factors that could cause or contribute to these differences include those factors discussed below and elsewhere in this Annual Report, particularly in the sections entitled “Special Note Regarding Forward-Looking Statements and Information” and “Risk Factors” included elsewhere in this Annual Report. Overview Select Interior Concepts, Inc. (collectively with all of its subsidiaries, “SIC,” the “Company,” “we,” “us” and “our”) is an installer and nationwide distributor of interior building products with market positions in residential interior design services. Through our Residential Design Services (which we refer to as “RDS”) operating segment, we serve national and regional homebuilders by providing an integrated, outsourced solution for the design, consultation, sourcing, distribution and installation needs of their homebuyer customers. Through our 21 design centers, our consultants work closely with homebuyers in the selection of a broad array of interior products and finishes, including flooring, cabinets, countertops, wall tile, finish carpentry, shower enclosures and mirrors, and related interior items, primarily for newly constructed homes. We then coordinate the ordering, fulfillment and installation of many of these interior product categories to provide for the homebuyer. With our design centers and our product sourcing and installation capabilities, we enable our homebuilder customers to outsource critical aspects of their business to us, thereby increasing their sales, profitability, and return on capital. We also have leading market positions in the selection and importation of natural and engineered stone slabs for kitchen and bathroom countertops and specialty tiles through our other operating segment, Architectural Surfaces Group (which we refer to as “ASG”). ASG sources natural and engineered stone from a global supply base and markets these materials through a national network of distribution centers and showrooms. In addition to serving the new residential and commercial construction markets with these materials, we also distribute them to the repair and remodel (which we refer to as “R&R”) market. Our platform originated in September 2014, when affiliates of Trive Capital Management LLC (which we refer to as “Trive Capital”) acquired RDS, which in turn acquired the assets of PT Tile Holdings, LP (which we refer to as “Pinnacle”) in February 2015, and 100% of the equity interests in Greencraft Holdings, LLC (which we refer to as “Greencraft”) in December 2017. In 2018, RDS then acquired the assets of Summit Stoneworks, LLC (which we refer to as “Summit”) in August 2018 and 100% of the equity interests in T.A.C. Ceramic Tile Co. (which we refer to as “TAC”) in December 2018. Affiliates of Trive Capital also formed a consolidation platform in the stone countertop market by acquiring 100% of the equity interests in Architectural Granite & Marble, LLC in June 2015, which in turn acquired the assets of Bermuda Import-Export, Inc. (which we refer to as “Modul”) in July 2016, 100% of the equity interests in Pental Granite and Marble, LLC (which we refer to as “Pental”) in February 2017, and the assets of Cosmic Stone & Tile Distributors, Inc. (which we refer to as “Cosmic”) in October 2017, and these acquired businesses were combined to form ASG. ASG then acquired the assets of Elegant Home Design, LLC (which we refer to as “Bedrock”) in January 2018, the assets of NSI, LLC (which we refer to as “NSI”) in March 2018, and the assets of The Tuscany Collection, LLC (which we refer to as “Tuscany”) in August 2018. November 2017 Restructuring Transactions In November 2017, Select Interior Concepts, Inc. entered into a series of restructuring transactions (which we refer to as the “November 2017 restructuring transactions”) pursuant to which it acquired all of the outstanding equity interests in each of RDS and ASG, including all of their respective wholly-owned subsidiaries. Following the November 2017 restructuring transactions, Select Interior Concepts, Inc. became a holding company that wholly owns RDS and ASG. November 2017 Private Offering and Private Placement In November 2017, we completed a private offering and private placement pursuant to which we issued an aggregate of 21,750,000 shares of our Class A Common Stock, which included shares issued pursuant to the exercise of the option granted by us to the initial purchaser and placement agent thereunder, in reliance upon the exemptions from the registration requirements of the Securities Act of 1933, as amended (which we refer to as the “Securities Act”), provided by Rule l44A, Regulation S, and Rule 506 of Regulation D under the Securities Act (which we refer to as the “November 2017 private offering and private placement”). We received net proceeds of $240.5 million from the November 2017 private offering and private placement, and we used $122.8 million in connection with the November 2017 restructuring transactions, which included our acquisition of all of the outstanding equity interests in each of RDS and ASG and the repurchase by us of shares of our Class B Common Stock from existing stockholders, and $112.8 million to repay our outstanding indebtedness, with the remaining $4.9 million of the net proceeds being used for working capital and general corporate purposes. Listing of Class A Common Stock on the Nasdaq Capital Market On August 13, 2018, our shelf registration statement was declared effective by the SEC, and on August 16, 2018, our Class A Common Stock commenced trading on the Nasdaq Capital Market under the ticker symbol “SIC.” At such time, each then remaining share of our Class B Common Stock was automatically converted into one share of Class A Common Stock, resulting in no shares of Class B Common Stock left outstanding. Operating Segments We have defined each of our operating segments based on the nature of its operations and its management structure and product offerings. Our management decisions are made by our Chief Executive Officer, whom we have determined to be our Chief Operating Decision Maker. Our management evaluates segment performance based on operating income. Our two reportable segments are described below. Residential Design Services RDS, our interior design and installation segment, is a service business that provides design center operation, interior design, product sourcing, and installation services to homebuilders, homeowners, general contractors and property managers. Products sold and installed by RDS include flooring, countertops, cabinets, wall tile, interior trim (doors, moldings, door and window casing), shower enclosures and doors, mirrors, and window treatments. New single-family and multi-family construction are the primary end markets, although we intend to explore growth opportunities in other markets, such as the R&R market. Architectural Surfaces Group ASG, our natural and engineered stone countertop distribution segment, distributes granite, marble, and quartz slabs for countertop and other uses, and ceramic and porcelain tile for flooring and backsplash and wall tile applications. Primary end markets are new residential and commercial construction and the R&R market. Key Factors Affecting Operating Results Our operating results are impacted by changes in the levels of new residential construction and of the demand for products and services in the R&R market. These are in turn affected by a broad range of macroeconomic factors including the rate of economic growth, unemployment, job and wage growth, interest rates, multi-family project financing, and residential mortgage lending conditions. Other important underlying factors include demographic variables such as household formation, immigration and aging trends, housing stock and vacant inventory levels, changes in the labor force, raw materials prices, the legal environment, and local and regional development and construction regulation. Demand for our products and services is dependent on the overall levels of new residential construction and investment in residential remodeling. These variables are in turn affected by macroeconomic variables such as employment levels, income growth, consumer confidence, interest rates generally, and mortgage rates specifically. During the Great Recession from 2007 to 2009, our revenue and profits declined significantly as demand for our products collapsed with the dramatic decline in residential construction. Since the trough of that recession in 2009, residential investment and demand for our products have entered into a sustained period of growth. We believe we are well positioned to take advantage of long-term growth trends in the single-family and R&R markets. We also believe that there is significant opportunity for additional penetration of the multi-family segment of the housing market. Material Costs The materials that we distribute and install are sourced through a wide array of quarries, manufacturers, and distributors located in the United States, Mexico, South America, Europe, Africa and Asia. As demand for these products continues to grow with housing demand, we expect that we may be subject to cost increases from time to time. There is no guarantee that our relationships with our customers will be such that we can pass these increases on to our customers. Affordability issues in new residential construction could temper our homebuilder customers’ ability to raise their prices, which could in turn limit our ability to increase prices to compensate for increases in our costs of materials. We believe, however, that over the long term, these same forces affecting housing prices would also limit our suppliers’ ability to increase prices, which would help us maintain our margins. Labor Costs Installation labor is a significant component of our aggregate labor force of approximately 1,360 employees. With the unemployment rate at 3.9% in December 2018 according to the U.S. Bureau of Labor Statistics, there is no guarantee that we will be able to attract the type and quality of skilled labor that we need in sufficient quantities to accomplish our growth plans. Correspondingly, we expect that tight labor markets will continue to lead to upward pressure on wages and could impact our gross profit margin and overall profitability negatively. We believe, however, that our scale will continue to give us the ability to provide steady work, an attractive benefits package, and a beneficial work environment, particularly as compared to our smaller competitors. Over time, we expect that the combination of these factors will gradually increase our relative advantage over smaller and less sophisticated competitors. Operating and Administrative Costs We incur costs related to the operation and administration of our businesses that are reported as period expenses separately from Cost of Goods Sold. These expenses include, but are not limited to, purchasing of materials, sales and distribution and shipping of our products, project management, customer service, human resources, accounting, information technology, general management, public company costs, and others. These costs will likely continue to grow as our businesses grow, but we believe that, overall, they will grow more slowly than the rate at which our gross profit grows due to improved utilization rates of these resources and the fact that we have implemented and intend to continue to implement scalable technology and process improvements that increase the efficiency of our operations. Cyclicality and Seasonality Our businesses are both cyclical and seasonal based on the homebuilding industry in the markets we serve. Because of the timing of installation of our major product lines, which are mainly installed near the end of the construction process, as well as overall housing seasonality, our sales activity is normally weighted toward the second half of the calendar year. Homebuilding-based businesses are also generally cyclical. Our financial performance will be impacted by economic changes nationally and locally in the markets we serve. The building products supply industry is dependent on new home construction and subject to cyclical market pressures. Our operations are subject to fluctuations arising from changes in supply and demand, national and international economic conditions, labor costs, competition, government regulation, trade policies, and other factors that affect the homebuilding industry such as demographic trends, interest rates, single-family housing starts, employment levels, consumer confidence, and the availability of credit to homebuilders, contractors and homeowners. After the dramatic recession that ran from 2007 to 2009, there have been nine straight years of relatively steady growth. While we believe that the underlying fundamentals of demand for new housing units and residential investment are indicative of continued growth into the future, there can be no assurance that macroeconomic or other factors will not change unexpectedly and cause a downturn in housing construction. Non-GAAP Measures In addition to the results reported in accordance with United States generally accepted accounting principles (which we refer to as “GAAP”), we have provided information in this Annual Report relating to EBITDA, Adjusted EBITDA, and Adjusted EBITDA margin. EBITDA is defined as consolidated net income before interest, taxes and depreciation and amortization. Adjusted EBITDA is defined as consolidated net income before (i) interest expense, (ii) income tax expense, (iii) depreciation and amortization expense, (iv) stock compensation expense, and (v) adjustments for costs that are deemed to be transitional in nature or not related to our core operations, such as severance, facility closure costs, and professional, financing and legal fees related to business acquisitions, or similar transitional costs and expenses related to business investments, greenfield investments, and integrating acquired businesses into our Company. Adjusted EBITDA margin is calculated as a percentage of our net revenue. EBITDA, Adjusted EBITDA, and Adjusted EBITDA margin are non-GAAP financial measures used by us as supplemental measures in evaluating our operating performance. Key Components of Results of Operations Net Revenue. Net revenue consists of revenue net of our homebuilder customers’ participation, which is their share of revenue from our sales of upgrades. In single-family construction, revenue is recognized when the work is complete or complete in all material respects. In multi-family construction, revenue is recognized on a percentage of completion basis as these projects often take place over several months. In our ASG segment, net revenue is derived from the sale of stone products and is recognized when such products have been accepted at the customer’s designated location. Cost of Revenue. Cost of revenue consists of the direct costs associated with revenue earned by the sale and installation of our interior products in the case of our RDS segment, or by delivering product in the case of our ASG segment. In our RDS segment, cost of revenue includes direct material costs associated with each project, the direct labor costs associated with installation (including taxes, benefits and insurance), rent, utilities and other period costs associated with warehouses and fabrication shops, depreciation associated with warehouses, material handling, fabrication and delivery costs, and other costs directly associated with delivering and installing product in our customers’ projects, offset by vendor rebates. In our ASG segment, cost of revenue includes direct material costs, inbound and outbound freight costs, overhead (such as rent, utilities and other period costs associated with product warehouses), depreciation associated with fixed assets used in warehousing, material handling and warehousing activities, warehouse labor, taxes, benefits and other costs directly associated with receiving, storing, handling and delivering product to customers in revenue earning transactions. Gross Profit and Gross Margin. Gross profit is revenue less the associated cost of revenue. Gross margin is gross profit divided by revenue. Operating Expenses. Operating expenses include overhead costs such as general management, project management, purchasing, sales, customer service, accounting, human resources, depreciation and amortization, information technology, public company costs and all other forms of wage and salary cost associated with operating our businesses, and the taxes and benefits associated with those costs. We also include other general-purpose expenses, including, but not limited to, office supplies, office rents, legal, consulting, insurance, and non-cash stock compensation costs. Professional services expenses, including audit and legal, and transaction costs are also included in operating expenses and were a significant component of our total costs in 2018 due to our transition to being a public company. Depreciation and Amortization. Depreciation and amortization expenses represent the estimated decline over time of the value of tangible assets such as vehicles, equipment and tenant improvements, and intangible assets such as customer lists and trade names. We recognize the expenses on a straight-line basis over the estimated economic life of the asset in question. Interest Expense. Interest expense represents amounts paid to or which have become due during the period to lenders and lessors under credit agreements and capital leases, as well as the amortization of debt issuance costs. Income Taxes. Income taxes are recorded using the asset and liability method of accounting for income taxes. Under the asset and liability method, deferred tax assets and liabilities are recognized for the deferred tax consequences attributable to temporary differences between the financial statement carrying amounts of existing assets and liabilities and their respective tax basis. Deferred tax assets and liabilities are measured using enacted tax rates expected to apply to taxable income in the years in which those differences are expected to be recovered or settled. Results of Operations Year Ended December 31, 2018 Compared to Year Ended December 31, 2017 Net Revenue. For the year ended December 31, 2018, net revenue increased by $136.8 million, or 38.8%, to $489.8 million, from $353.0 million for the year ended December 31, 2017. This increase in net revenue was driven by the impact of organic growth and acquisitions in both our RDS and ASG operating segments. In our RDS segment, net revenue increased by $75.2 million, or 38.9%, to $268.4 million for the year ended December 31, 2018, from $193.2 million for the year ended December 31, 2017. This increase was largely due to the acquisitions of Greencraft and Summit Stoneworks, which accounted for $55.6 million of the RDS growth. Additionally, organic revenue increased $19.6 million through continued expansion of share in new geographies, increased product offerings, and price/mix. In our ASG segment, net revenue increased by $62.9 million, or 39.0%, to $224.0 million for the year ended December 31, 2018, from $161.1 million for the year ended December 31, 2017. This increase was largely due to the acquisitions of Cosmic, Bedrock, NSI, Pental and Tuscany which accounted for $52.5 million of the growth. Additionally, organic revenue increased $10.4 million due to volume increases, greenfield expansion, and price/mix. Cost of Revenue. For the year ended December 31, 2018, cost of revenue increased by $107.2 million, or 43.0%, to $356.3 million, from $249.1 million for the year ended December 31, 2017. In our RDS segment, cost of revenue increased by $54.3 million, or 38.7%, to $194.5 million for the year ended December 31, 2018, from $140.2 million for the year ended December 31, 2017. The acquisitions of Greencraft and Summit drove $37.8 million of the year over year increase. The remaining $16.5 million increase in cost of revenues was substantially driven by an increase in sales in the legacy RDS business. In our ASG segment, cost of revenue increased by $54.2 million, or 49.2%, to $164.3 million for the year ended December 31, 2018, from $110.1 million for the year ended December 31, 2017. This increase was primarily due to the acquisitions of Cosmic, Bedrock, NSI, Pental and Tuscany contributing $41.1 million, as well as a $13.1 million increase in cost of revenue in the legacy ASG business. Gross Profit and Margin. For the year ended December 31, 2018, gross profit increased by $29.6 million, or 28.5%, to $133.5 million, from $103.9 million for the year ended December 31, 2017. For the year ended December 31, 2018, gross margin decreased by 2.2% to 27.2%, from 29.4% for the year ended December 31, 2017. In our RDS segment, gross margin increased by 0.1% to 27.5% for the year ended December 31, 2018, from 27.4% for the year ended December 31, 2017. This increase was the result of improved margins from acquisitions and a slight shift in product and customer mix, partially offset by higher depreciation in cost of revenue. In our ASG segment, gross margin decreased by 5.0% to 26.6% for the year ended December 31, 2018, from 31.6% for the year ended December 31, 2017. This decrease in margin was driven by the ramp up of our greenfield sites that delivered lower contribution margin than the base business as anticipated, lower margin from the opportunistic acquisitions of Cosmic, NSI and Bedrock, one-time non-cash charges, and higher depreciation in cost of revenue. Operating Expense. For the year ended December 31, 2018, operating expenses increased by $23.7 million, or 24.3%, to $121.4 million, from $97.7 million for the year ended December 31, 2017. This increase in operating expenses was primarily due to selling, general, and administrative expenses from acquired businesses, non-cash long-term incentive plan expenses, one-time nonrecurring costs for completed acquisitions, the opening of greenfield locations, investments in SIC infrastructure as a new public company, the addition of M&A resources, and higher depreciation and amortization. In our RDS segment, operating expenses increased by $6.5 million to $59.6 million for the year ended December 31, 2018, from $53.1 million for the year ended December 31, 2017. This increase was related to the Greencraft and Summit acquisitions, sales and marketing expenses to support increased revenues, and other expenses related to the growth of the business. In our ASG segment, operating expenses increased by $4.7 million to $47.7 million for the year ended December 31, 2018, from $43.0 million for the year ended December 31, 2017. This increase was related to the Cosmic, Bedrock, NSI, Pental and Tuscany acquisitions, and expenses related to the opening of greenfield locations. The remaining $14.0 million of the increase in operating expenses was related to costs for developing public company infrastructure, mergers and acquisitions resources, and stock-based compensation accrual expense incurred by the SIC parent company. Depreciation and Amortization. For the year ended December 31, 2018, depreciation and amortization expenses increased by $5.7 million, or 38.5%, to $20.5 million, from $14.8 million for the year ended December 31, 2017. In our RDS segment, depreciation and amortization expenses increased by $2.7 million, or 39.1%, to $9.6 million for the year ended December 31, 2018, from $6.9 million for the year ended December 31, 2017. This was primarily due to the depreciation associated with the acquired Greencraft and Summit assets and amortization related to intangible assets recognized in the purchase accounting for the Greencraft and Summit acquisitions. In our ASG segment, depreciation and amortization expenses increased by $2.8 million, or 35.0%, to $10.8 million for the year ended December 31, 2018 from $8.0 million for the year ended December 31, 2017. Amortization of intangible assets acquired in the Bedrock and Tuscany acquisitions accounted for the majority of this increase with the remaining increase due to the depreciation of additional assets from new locations. Interest Expense. For the year ended December 31, 2018, interest expense decreased by $2.3 million, or 16.8%, to $11.4 million, from $13.7 million for the year ended December 31, 2017. Our interest expense was reduced because we decreased our borrowing significantly by paying off our RDS term loan and repaying a significant amount of our ASG term debt with proceeds from the November 2017 private offering and private placement. We offset this decrease by increasing our long-term debt to finance the Greencraft, Bedrock, Tuscany, Summit and TAC acquisitions. Income Taxes. For the year ended December 31, 2018, we recognized income tax expense of $1.0 million, a decrease of $2.3 million from income tax expense of $3.3 million for the year ended December 31, 2017. Our deferred tax assets were revalued as a result of the Tax Cuts and Jobs Act in December 2017, which resulted in a $5.3 million increase to income tax expense in 2017. Net (Loss) Income. For the year ended December 31, 2018, net loss decreased by $8.8 million to $2.5 million, from $11.3 million for the year ended December 31, 2017. Adjusted EBITDA. For the year ended December 31, 2018, Adjusted EBITDA increased to $54.4 million, from $47.0 million for the year ended December 31, 2017, as a result of $7.7 million in organic growth and $13.7 million of incremental operating profit from acquisitions, partially offset by $14.0 million of additional cost and investments in SIC infrastructure as a new public company, establishing M&A resources, and increased cost of revenue and operating expenses in both operating segments. Nonrecurring costs in 2018 include restructuring and severance related activity, acquisition and integrations costs, costs related to the filing of our Registration Statement on Form S-1, and greenfield costs. Adjusted EBITDA Margin. For the year ended December 31, 2018, Adjusted EBITDA margin decreased to 11.1%, from 13.3% for the year ended December 31, 2017. The decrease in the Adjusted EBITDA margin was primarily due to investments in SIC for public company infrastructure, establishing a business development function, certain acquisitions by ASG that have slightly lower margins than ASG’s legacy business, and increased costs of revenue and operating expenses in both operating segments. Year Ended December 31, 2017 Compared to Year Ended December 31, 2016 Net Revenue. For the year ended December 31, 2017, net revenue increased by $119.1 million, or 50.9%, to $353.0 million, from $233.9 million for the year ended December 31, 2016. Net revenue includes the elimination of intercompany sales. In our RDS segment, revenue increased by $17.4 million, or 9.9%, to $193.2 million for the year ended December 31, 2017, from $175.8 million for the year ended December 31, 2016. This increase was largely due to the volume increases, measured in square feet of installed product, in our core business of flooring, countertops, and wall tile, as a result of a higher average size of the homes we serviced. In our ASG segment, revenue increased by $102.3 million, or 173.9%, to $161.1 million for the year ended December 31, 2017, from $58.8 million for the year ended December 31, 2016. This increase was largely due to the Pental acquisition, which accounted for $84.7 million, or 82.8 %, of the total growth for the year ended December 31, 2017. The remainder of the growth of $17.6 million in our ASG segment for the year ended December 31, 2017 was due to increased revenue from new locations and a full year of revenue attributable to the Modul acquisition, which closed in July 2016. Cost of Revenue. For the year ended December 31, 2017, cost of revenue increased by $82.1 million, or 49.1%, to $249.1 million, from $167.0 million for the year ended December 31, 2016. In our RDS segment, cost of revenue increased by $12.2 million, or 9.5%, to $140.2 million for the year ended December 31, 2017, from $128.0 million for the year ended December 31, 2016. This increase in cost of revenue was primarily due to an increase in sales. In our ASG segment, cost of revenue increased by $70.3 million, or 176.8%, to $110.1 million for the year ended December 31, 2017, from $39.8 million for the year ended December 31, 2016. This increase was due to the Pental acquisition and the resulting increase in revenue. Gross Profit and Margin. For the year ended December 31, 2017, gross profit increased by $37.1 million, or 55.5%, to $103.9 million, from $66.8 million for the year ended December 31, 2016. Gross margin also increased by 0.9% to 29.4% in 2017, from 28.6% in 2016. This increase was primarily due to higher margin ASG business comprising a greater portion of our revenue mix in 2017 versus 2016 due to the acquisition of Pental. In our RDS segment, gross margin increased by 0.2% to 27.4% for the year ended December 31, 2017, from 27.2% for the year ended December 31, 2016. This increase was the result of a slightly favorable shift toward houses where we generally installed higher amounts of upgrades in 2017. In our ASG segment, gross margin decreased by 0.8% to 31.6% for the year ended December 31, 2017, from 32.4% for the year ended December 31, 2016. This decrease was due to a slightly unfavorable shift in product mix. Operating Expenses. For the year ended December 31, 2017, operating expenses increased by $45.3 million, or 86.5%, to $97.7 million, from $52.4 million for the year ended December 31, 2016. In our RDS segment, operating expenses increased by $13.8 million to $53.1 million for the year ended December 31, 2017, from $39.3 million for the year ended December 31, 2016. $10.9 million of this increase was due to transaction costs and equity bonuses related to a February refinancing transaction and the November 2017 private offering and private placement. The remaining $2.9 million of the increase was a result of growth in volume during the year. In our ASG segment, operating expenses increased by $29.9 million to $43.0 million for the year ended December 31, 2017, from $13.1 million for the year ended December 31, 2016. $13.1 million of this increase was due to the addition of ten months of Pental operating expenses, $10.5 million was related to the financing for the Pental acquisition and bonus payments made as a result of the November 2017 private offering and private placement, and the rest was related to general company growth and costs associated with the opening of new locations. The remaining $1.6 million of the increase in operating expenses was related to overhead costs incurred by us at the SIC parent company level. Depreciation and Amortization. For the year ended December 31, 2017, depreciation and amortization expenses increased by $5.6 million, or 61.3%, to $14.8 million, from $9.2 million for the year ended December 31, 2016. In our RDS segment, depreciation and amortization expenses increased by $0.6 million, or 9.6%, to $6.9 million for the year ended December 31, 2017, from $6.3 million for the year ended December 31, 2016. This increase was due to an increase in fixed assets acquired to support revenue growth. In our ASG segment, depreciation and amortization expenses increased by $5.0 million, or 171.4%, to $8.0 million for the year ended December 31, 2017, from $3.0 million for the year ended December 31, 2016. This increase was due almost entirely to depreciation associated with the acquired Pental assets and amortization related to intangible assets recognized in the purchase accounting for the Pental acquisition. Interest Expense. For the year ended December 31, 2017, interest expense increased by $9.0 million, or 191.5%, to $13.7 million, from $4.7 million for the year ended December 31, 2016. During the year ended December 31, 2017, our RDS segment increased its borrowing for the purpose of a dividend distribution, and our ASG segment increased its borrowing to finance the Pental acquisition, prior to our repayment of a significant amount of debt with a portion of the proceeds from the November 2017 private offering and private placement. Income Taxes. For the year ended December 31, 2017, we recognized income tax expense of $3.3 million, an increase of $0.7 million from income tax expense of $2.6 million for the year ended December 31, 2016. Our deferred tax assets were revalued as a result of the Tax Cuts and Jobs Act in December 2017, which resulted in a $5.3 million increase to income tax expense in 2017. Net (Loss) Income. For the year ended December 31, 2017, net income decreased by $18.4 million to a net (loss) of $(11.3) million, from net income of $7.1 million for the year ended December 31, 2016. Adjusted EBITDA. For the year ended December 31, 2017, Adjusted EBITDA increased to $47.0 million, from $27.4 million for the year ended December 31, 2016. Incremental operating profit from the Pental acquisition and an increase in operating profit in our RDS segment were partially offset by increases in operating expenses related to opening new locations in our ASG segment. Adjusted EBITDA Margin. For the year ended December 31, 2017, Adjusted EBITDA margin increased to 13.3%, from 11.7% for the year ended December 31, 2016. The increase in the Adjusted EBITDA margin was primarily due to incremental operating profit from the Pental acquisition, which produced higher Adjusted EBITDA margin relative to our Company average prior to the Pental acquisition. Customer Concentration For the years ended December 31, 2018, 2017 and 2016, the Company recognized revenue from one customer which accounted for 11.4%, 12.6% and 11.0% of total revenue, respectively. There were no customers which accounted for 10% or more of total accounts receivable, as of December 21, 2018 and 2017. Liquidity and Capital Resources Working capital is the largest element of our capital needs, as inventory and receivables are our most significant investments. We also require funding for acquisitions, to cover ongoing operating expenses, and to meet required obligations related to financing, such as lease payments and principal and interest payments. Our capital resources primarily consist of cash from operations and borrowings under our long-term revolving credit facilities, capital equipment leases, and operating leases. As our revenue and profitability have improved during the recovery of the housing market, we have used increased borrowing capacity under our revolving credit facilities to fund working capital needs. We have utilized capital leases and secured equipment loans to finance our vehicles and equipment needed for both replacement and expansion purposes. As of December 31, 2018, we had $6.4 million of cash and cash equivalents and $52.5 million of available borrowing capacity under our revolving credit facilities. Based on our positive cash flow, our ability to effectively manage working capital needs, and available borrowing capacity, we believe that we have sufficient funding available or in place to finance our operations and immediate growth plans. Financing Sources; Debt SIC Credit Facility In June 2018, the Company and certain of its subsidiaries entered into an amended and restated loan, security and guaranty agreement, dated as of June 28, 2018, which was amended on December 11, 2018 (which we refer to as the “SIC Credit Facility”), with a commercial bank, which amended and restated each of the RDS credit agreement and the ASG credit agreements in their entirety. The SIC Credit Facility is used by the Company, including both RDS and ASG, for operational purposes. Pursuant to the SIC Credit Facility, the Company has a borrowing-base-governed revolving credit facility that provides for borrowings of up to an aggregate of $90 million, after it was increased by $10 million through an amendment in December 2018, and which may be further increased to an aggregate amount not to exceed $130 million upon the satisfaction of certain conditions. Under the terms of the SIC Credit Facility, the Company has the ability to request the issuance of letters of credit up to a maximum aggregate stated amount of $15 million. The ability to borrow revolving loans under the SIC Credit Facility is reduced on a dollar-for-dollar basis by the aggregate stated amount of all outstanding letters of credit. The indebtedness outstanding under the SIC Credit Facility is secured by substantially all of the assets of the Company and its subsidiaries. The revolving loans under the SIC Credit Facility bear interest at a floating rate equal to an index rate (which the Company can elect between an index based on a LIBOR based rate or an index based on a Prime, Federal Funds or LIBOR based rate) plus an applicable margin. The applicable margin is determined quarterly based on the borrowers’ average daily availability (calculated by reference to their accounts receivable and inventory that comprise their borrowing base) during the immediately preceding fiscal quarter. Upon the occurrence of certain events of default under the SIC Credit Facility, the interest rate applicable to the obligations thereunder may be increased by two hundred basis points (2.00%). All revolving loans under the SIC Credit Facility are due and payable in full on June 28, 2023, subject to earlier acceleration upon certain conditions. Letter of credit obligations are due and payable on the date set forth in the respective loan documents or upon demand by the lender. Under the SIC Credit Facility, the Company and its subsidiaries are required to comply with certain customary restrictive covenants that, among other things and with certain exceptions, limit the ability of the Company and its subsidiaries, as applicable, to (i) incur additional indebtedness and liens in connection therewith, (ii) pay dividends and make certain other restricted payments, (iii) effect mergers or consolidations, (iv) enter into transactions with affiliates, (v) sell or dispose of property or assets, and (vi) engage in unrelated lines of business. The SIC Credit Facility is subject to certain financial covenants. At December 31, 2018, the Company was in compliance with the financial covenants. As of December 31, 2018, $37.2 million was outstanding under the SIC Credit Facility. The Company also had $0.3 million of outstanding letters of credit under the SIC Credit Facility at December 31, 2018. Term Loan Facility On February 28, 2017, AG&M and Pental, as the borrowers, entered into a financing agreement, as amended, with the lenders party thereto and Cerberus Business Finance, LLC, as the agent for the lenders (which we refer to as the “Term Loan Facility”), which initially provided for a $105.0 million term loan facility. The Term Loan Facility was amended in June 2018 to define the borrowers as Select Interior Concepts, Inc. and its subsidiaries, was amended in August 2018 to adjust the borrowing capacity to $101.4 million and was amended in December 2018 to increase the borrowing capacity to $174.2 million. Borrowings under the Term Loan Facility bear interest per year equal to either: (i) the base rate plus 5.25% for a base rate loan, or (ii) the LIBOR rate plus 7.25% for a LIBOR loan. The base rate is the greater of the publicly announced interest rate by the reference bank as its reference rate, the base commercial lending rate or prime rate, and 3.5% per annum. During an insolvency proceeding or during any other event of default (if elected by the required lenders), the borrowings under the Term Loan Facility bear interest at the default rate, which is 2% per annum plus the interest rate otherwise applicable to such indebtedness. The borrowings under the Term Loan Facility are secured by substantially all of the assets of, and the performance and payment by borrowers thereunder are guaranteed by, the Company and certain of its subsidiaries. Following the delivery of audited annual financial statements for each fiscal year, the Term Loan Facility requires the Company to prepay amounts outstanding under the Term Loan Facility with (i) 75% of the excess cash flow of the Company minus the aggregate principal amount of all optional prepayments made in such preceding fiscal year, if the leverage ratio is greater than 3.25:1.00, or (ii) 50% of the excess cash flow of the Company minus the aggregate principal amount of all optional prepayments made in such preceding fiscal year, if the leverage ratio is less than or equal to 3.25:1.00. In addition, the Term Loan Facility also requires the Company to prepay amounts outstanding, subject to certain exceptions (and, with respect to clauses (i) and (ii) below, certain limited reinvestment rights), with: (i) 100% of the net proceeds of any asset disposition in excess of $0.75 million in any fiscal year, (ii) 100% of any insurance or condemnation awards that are greater than $2.5 million, (iii) 100% of the net proceeds of any equity issuances, (iv) 100% of the net proceeds of any issuance of indebtedness (other than certain permitted indebtedness), and (v) 100% of any net cash proceeds received outside the ordinary course of business. All term loans under the Term Loan Facility are due and payable in full on February 28, 2023, subject to earlier acceleration upon certain conditions. Under the Term Loan Facility, the Company is required to comply with certain customary restrictive covenants that, among other things and with certain exceptions, limit the ability of the Company to (i) incur additional indebtedness and liens, (ii) make certain capital expenditures, (iii) pay dividends and make certain other distributions, (iv) sell or dispose of property or assets, (v) make loans, (vi) make payment of certain debt, (vii) make fundamental changes, (viii) enter into transactions with affiliates, and (ix) engage in any new businesses. The Term Loan Facility also contains certain customary representations and warranties, affirmative covenants, and reporting obligations. Substantially all of the Company’s assets are collateral for these loans except assets collateralized by the SIC Credit Facility which hold a senior position. These assets include all of accounts receivable and inventory, with the exception of newly acquired assets from the TAC acquisition amounting to $7.0 million for accounts receivable and $4.3 million for inventory. The Company is also restricted from paying dividends to its stockholders. Additionally, substantially all of the net assets of the Company’s subsidiaries are restricted by the term loan agreement from providing loans, advances and dividends to the SIC parent company. The Company is required to meet certain financial and nonfinancial covenants pursuant to these term loans. The Company was in compliance with all financial and nonfinancial covenants as of December 31, 2018 and 2017. As of December 31, 2018, approximately $144.2 million of indebtedness was outstanding under the Term Loan Facility. Vehicle and Equipment Financing We have used various secured loans and leases to finance our acquisition of vehicles. As of December 31, 2018, approximately $3.0 million of indebtedness was outstanding under vehicle and equipment loans and capital leases. Historical Cash Flow Information Working Capital Inventory and accounts receivable represent over 85% of our tangible assets as of December 31, 2018, and accordingly, management of working capital is important to our businesses. Working capital (defined as current assets less current liabilities, excluding debt and cash) totaled $100.2 million at December 31, 2018, compared to $73.4 million at December 31, 2017. Working capital levels have increased primarily due to current year acquisitions. In our RDS segment, for the year ended December 31, 2018, working capital increased by $3.0 million to $16.9 million, compared to $13.9 million for the year ended December 31, 2017. Increases in accounts receivable and inventory associated with higher sales volume were offset by a corresponding increase in accounts payable. In our ASG segment, for the year months ended December 31, 2018, working capital increased by $24.2 million to $84.9 million, compared to $60.7 million for the year ended December 31, 2017. This increase was largely due to inventory and accounts receivable increases related to the Cosmic, Bedrock, NSI, and Tuscany acquisitions. Higher levels of inventory outside of the acquisitions that contributed to the working capital increase were attributable to new branch locations and an increase of imported purchases in advance of expected tariffs on Chinese quartz and an expansion of the product line. Cash Flows Provided by / (Used in) Operating Activities Net cash provided by / (used in) operating activities was $12.2 million and $(8.4) million for the years ended December 31, 2018 and 2017, respectively. Net loss was $2.5 million and $11.3 million for the years ended December 31, 2018 and 2017, respectively. Adjustments for noncash expenses included in the calculation of net cash provided by operating activities, including amortization and depreciation, changes in deferred income taxes and other noncash items, totaled $21.8, and $26.7 million for the years ended December 31, 2018 and 2017, respectively. Changes in operating assets and liabilities resulted in net cash used of $7.1 million and $23.7 million for the years ended December 31, 2018 and 2017, respectively, due to investments in working capital. Cash Flows Used in Investing Activities For the year ended December 31, 2018, cash flow used in investing activities was $80.6 million, with $72.1 million resulting from our investments in acquisitions. Capital expenditures for property and equipment, net of proceeds from disposals, totaled $8.5 million. For the year ended December 31, 2017, cash flow used in investing activities was $118.8 million, which consisted of $88.0 million for the acquisition of Pental and $26.8 million for the acquisition of Greencraft. Capital expenditures for property and equipment, net of proceeds from disposals, totaled $4.1 million. Cash Flows Provided by Financing Activities Net cash provided by financing activities was $72.2 million and $128.0 million for the years ended December 31, 2018 and 2017, respectively. Cash flows provided by financing activities supported our acquisition strategies. For the year ended December 31, 2018, we borrowed an additional $57.2 million in term debt, with debt issuance costs of $0.5 million, and made principal payments of $2.5 million. Aggregate net borrowings on the SIC Credit Facility were $17.9 million, with issuance costs of $0.5 million. Proceeds from employee stock purchases were $0.6 million. For the year ended December 31, 2017, we raised $240.5 million in net proceeds from the November 2017 private offering and private placement, used $122.8 million to repurchase and retire shares of our Class B Common Stock, and made distributions to equityholders of $35.4 million. We also borrowed an additional $130.0 million in term debt and made principal payments of $88.9 million, for a net increase in term debt of $41.1 million. Aggregate net borrowings under the RDS credit facility and ASG credit facility were $8.2 million. Contractual Obligations In the table below, we set forth our enforceable and legally binding obligations as of December 31, 2018. Some of the amounts included in the table are based on management’s estimates and assumptions about these obligations, including their duration, the possibility of renewal, anticipated actions by third parties, and other factors. Because these estimates and assumptions are necessarily subjective, our actual payments may vary from those reflected in the table. (1) Long-term debt obligations include principal payments on our term loans as well as our notes payable. Long-term debt obligations do not include interest or fees on the unused portion of our revolving letters of credit or financing fees associated with the issuance of debt. (2) Capital lease obligations include payments on capital leases for vehicles and equipment purchased. (3) We lease certain locations, including, but not limited to, corporate offices, warehouses, fabrication shops, and design centers. For additional information, see Note 10-Commitments and Contingencies to our consolidated financial statements included in this Annual Report. (4) These amounts take into account a contract with a supplier of engineered stone on an exclusive basis in certain states within the United States. As part of the terms of the exclusive right to distribute the products provided under the contract, we are obligated to take delivery of a certain minimum amount of product from this supplier. If we fall short of these minimum purchase requirements in any given calendar year, we have agreed to negotiate with the supplier to arrive at a mutually acceptable resolution. There are no financial penalties to us if such commitments are not met; however, in such a case, the supplier has reserved the right, under the contract, to withdraw the exclusive distribution rights granted to us. The amount of the payment is estimated by multiplying the minimum quantity required under the contract by the average price paid in 2018. This amounts to approximately $36.2 million in 2019 and 2020. In addition to the contractual obligations set forth above, as of December 31, 2018, we had an aggregate of approximately $37.2 million of indebtedness outstanding under the SIC Credit Facility. Off-Balance Sheet Arrangements As of December 31, 2018, with the exception of operating leases that we typically use in the ordinary course of business, we were not party to any material off-balance sheet financial arrangements that are reasonably likely to have a current or future effect on our financial condition or operating results. We do not have any relationship with unconsolidated entities or financial partnerships for the purpose of facilitating off-balance sheet arrangements or for other contractually narrow or limited purposes. Critical Accounting Policies and Estimates Management’s discussion and analysis of our financial condition and results of operations is based upon our consolidated financial statements, which have been prepared in accordance with GAAP. The preparation of our consolidated financial statements requires us to make estimates and assumptions that affect the reported amounts of assets, liabilities, revenues and expenses, and related disclosure of contingent assets and liabilities. Certain accounting policies involve judgments and uncertainties to such an extent that there is a reasonable likelihood that materially different amounts could have been reported using different assumptions or under different conditions. We evaluate our estimates and assumptions on a regular basis. We base our estimates on historical experience and various other assumptions that are believed to be reasonable under the circumstances, the results of which form the basis for making judgments about the carrying values of our assets and liabilities that are not readily apparent from other sources. Actual results may differ from these estimates and assumptions used in preparation of our consolidated financial statements. Revenue Recognition Our revenue derived from the sale of imported granite, marble, and related items is recognized when persuasive evidence of an agreement exists through a purchase order or signed contract detailing the quantity and price, delivery per the agreement has been made, and collectability is reasonably assured. Our contracts with our homebuilder customers are generally treated as short-term contracts for accounting purposes. These contracts will generally range in length from several days to several weeks. We account for these contracts under the completed contract method of accounting and will recognize revenue and cost of revenues when the contract is complete and performance has been delivered. Our contracts related to multifamily projects are treated as long-term contacts for accounting purposes. Accordingly, the Company recognizes revenue using the percentage-of-completion method of accounting. For the years ended December 31, 2018 and 2017, multifamily projects accounted for approximately 2% and 5% of our combined revenues, respectively. At December 31, 2018 and 2017, the under billings (revenues in excess of billings) on multifamily projects in progress were not significant. We estimate provisions for returns which are accrued at the time a sale is recognized. The Company also realized rebates to customers as a reduction to revenue in the period the rebate is earned. Cost of Revenue RDS’s cost of revenue is comprised of the costs of materials and labor to purchase and install products for our customers. ASG’s cost of revenue primarily consists of purchased materials, sourcing fees for inventory procurement, and freight costs. RDS and ASG also include payroll taxes and benefits, workers’ compensation insurance, vehicle-related expenses and overhead costs, including rent, depreciation, utilities, property taxes, repairs and maintenance costs in the cost of revenue. Our cost of revenue is reduced by rebates provided by suppliers in the period the rebate is earned. Accounts Receivable Accounts receivable are recorded at net realizable value. We continually assess the collectability of outstanding customer invoices; and if deemed necessary, maintain an allowance for estimated losses resulting from the non-collection of customer receivables. In estimating this allowance, we consider factors such as: historical collection experience, a customer’s current creditworthiness, customer concentrations, age of the receivable balance both individually and in the aggregate and general economic conditions that may affect a customer’s ability to pay. We have the ability to place liens against the significant amount of RDS customers in order to secure receivables. Actual customer collections could differ from the our estimates. At December 31, 2018 and 2017, the allowance for doubtful accounts was $0.5 million and $0.2 million, respectively. Inventories Inventories consist of stone slabs, tile and sinks, and include the costs to acquire the inventories and bring them to their existing location and condition. Inventory also includes flooring, cabinets, doors and trim, glass, and countertops, which have not yet been installed, as well as labor and related costs for installations in process. Inventory is valued at the lower of cost (using the specific identification and first-in, first-out methods) or net realizable value. Intangible Assets Intangible assets consist of customer relationships, trade names and non-compete agreements. We consider all our intangible assets to have definite lives and are being amortized on the straight-line method over the estimated useful lives of the respective assets or on an accelerated basis based on the expected cash flows generated by the existing customers as follows: Business Combinations We record business combinations using the acquisition method of accounting. Under the acquisition method of accounting, identifiable assets acquired and liabilities assumed are recorded at their acquisition date fair values. The excess of the purchase price over the estimated fair value is recorded as goodwill. Changes in the estimated fair values of net assets recorded for acquisitions prior to the finalization of more detailed analysis, but not to exceed one year from the date of acquisition, will adjust the amount of the purchase price allocable to goodwill. Measurement period adjustments are reflected in the period in which they occur. Goodwill Goodwill represents the excess of the cost of an acquired entity over the fair value of the acquired net assets. We account for goodwill in accordance with FASB ASC topic 350, Intangibles-Goodwill and Other Intangible Assets, which among other things, addresses financial accounting and reporting requirements for acquired goodwill and other intangible assets having indefinite useful lives. ASC topic 350 requires goodwill to be carried at cost, prohibits the amortization of goodwill and requires us to test goodwill for impairment at least annually. We test for impairment of goodwill annually during the fourth quarter or more frequently if events or changes in circumstances indicate that the goodwill may be impaired. Events or changes in circumstances which could trigger an impairment review include a significant adverse change in legal factors or in the business climate, an adverse action or assessment by a regulator, unanticipated competition, a loss of key personnel, significant changes in the manner of our use of the acquired assets or the strategy for our overall business, significant negative industry or economic trends, or significant underperformance relative to expected historical or projected future results of operations. We identified RDS and ASG as reporting units and determined each reporting unit’s fair value substantially exceeded such reporting unit’s carrying value. There were no impairment charges related to goodwill for the years ended December 31, 2018 and 2017. Equity based compensation We account for equity based awards by measuring the awards at the date of grant and recognizing the grant-date fair value as an expense using either straight-line or accelerated attribution, depending on the specific terms of the award agreements over the requisite service or performance period, which is usually equivalent to the vesting period. Income Taxes The provision for income taxes is accounted for under the asset and liability method prescribed by ASC 740 (Topic 740, Income Taxes). Deferred tax assets and liabilities are recognized for the future tax consequences attributable to differences between the financial statement carrying amounts of existing assets and liabilities and their respective tax bases, operating losses and tax credit carryforwards. Deferred tax assets and liabilities are measured using the enacted tax rates expected to apply to taxable income in the years in which those temporary differences are expected to be recovered or settled. The effect on deferred tax assets and liabilities of a change in tax rates is recognized in income in the period the tax rate changes are enacted. We recognize the tax benefit from an uncertain tax position only if it is more likely than not the tax position will be sustained on examination by the taxing authorities, based on the technical merits of the position. The tax benefits recognized in the financial statements from such positions are then measured based on the largest benefit that has a greater than 50% likelihood of being realized upon settlement. On December 22, 2017, the Tax Cuts and Jobs Act (which we refer to as the “Tax Act”) was adopted into law. The Tax Act makes broad and complex changes to the Internal Revenue Code of 1986, including, but not limited to, (i) reducing the U.S. federal corporate tax rate from 35% to 21%; (ii) eliminating the corporate alternative minimum tax (“AMT”) and changing how existing AMT credits are realized; (iii) creating a new limitation on deductible interest expense; and (iv) changing rules related to uses and limitation of net operating loss carryforwards created in tax years beginning after December 31, 2017. As of December 31, 2018 and 2017, our deferred tax assets and liabilities were valued at the 21.0% rate expected for 2018 and beyond. Our policy is to recognize interest and/or penalties related to all tax positions as income tax expense. To the extent that accrued interest and penalties do not ultimately become payable, amounts accrued will be reduced and reflected as a reduction of the overall income tax provision in the period that such determination is made. We have recognized $0.5 million in interest and penalties related to uncertain tax positions as of December 31, 2018. No interest or penalties were accrued as of December 31, 2017. Recent Accounting Pronouncements See Note 1 - Organization and Business Description to our audited consolidated financial statements included in this Annual Report for a description of recent accounting pronouncements issued.

<s>[INST] OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS The following information should be read in conjunction with Item 6. “Selected Financial Data” above and the accompanying consolidated financial statements and related notes included in this Annual Report. The following discussion may contain forwardlooking statements that reflect our plans, estimates, and beliefs. Our actual results could differ materially from those discussed in these forwardlooking statements. Factors that could cause or contribute to these differences include those factors discussed below and elsewhere in this Annual Report, particularly in the sections entitled “Special Note Regarding ForwardLooking Statements and Information” and “Risk Factors” included elsewhere in this Annual Report. Overview Select Interior Concepts, Inc. (collectively with all of its subsidiaries, “SIC,” the “Company,” “we,” “us” and “our”) is an installer and nationwide distributor of interior building products with market positions in residential interior design services. Through our Residential Design Services (which we refer to as “RDS”) operating segment, we serve national and regional homebuilders by providing an integrated, outsourced solution for the design, consultation, sourcing, distribution and installation needs of their homebuyer customers. Through our 21 design centers, our consultants work closely with homebuyers in the selection of a broad array of interior products and finishes, including flooring, cabinets, countertops, wall tile, finish carpentry, shower enclosures and mirrors, and related interior items, primarily for newly constructed homes. We then coordinate the ordering, fulfillment and installation of many of these interior product categories to provide for the homebuyer. With our design centers and our product sourcing and installation capabilities, we enable our homebuilder customers to outsource critical aspects of their business to us, thereby increasing their sales, profitability, and return on capital. We also have leading market positions in the selection and importation of natural and engineered stone slabs for kitchen and bathroom countertops and specialty tiles through our other operating segment, Architectural Surfaces Group (which we refer to as “ASG”). ASG sources natural and engineered stone from a global supply base and markets these materials through a national network of distribution centers and showrooms. In addition to serving the new residential and commercial construction markets with these materials, we also distribute them to the repair and remodel (which we refer to as “R&R”) market. Our platform originated in September 2014, when affiliates of Trive Capital Management LLC (which we refer to as “Trive Capital”) acquired RDS, which in turn acquired the assets of PT Tile Holdings, LP (which we refer to as “Pinnacle”) in February 2015, and 100% of the equity interests in Greencraft Holdings, LLC (which we refer to as “Greencraft”) in December 2017. In 2018, RDS then acquired the assets of Summit Stoneworks, LLC (which we refer to as “Summit”) in August 2018 and 100% of the equity interests in T.A.C. Ceramic Tile Co. (which we refer to as “TAC”) in December 2018. Affiliates of Trive Capital also formed a consolidation platform in the stone countertop market by acquiring 100% of the equity interests in Architectural Granite & Marble, LLC in June 2015, which in turn acquired the assets of Bermuda ImportExport, Inc. (which we refer to as “Modul”) in July 2016, 100% of the equity interests in Pental Granite and Marble, LLC (which we refer to as “Pental”) in February 2017, and the assets of Cosmic Stone & Tile Distributors, Inc. (which we refer to as “Cosmic”) in October 2017, and these acquired businesses were combined to form ASG. ASG then acquired the assets of Elegant Home Design, LLC (which we refer to as “Bedrock”) in January 2018, the assets of NSI, LLC (which we refer to as “NSI”) in March 2018, and the assets of The Tuscany Collection, LLC (which we refer to as “Tuscany”) in [/INST] Negative. </s>

Select Interior Concepts, Inc.

2020-03-12

2019-12-31

Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS The following information should be read in conjunction with Item 6. “Selected Financial Data” above and the accompanying consolidated financial statements and related notes included in this Annual Report. The following discussion may contain forward-looking statements that reflect our plans, estimates, and beliefs. Our actual results could differ materially from those discussed in these forward-looking statements. Factors that could cause or contribute to these differences include those factors discussed below and elsewhere in this Annual Report, particularly in the sections entitled “Special Note Regarding Forward-Looking Statements and Information” and “Risk Factors” included elsewhere in this Annual Report. Overview Select Interior Concepts, Inc. (collectively with all of its subsidiaries, “SIC,” the “Company,” “we,” “us” and “our”) is an installer and nationwide distributor of interior building products with market positions in residential interior design services. Through our Residential Design Services (which we refer to as “RDS”) operating segment, we serve national and regional homebuilders by providing an integrated, outsourced solution for the design, consultation, sourcing, distribution and installation needs of their homebuyer customers. Through our 18 design centers, our designers work closely with homebuyers in the selection of a broad array of interior products and finishes, including flooring, cabinets, countertops, wall tile, and related interior items, primarily for newly constructed homes. We then coordinate the ordering, fulfillment and installation of many of these interior product categories to provide for the homebuyer. With our design centers and our product sourcing and installation capabilities, we enable our homebuilder customers to outsource critical aspects of their business to us, thereby increasing their sales, profitability, and return on capital. We also have leading market positions in the selection and importation of natural and engineered stone slabs for kitchen and bathroom countertops and specialty tiles through our other operating segment, Architectural Surfaces Group (which we refer to as “ASG”). ASG sources natural and engineered stone from a global supply base and markets these materials through a national network of 23 distribution centers and showrooms. In addition to serving the new residential and commercial construction markets with these materials, we also distribute them to the repair and remodel (which we refer to as “R&R”) market. Operating Segments We have defined each of our operating segments based on the nature of its operations and its management structure and product offerings. Our management decisions are made by our Chief Executive Officer, whom we have determined to be our Chief Operating Decision Maker. Our two reportable segments are described below. Residential Design Services RDS, our interior design and installation segment, is a service business that provides design center operation, interior design, product sourcing, and installation services to homebuilders, homeowners, general contractors and property managers. Products sold and installed by RDS include flooring, countertops, cabinets, and wall tile. New single-family and multi-family construction are the primary end markets, although we intend to explore growth opportunities in other markets, such as the R&R market. Architectural Surfaces Group ASG, our natural and engineered stone countertop distribution segment, distributes granite, marble, porcelain and quartz slabs for countertop and other uses, and ceramic and porcelain tile for flooring and backsplash and wall tile applications. Primary end markets are new residential and commercial construction and the R&R market. Key Factors Affecting Operating Results Our operating results are impacted by changes in the levels of new residential construction and of the demand for products and services in the R&R market. These are in turn affected by a broad range of macroeconomic factors including the rate of economic growth, unemployment, job and wage growth, interest rates, multi-family project financing, and residential mortgage lending conditions. Other important underlying factors include demographic variables such as household formation, immigration and aging trends, housing stock and vacant inventory levels, changes in the labor force, raw materials prices, the legal environment, and local and regional development and construction regulation. Material Costs The materials that we distribute and install are sourced through a wide array of quarries, manufacturers, and distributors located in North America, South America, Europe, Africa and Asia. As demand for these products continues to grow with housing demand, we expect that we may be subject to cost increases from time to time. There is no guarantee that our relationships with our customers will be such that we can pass these increases on to our customers. Affordability issues in new residential construction could temper our homebuilder customers’ ability to raise their prices, which could in turn limit our ability to increase prices to compensate for increases in our costs of materials. We believe, however, that over the long term, these same forces affecting housing prices would also limit our suppliers’ ability to increase prices, which would help us maintain our margins. Labor Costs Installation labor is a significant component of our aggregate labor force of approximately 1,850 employees. With the unemployment rate at 3.5% in December 2019 according to the U.S. Bureau of Labor Statistics, there is no guarantee that we will be able to attract the type and quality of skilled labor that we need in sufficient quantities to accomplish our growth plans. Correspondingly, we expect that tight labor markets will continue to lead to upward pressure on wages and could impact our gross profit margin and overall profitability negatively. We believe, however, that our scale will continue to give us the ability to provide steady work, an attractive benefits package, and a beneficial work environment, particularly as compared to our smaller competitors. Over time, we expect that the combination of these factors will gradually increase our relative advantage over smaller and less sophisticated competitors. Operating and Administrative Costs We incur costs related to the operation and administration of our businesses that are reported as period expenses separately from Cost of Goods Sold. These expenses include, but are not limited to, project management, customer service, human resources, accounting, information technology, general management, public company costs, and others. These costs will likely continue to grow as our businesses grow, but we believe that, overall, they will grow more slowly than the rate at which our gross profit grows due to improved utilization rates of these resources and the fact that we have implemented and intend to continue to implement scalable technology and process improvements that increase the efficiency of our operations. Non-GAAP Measures In addition to the results reported in accordance with United States generally accepted accounting principles (which we refer to as “GAAP”), we have provided information in this Report relating to EBITDA, Adjusted EBITDA, and Adjusted EBITDA margin. We have provided definitions below for these non-GAAP financial measures and have provided the tables above reconciling these non-GAAP financial measures to the comparable GAAP financial measures. We believe that these non-GAAP financial measures provide valuable information regarding our earnings and business trends by excluding specific items that we believe are not indicative of the ongoing operating results of our businesses, providing a useful way for investors to make a comparison of our performance over time and against other companies in our industry. We have provided these non-GAAP financial measures as supplemental information to our GAAP financial measures and believe these non-GAAP measures provide investors with additional meaningful financial information regarding our operating performance and cash flows. Our management and board of directors also use these non-GAAP measures as supplemental measures to evaluate our businesses and the performance of management, including the determination of performance-based compensation, to make operating and strategic decisions, and to allocate financial resources. We believe that these non-GAAP measures also provide meaningful information for investors and securities analysts to evaluate our historical and prospective financial performance. These non-GAAP measures should not be considered a substitute for or superior to GAAP results. Furthermore, the non-GAAP measures presented by us may not be comparable to similarly titled measures of other companies. EBITDA is defined as consolidated net income before interest, taxes and depreciation and amortization. Adjusted EBITDA is defined as consolidated net income before (i) interest expense, (ii) income tax expense, (iii) depreciation and amortization expense, (iv) stock compensation expense, and (v) adjustments for costs that are deemed to be transitional in nature or not related to our core operations, such as severance and employee related reorganization costs, purchase accounting fair value adjustments, strategic alternatives costs, facility closure costs, and professional, financing and legal fees related to business acquisitions, or similar transitional costs and expenses related to business investments, greenfield investments, and integrating acquired businesses into our Company. Adjusted EBITDA margin is calculated as a percentage of our net revenue. EBITDA, Adjusted EBITDA, and Adjusted EBITDA margin are non-GAAP financial measures used by us as supplemental measures in evaluating our operating performance. Key Components of Results of Operations Net Revenue. Revenue at our RDS segment is recognized on a percentage of completion basis over the terms of the performance obligation with the homebuilder or other contracted customer. In our ASG segment, net revenue is derived from the sale of stone products and is recognized at a point in time when such products have been accepted at the customer’s designated location and the performance obligation is completed. Cost of Revenue. Cost of revenue consists of the direct costs associated with revenue earned by the sale and installation of our interior products in the case of our RDS segment, or by delivering product in the case of our ASG segment. In our RDS segment, cost of revenue includes direct material costs associated with each project, the direct labor costs associated with installation (including taxes, benefits and insurance), rent, utilities and other period costs associated with warehouses and fabrication shops, depreciation associated with warehouses, material handling, fabrication and delivery costs, and other costs directly associated with delivering and installing product in our customers’ projects, offset by vendor rebates. In our ASG segment, cost of revenue includes direct material costs, inbound and outbound freight costs, overhead (such as rent, utilities and other period costs associated with product warehouses), depreciation associated with fixed assets used in warehousing, material handling and warehousing activities, warehouse labor, taxes, benefits and other costs directly associated with receiving, storing, handling and delivering product to customers in revenue earning transactions. Gross Profit and Gross Margin. Gross profit is revenue less the associated cost of revenue. Gross margin is gross profit divided by revenue. Operating Expenses. Operating expenses include overhead costs such as general management, project management, purchasing, sales, customer service, accounting, human resources, depreciation and amortization, information technology, public company costs and all other forms of wage and salary cost associated with operating our businesses, and the taxes and benefits associated with those costs. We also include other general-purpose expenses, including, but not limited to, office supplies, office rents, legal, consulting, insurance, and non-cash stock compensation costs. Professional services expenses, including audit and legal, and transaction costs are also included in operating expenses. Depreciation and Amortization. Depreciation and amortization expenses represent the estimated decline over time of the value of tangible assets such as vehicles, equipment and tenant improvements, and intangible assets such as customer lists and trade names. We recognize the expenses on a straight-line basis over the estimated economic life of the asset in question. Interest Expense. Interest expense represents amounts paid to or which have become due during the period to lenders and lessors under credit agreements and capital leases, as well as the amortization of debt issuance costs. Income Taxes. Income taxes are recorded using the asset and liability method of accounting for income taxes. Under the asset and liability method, deferred tax assets and liabilities are recognized for the deferred tax consequences attributable to temporary differences between the financial statement carrying amounts of existing assets and liabilities and their respective tax basis. Deferred tax assets and liabilities are measured using enacted tax rates expected to apply to taxable income in the years in which those differences are expected to be recovered or settled. Results of Operations Year Ended December 31, 2019 Compared to Year Ended December 31, 2018 Net Revenue. For the year ended December 31, 2019, net revenue increased by $120.6 million, or 24.6%, to $610.4 million, from $489.8 million for the year ended December 31, 2018. Net revenue for the years ended December 31, 2019 and 2018 is adjusted for the elimination of intercompany sales of $3.0 million and $2.6 million, respectively. In our RDS segment, net revenue increased by $100.2 million, or 37.3%, to $368.6 million for the year ended December 31, 2019, from $268.4 million for the year ended December 31, 2018. The increase was primarily due to the acquisitions of Summit, TAC, and Intown, which accounted for $104.1 million of the growth in RDS revenues. During the period, revenues from organic sales decreased $3.9 million as we continue to face softening in the Southern California housing market of the Western region, which is our largest market. In our ASG segment, net revenue increased by $20.8 million, or 9.3%, to $244.8 million for the year ended December 31, 2019, from $224.0 million for the year ended December 31, 2018. The increase was due to the acquisitions of Bedrock, NSI, and Tuscany, which collectively accounted for $8.0 million of ASG growth, with the remainder of the growth of $12.8 million in our ASG segment attributable to increased revenue from organic volume, price and product mix and new locations started in 2018. Cost of Revenue. For the year ended December 31, 2019, cost of revenue increased by $90.0 million, or 25.3%, to $446.3 million, from $356.3 million for the year ended December 31, 2018. Cost of revenue for the year ended December 31, 2019 and 2018 is adjusted for the elimination of intercompany sales of $3.1 million and $2.5 million, respectively. In our RDS segment, cost of revenue increased by $75.3 million, or 38.8%, to $269.8 million for the year ended December 31, 2019, from $194.5 million for the year ended December 31, 2018. The acquisitions of Summit, TAC and Intown were primarily responsible for this increase, contributing $74.6 million. The remaining increase of $0.8 million is due to additional costs in the organic business. In our ASG segment, cost of revenue increased by $15.2 million, or 9.2%, to $179.5 million for the year ended December 31, 2019, from $164.3 million for the year ended December 31, 2018. This was partially due to the acquisitions of Bedrock, NSI, and Tuscany, which contributed $5.8 million of the increase, with the remaining increase due to costs associated with organic growth. Gross Profit and Margin. For the year ended December 31, 2019, gross profit increased by $30.6 million, or 22.9%, to $164.1 million, from $133.5 million for the year ended December 31, 2018. For the year ended December 31, 2019, gross margin decreased by 0.3% to 26.9%, from 27.2% for the year ended December 31, 2018. In our RDS segment, gross margin decreased by 0.7% to 26.8% for the year ended December 31, 2019, from 27.5% for the year ended December 31, 2018. This decrease is due to an unfavorable product mix primarily due to entry- to mid-level homebuilding comprising a larger share of project activity in our markets. In our ASG segment, gross margin remained consistent, increasing by only 0.1% to 26.7% for the year ended December 31, 2019, from 26.6% for the year ended December 31, 2018, due to the non-recurrence of non-cash inventory expenses that were recorded in the prior year, offset by higher supply chain related costs and lower margin sales in the full year 2019. Operating Expense. For the year ended December 31, 2019, operating expenses increased by $23.5 million, or 19.3%, to $144.8 million, from $121.4 million for the year ended December 31, 2018. In our RDS segment, operating expenses increased by $21.6 million to $81.2 million for the year ended December 31, 2019, from $59.6 million for the year ended December 31, 2018. This increase was primarily related to the acquisitions of Summit, TAC, and Intown. In our ASG segment, operating expenses decreased by $2.3 million to $45.4 million for the year ended December 31, 2019, from $47.7 million for the year ended December 31, 2018. This decrease was due to one-time non-recurring expenses related to the Bedrock and Tuscany acquisitions, and expenses related to the opening of new locations incurred during the year ended December 31, 2018. The remaining $4.2 million of the increase in operating expenses was related to an increase in the amount of equity-based compensation awarded in 2019 in the amount of $3.1 million, as well as other overhead costs at the corporate level that were in place for a full year in 2019 compared to only a partial year in 2018. Depreciation and Amortization. For the year ended December 31, 2019, depreciation and amortization expenses increased by $3.7 million, or 17.9%, to $24.2 million, from $20.5 million for the year ended December 31, 2018. In our RDS segment, depreciation and amortization expenses increased by $3.3 million, or 33.9%, to $12.9 million for the year ended December 31, 2019, from $9.6 million for the year ended December 31, 2018, which was primarily due to depreciation and amortization associated with the assets acquired in the Summit, TAC, and Intown acquisitions. In our ASG segment, depreciation and amortization expenses increased by $0.3 million, or 3.0%, to $11.2 million for the year ended December 31, 2019 from $10.8 million for the year ended December 31, 2018, which is primarily due to amortization associated with the Tuscany acquisition. Interest Expense. For the year ended December 31, 2019, interest expense increased by $5.8 million, or 50.7%, to $17.2 million, from $11.4 million for the year ended December 31, 2018. This increase is primarily due to the borrowings associated with funding the TAC and Intown acquisitions offset by lower interest rates. Income Taxes. For the year ended December 31, 2019, we recognized income tax expense of $1.5 million, an increase of $0.5 million from income tax expense of $1.0 million for the year ended December 31, 2018. The increase in income taxes is due primarily to the increase in pre-tax income in 2019 compared to 2018. Net (Loss) Income. For the year ended December 31, 2019, net income increased by $9.5 million to $7.0 million, from a net loss of $2.5 million for the year ended December 31, 2018. Adjusted EBITDA. For the year ended December 31, 2019, Adjusted EBITDA increased by $5.5 million to $59.9 million from $54.4 million for the year ended December 31, 2018, primarily as a result of the factors discussed above. Adjusted EBITDA Margin. For the year ended December 31, 2019, Adjusted EBITDA margin decreased to 9.8%, from 11.1% for the year ended December 31, 2018, primarily as a result of the factors discussed above. Year Ended December 31, 2018 Compared to Year Ended December 31, 2017 Net Revenue. For the year ended December 31, 2018, net revenue increased by $136.8 million, or 38.8%, to $489.8 million, from $353.0 million for the year ended December 31, 2017. Net revenue for the year ended December 31, 2018 and 2017 is adjusted for the elimination of intercompany sales of $2.6 million and $1.4 million, respectively. In our RDS segment, revenue increased by $75.2 million, or 38.9%, to $268.4 million for the year ended December 31, 2018, from $193.2 million for the year ended December 31, 2017. This increase was largely due to the acquisitions of Greencraft and Summit Stoneworks, which accounted for $55.6 million of the RDS growth. Additionally, organic revenue increased $19.6 million through continued expansion of share in new geographies, increased product offerings, and price/mix. In our ASG segment, net revenue increased by $62.9 million, or 39.0%, to $224.0 million for the year ended December 31, 2018, from $161.1 million for the year ended December 31, 2017. This increase was largely due to the acquisitions of Cosmic, Bedrock, NSI, Pental and Tuscany which accounted for $52.5 million of the growth. Additionally, organic revenue increased $10.4 million due to volume increases, greenfield expansion, and price/mix. Cost of Revenue. For the year ended December 31, 2018, cost of revenue increased by $107.2 million, or 43.0%, to $356.3 million, from $249.1 million for the year ended December 31, 2017. Cost of revenue for the year ended December 31, 2018 and 2017 is adjusted for the elimination of intercompany sales of $2.5 million and $1.3 million, respectively. In our RDS segment, cost of revenue increased by $54.3 million, or 38.7%, to $194.5 million for the year ended December 31, 2018, from $140.2 million for the year ended December 31, 2017. The acquisitions of Greencraft and Summit drove $37.8 million of the year over year increase. The remaining $16.5 million increase in cost of revenues was substantially driven by an increase in sales in the legacy RDS business. In our ASG segment, cost of revenue increased by $54.2 million, or 49.2%, to $164.3 million for the year ended December 31, 2018, from $110.1 million for the year ended December 31, 2017. This increase was primarily due to the acquisitions of Cosmic, Bedrock, NSI, Pental and Tuscany contributing $41.1 million, as well as a $13.1 million increase in cost of revenue in the legacy ASG business. Gross Profit and Margin. For the year ended December 31, 2018, gross profit increased by $29.6 million, or 28.5%, to $133.5 million, from $103.9 million for the year ended December 31, 2017. For the year ended December 31, 2018, gross margin decreased by 2.2% to 27.2%, from 29.4% for the year ended December 31, 2017. In our RDS segment, gross margin increased by 0.1% to 27.5% for the year ended December 31, 2018, from 27.4% for the year ended December 31, 2017. This increase was the result of improved margins from acquisitions and a slight shift in product and customer mix, partially offset by higher depreciation in cost of revenue. In our ASG segment, gross margin decreased by 5.0% to 26.6% for the year ended December 31, 2018, from 31.6% for the year ended December 31, 2017. This decrease in margin was driven by the ramp up of our greenfield sites that delivered lower contribution margin than the base business as anticipated, lower margin from the opportunistic acquisitions of Cosmic, NSI and Bedrock, one-time non-cash charges, and higher depreciation in cost of revenue. Operating Expenses. For the year ended December 31, 2018, operating expenses increased by $23.7 million, or 24.3%, to $121.4 million, from $97.7 million for the year ended December 31, 2017. This increase in operating expenses was primarily due to selling, general, and administrative expenses from acquired businesses, non-cash long-term incentive plan expenses, one-time nonrecurring costs for completed acquisitions, the opening of greenfield locations, investments in SIC infrastructure as a new public company, the addition of M&A resources, and higher depreciation and amortization. In our RDS segment, operating expenses increased by $6.5 million to $59.6 million for the year ended December 31, 2018, from $53.1 million for the year ended December 31, 2017. This increase was related to the Greencraft and Summit acquisitions, sales and marketing expenses to support increased revenues, and other expenses related to the growth of the business. In our ASG segment, operating expenses increased by $4.7 million to $47.7 million for the year ended December 31, 2018, from $43.0 million for the year ended December 31, 2017. This increase was related to the Cosmic, Bedrock, NSI, Pental and Tuscany acquisitions, and expenses related to the opening of greenfield locations. The remaining $14.0 million of the increase in operating expenses was related to costs for developing public company infrastructure, mergers and acquisitions resources, and stock-based compensation accrual expense incurred by the SIC parent company. Depreciation and Amortization. For the year ended December 31, 2018, depreciation and amortization expenses increased by $5.7 million, or 38.5%, to $20.5 million, from $14.8 million for the year ended December 31, 2017. In our RDS segment, depreciation and amortization expenses increased by $2.7 million, or 39.1%, to $9.6 million for the year ended December 31, 2018, from $6.9 million for the year ended December 31, 2017. This was primarily due to the depreciation associated with the acquired Greencraft and Summit assets and amortization related to intangible assets recognized in the purchase accounting for the Greencraft and Summit acquisitions. In our ASG segment, depreciation and amortization expenses increased by $2.8 million, or 35.0%, to $10.8 million for the year ended December 31, 2018 from $8.0 million for the year ended December 31, 2017. Amortization of intangible assets acquired in the Bedrock and Tuscany acquisitions accounted for the majority of this increase with the remaining increase due to the depreciation of additional assets from new locations. Interest Expense. For the year ended December 31, 2018, interest expense decreased by $2.3 million, or 16.8%, to $11.4 million, from $13.7 million for the year ended December 31, 2017. Our interest expense was reduced because we decreased our borrowing significantly by paying off our RDS term loan and repaying a significant amount of our ASG term debt with proceeds from the November 2017 private offering and private placement. We offset this decrease by increasing our long-term debt to finance the Greencraft, Bedrock, Tuscany, Summit and TAC acquisitions. Income Taxes. For the year ended December 31, 2018, we recognized income tax expense of $1.0 million, a decrease of $2.3 million from income tax expense of $3.3 million for the year ended December 31, 2017. Our deferred tax assets were revalued as a result of the Tax Cuts and Jobs Act in December 2017, which resulted in a $5.3 million increase to income tax expense in 2017. Net (Loss) Income. For the year ended December 31, 2018, net loss decreased by $8.8 million to $2.5 million, from $11.3 million for the year ended December 31, 2017. Adjusted EBITDA. For the year ended December 31, 2018, Adjusted EBITDA increased to $54.4 million, from $47.0 million for the year ended December 31, 2017, as a result of $7.7 million in organic growth and $13.7 million of incremental operating profit from acquisitions, partially offset by $14.0 million of additional cost and investments in SIC infrastructure as a new public company, establishing M&A resources, and increased cost of revenue and operating expenses in both operating segments. Adjusted EBITDA Margin. For the year ended December 31, 2018, Adjusted EBITDA margin decreased to 11.1%, from 13.3% for the year ended December 31, 2017. The decrease in the Adjusted EBITDA margin was primarily due to investments in SIC for public company infrastructure, establishing a business development function, certain acquisitions by ASG that have slightly lower margins than ASG’s legacy business, and increased costs of revenue and operating expenses in both operating segments. Liquidity and Capital Resources Working capital is the largest element of our capital needs, as inventory and receivables are our most significant investments. We also require funding for acquisitions, to cover ongoing operating expenses, and to meet required obligations related to financing, such as lease payments and principal and interest payments. Our capital resources primarily consist of cash from operations and borrowings under our revolving credit facilities, capital equipment leases, and operating leases. As our revenue and profitability have improved during the recovery of the housing market, we have used increased borrowing capacity under our revolving credit facilities to fund working capital needs. We have utilized capital leases and secured equipment loans to finance our vehicles and equipment needed for both replacement and expansion purposes. As of December 31, 2019, we had $5.0 million of cash and cash equivalents and $75.6 million of available borrowing capacity under our revolving credit facilities. Based on our positive cash flow, our ability to effectively manage working capital needs, and available borrowing capacity, we believe that we have sufficient funding available to finance our operations. Financing Sources; Debt SIC Credit Facility In June 2018, the Company and certain of its subsidiaries entered into an amended and restated loan, security and guaranty agreement, dated as of June 28, 2018, which was amended on December 11, 2018, July 23, 2019 and August 19, 2019 (which we refer to as the “SIC Credit Facility”), with Bank of America, N.A. The SIC Credit Facility is used by the Company, including both RDS and ASG, for operational purposes. Pursuant to the SIC Credit Facility, the Company has a borrowing-base-governed revolving credit facility that provides for borrowings of up to an aggregate of $100 million (after it was increased by $10 million through the amendment entered into on August 19, 2019). All revolving loans under the SIC Credit Facility are due and payable in full on June 28, 2023, subject to acceleration upon certain conditions. The Company is required to meet certain financial and nonfinancial covenants pursuant to the SIC Credit Facility. The Company was in compliance with all financial and nonfinancial covenants as of December 31, 2019. As of December 31, 2019, $22.2 million of indebtedness was outstanding under the SIC Credit Facility. The Company also had $0.4 million of outstanding letters of credit under the SIC Credit Facility at December 31, 2019. Term Loan Facility On February 28, 2017, AG&M and Pental, as the borrowers, entered into a financing agreement, as amended, with third party lenders (which we refer to as the “Term Loan Facility”), which initially provided for a $105.0 million term loan facility. The Term Loan Facility was amended in June 2018 to define the borrowers as Select Interior Concepts, Inc. and its subsidiaries. The Term Loan Facility was subsequently amended in December 2018 to increase the borrowing capacity to $174.2 million and in July 2019 to amend certain covenants. On August 19, 2019, the Term Loan Facility was further amended, resulting in an adjusted rate of interest payable on borrowings under the Term Loan Facility. Additionally, the August 19, 2019 amendment imposes a prepayment premium with respect to an optional prepayment of the term loans under the Financing Agreement occurring within fifteen months of August 19, 2019 (other than prepayments in connection with a change of control) in an amount equal to 1.50% of any such principal amount prepaid. All term loans under the Term Loan Facility are due and payable in full on February 28, 2023, subject to acceleration upon certain conditions. The Company is required to meet certain financial and nonfinancial covenants pursuant to the Term Loan Facility. The Company was in compliance with all financial and nonfinancial covenants as of December 31, 2019. As of December 31, 2019, approximately $153.8 million of indebtedness was outstanding under the Term Loan Facility. Vehicle and Equipment Financing We have used various secured loans and leases to finance our acquisition of vehicles and equipment. As of December 31, 2019, approximately $10.2 million of indebtedness was outstanding under vehicle and equipment loans and capital leases. Historical Cash Flow Information Working Capital Inventory and accounts receivable represent approximately 75% of our tangible assets as of December 31, 2019, and accordingly, management of working capital is important to our businesses. Working capital (defined as current assets less current liabilities, excluding debt and cash) totaled $113.4 million at December 31, 2019, compared to $100.2 million at December 31, 2018. Working capital levels have increased primarily due to the Intown acquisition and the decrease in earn-out liabilities. In our RDS segment, for the year ended December 31, 2019, working capital increased by $17.8 million to $34.7 million, compared to $16.9 million for the year ended December 31, 2018. This increase is primarily due to the decrease in accrued liabilities related to earn-out obligations and an increase in working capital due to the acquisition of Intown. In our ASG segment, for the year ended December 31, 2019, working capital decreased by $5.2 million to $79.7 million, compared to $84.9 million for the year ended December 31, 2018. This decrease was largely due to accounts receivable decreases and an increase in accounts payable due to timing of payments. Cash Flows Provided by Operating Activities Net cash provided by operating activities was $31.0 million and $12.2 million for the years ended December 31, 2019 and 2018, respectively. Net income (loss) was $7.0 million and $(2.5) million for the years ended December 31, 2019 and 2018, respectively. Adjustments for noncash expenses included in the calculation of net cash provided by operating activities, including amortization and depreciation, changes in deferred income taxes and other noncash items, totaled $23.1 and $21.8 million for the years ended December 31, 2019 and 2018, respectively. Changes in operating assets and liabilities resulted in net cash provided (used) of $0.9 million and $(7.1) million for the years ended December 31, 2019 and 2018, respectively. Cash Flows Used in Investing Activities For the year ended December 31, 2019, cash flow used in investing activities was $24.7 million, with $11.5 million resulting from our investments in acquisitions, $1.0 million for the indemnity payment related to the Bedrock acquisition, and $3.0 million for the escrow payment related to the Greencraft acquisition. Capital expenditures for property and equipment, net of proceeds from disposals, totaled $9.1 million. For the year ended December 31, 2018, cash flow used in investing activities was $80.6 million, with $72.1 million resulting from our investments in acquisitions. Capital expenditures for property and equipment, net of proceeds from disposals, totaled $8.5 million. Cash Flows (Used in) / Provided by Financing Activities Net cash (used) provided by financing activities was $(10.7) million and $72.2 million for the years ended December 31, 2019 and 2018, respectively. Cash flows used in financing activities supported our acquisition strategies. For the year ended December 31, 2019, we borrowed an additional $11.5 million in term debt to fund the Intown acquisition and made principal payments of $1.9 million, for a net increase in term debt of $9.6 million. We also received $2.7 million in an ERP financing transaction. During the year ended December 31, 2019, aggregate net payments on the SIC Credit Facility were $14.9 million and payments on notes payable were $1.9 million. We also classified $5.8 million of the total $8.0 million Greencraft earn-out payment as a financing activity, as this was the fair value of the contingent liability accrued at purchase. For the year ended December 31, 2018, we borrowed an additional $57.2 million in term debt, with debt issuance costs of $0.5 million, and made principal payments of $2.5 million. Aggregate net borrowings on the SIC Credit Facility were $17.9 million, with issuance costs of $0.5 million. Proceeds from employee stock purchases were $0.6 million. Contractual Obligations In the table below, we set forth our enforceable and legally binding obligations as of December 31, 2019. Some of the amounts included in the table are based on management’s estimates and assumptions about these obligations, including their duration, the possibility of renewal, anticipated actions by third parties, and other factors. Because these estimates and assumptions are necessarily subjective, our actual payments may vary from those reflected in the table. (1) Long-term debt obligations include principal payments on our term loans as well as our notes payable. Long-term debt obligations do not include interest or fees on the unused portion of our revolving letters of credit or financing fees associated with the issuance of debt. (2) Capital lease obligations include minimum lease payments on capital leases for vehicles and equipment purchased. (3) We lease certain locations, including, but not limited to, corporate offices, warehouses, fabrication shops, and design centers. For additional information, see Note 11-Commitments and Contingencies to our consolidated financial statements included in this Annual Report. (4) These amounts take into account a contract with a supplier of engineered stone on an exclusive basis in certain states within the United States. As part of the terms of the exclusive right to distribute the products provided under the contract, we are obligated to take delivery of a certain minimum amount of product from this supplier. If we fall short of these minimum purchase requirements in any given calendar year, we have agreed to negotiate with the supplier to arrive at a mutually acceptable resolution. There are no financial penalties to us if such commitments are not met; however, in such a case, the supplier has reserved the right, under the contract, to withdraw the exclusive distribution rights granted to us. The amount of the payment is estimated by multiplying the minimum quantity required under the contract by the average price paid in 2019. This amounts to approximately $37.4 million in 2020. In February 2020, a new exclusive rights agreement was entered into with the same vendor under similar terms, but with increased purchase obligation amounts through December 31, 2025. The total purchase obligation payments for less than 1 year increases from $39.4 million to $73.7 million and the obligations for 1-3 years increases from $2 million to $199.5 million as a result of the new agreement. The additional purchase obligation amount under the new agreement for 3-5 years is $282.7 million and more than 5 years is $184.6 million. For additional information, see Note 11-Commitments and Contingencies to our consolidated financial statements included in this Annual Report. In addition to the contractual obligations set forth above, as of December 31, 2019, we had an aggregate of approximately $22.2 million of indebtedness outstanding under the SIC Credit Facility. Off-Balance Sheet Arrangements As of December 31, 2019, with the exception of operating leases that we typically use in the ordinary course of business, we were not party to any material off-balance sheet financial arrangements that are reasonably likely to have a current or future effect on our financial condition or operating results. We do not have any relationship with unconsolidated entities or financial partnerships for the purpose of facilitating off-balance sheet arrangements or for other contractually narrow or limited purposes. Critical Accounting Policies and Estimates Management’s discussion and analysis of our financial condition and results of operations is based upon our consolidated financial statements, which have been prepared in accordance with GAAP. The preparation of our consolidated financial statements requires us to make estimates and assumptions that affect the reported amounts of assets, liabilities, revenues and expenses, and related disclosure of contingent assets and liabilities. Certain accounting policies involve judgments and uncertainties to such an extent that there is a reasonable likelihood that materially different amounts could have been reported using different assumptions or under different conditions. We evaluate our estimates and assumptions on a regular basis. We base our estimates on historical experience and various other assumptions that are believed to be reasonable under the circumstances, the results of which form the basis for making judgments about the carrying values of our assets and liabilities that are not readily apparent from other sources. Actual results may differ from these estimates and assumptions used in preparation of our consolidated financial statements. Revenue Recognition The Company’s revenue derived from the sale of imported granite, marble, and related items, primarily in our ASG operating segment, is recognized at a point in time when control over a product is transferred to a customer. This transfer occurs primarily when goods are picked up by a customer at the branch or when goods are delivered to a customer location. The Company’s contracts with its home builder customers within our RDS operating segment are usually short-term in nature and will generally range in length from several days to several weeks. The Company’s contracts related to multi-family and commercial projects are generally long-term in nature. We recognize revenue from both short-term and long-term contracts for each distinct performance obligation identified over time on a percentage-of-completion basis of accounting, utilizing the output method as a measure of progress, as we believe this represents the best measure of when goods and services are transferred to the customer. Revenue is measured at the transaction price, which is based on the amount of consideration the Company expects to receive in exchange for transferring the promised goods or services to the customer. The transaction price will include estimates of variable consideration, such as any returns and sales incentives. Applicable customer sales taxes, when remitted, are recorded as a liability and excluded from revenue on a net basis. In the fourth quarter of 2019, the Company adopted ASU 2014-09, the new accounting standard under ASC Topic 606, using the modified retrospective method as of January 1, 2019. Cost of Revenue RDS’s cost of revenue is comprised of the costs of materials and labor to purchase and install products for our customers. ASG’s cost of revenue primarily consists of purchased materials, sourcing fees for inventory procurement, and freight costs. RDS and ASG also include payroll taxes and benefits, workers’ compensation insurance, vehicle-related expenses and overhead costs, including rent, depreciation, utilities, property taxes, repairs and maintenance costs in the cost of revenue. Our cost of revenue is reduced by rebates provided by suppliers in the period the rebate is earned. Accounts Receivable Accounts receivable are recorded at net realizable value. We continually assess the collectability of outstanding customer invoices; and if deemed necessary, maintain an allowance for estimated losses resulting from the non-collection of customer receivables. In estimating this allowance, we consider factors such as: historical collection experience, a customer’s current creditworthiness, customer concentrations, personal guarantees, credit insurance, age of the receivable balance both individually and in the aggregate and general economic conditions that may affect a customer’s ability to pay. We have the ability to place liens against the significant amount of RDS customers in order to secure receivables. Actual customer collections could differ from our estimates. At December 31, 2019 and 2018, the allowance for doubtful accounts was $0.8 million and $0.5 million, respectively. Inventories Inventories consist of stone slabs, tile and sinks, and include the costs to acquire the inventories and bring them to their existing location and condition. Inventory also includes flooring, cabinets, doors and trim, glass, and countertops, which have not yet been installed, as well as labor and related costs for installations in process. Inventory is valued at the lower of cost (using the specific identification and first-in, first-out methods) or net realizable value. Intangible Assets Intangible assets consist of customer relationships, trade names and non-compete agreements. We consider all our intangible assets to have definite lives and such intangible assets are amortized on the straight-line method over the estimated useful lives of the respective assets or on an accelerated basis based on the expected cash flows generated by the existing customers as follows: Business Combinations We record business combinations using the acquisition method of accounting. Under the acquisition method of accounting, identifiable assets acquired and liabilities assumed are recorded at their acquisition date fair values. The excess of the purchase price over the estimated fair value is recorded as goodwill. Changes in the estimated fair values of net assets recorded for acquisitions prior to the finalization of more detailed analysis, but not to exceed one year from the date of acquisition, will adjust the amount of the purchase price allocable to goodwill. Measurement period adjustments are reflected in the period in which they occur. Goodwill Goodwill represents the excess of the cost of an acquired entity over the fair value of the acquired net assets. We account for goodwill in accordance with FASB ASC topic 350, Intangibles-Goodwill and Other Intangible Assets, which among other things, addresses financial accounting and reporting requirements for acquired goodwill and other intangible assets having indefinite useful lives. ASC topic 350 requires goodwill to be carried at cost, prohibits the amortization of goodwill and requires us to test goodwill for impairment at least annually. We test for impairment of goodwill annually during the fourth quarter or more frequently if events or changes in circumstances indicate that the goodwill may be impaired. Events or changes in circumstances which could trigger an impairment review include a significant adverse change in legal factors or in the business climate, an adverse action or assessment by a regulator, unanticipated competition, a loss of key personnel, significant changes in the manner of our use of the acquired assets or the strategy for our overall business, significant negative industry or economic trends, or significant underperformance relative to expected historical or projected future results of operations. We identified RDS and ASG as reporting units and determined each reporting unit’s fair value substantially exceeded such reporting unit’s carrying value. There were no impairment charges related to goodwill for the years ended December 31, 2019 and 2018. Equity-based compensation We account for equity-based awards by measuring the awards at the date of grant and recognizing the grant-date fair value as an expense using either straight-line or accelerated attribution, depending on the specific terms of the award agreements over the requisite service or performance period, which is usually equivalent to the vesting period. Income Taxes The provision for income taxes is accounted for under the asset and liability method prescribed by ASC 740 (Topic 740, Income Taxes). Deferred tax assets and liabilities are recognized for the future tax consequences attributable to differences between the financial statement carrying amounts of existing assets and liabilities and their respective tax bases, operating losses and tax credit carryforwards. Deferred tax assets and liabilities are measured using the enacted tax rates expected to apply to taxable income in the years in which those temporary differences are expected to be recovered or settled. The effect on deferred tax assets and liabilities of a change in tax rates is recognized in income in the period the tax rate changes are enacted. We recognize the tax benefit from an uncertain tax position only if it is more likely than not the tax position will be sustained on examination by the taxing authorities, based on the technical merits of the position. The tax benefits recognized in the financial statements from such positions are then measured based on the largest benefit that has a greater than 50% likelihood of being realized upon settlement. On December 22, 2017, the Tax Cuts and Jobs Act (which we refer to as the “Tax Act”) was adopted into law. The Tax Act makes broad and complex changes to the Internal Revenue Code of 1986, including, but not limited to, (i) reducing the U.S. federal corporate tax rate from 35% to 21%; (ii) eliminating the corporate alternative minimum tax (“AMT”) and changing how existing AMT credits are realized; (iii) creating a new limitation on deductible interest expense; and (iv) changing rules related to uses and limitation of net operating loss carryforwards created in tax years beginning after December 31, 2017. Our policy is to recognize interest and/or penalties related to all tax positions as income tax expense. To the extent that accrued interest and penalties do not ultimately become payable, amounts accrued will be reduced and reflected as a reduction of the overall income tax provision in the period that such determination is made. We have recognized $0.4 million and $0.5 million in combined interest and penalties related to uncertain tax positions for the years ended December 31, 2019 and 2018, respectively. Recent Accounting Pronouncements See Note 1 - Organization and Business Description to our audited consolidated financial statements included in this Annual Report for a description of recent accounting pronouncements issued.

<s>[INST] OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS The following information should be read in conjunction with Item 6. “Selected Financial Data” above and the accompanying consolidated financial statements and related notes included in this Annual Report. The following discussion may contain forwardlooking statements that reflect our plans, estimates, and beliefs. Our actual results could differ materially from those discussed in these forwardlooking statements. Factors that could cause or contribute to these differences include those factors discussed below and elsewhere in this Annual Report, particularly in the sections entitled “Special Note Regarding ForwardLooking Statements and Information” and “Risk Factors” included elsewhere in this Annual Report. Overview Select Interior Concepts, Inc. (collectively with all of its subsidiaries, “SIC,” the “Company,” “we,” “us” and “our”) is an installer and nationwide distributor of interior building products with market positions in residential interior design services. Through our Residential Design Services (which we refer to as “RDS”) operating segment, we serve national and regional homebuilders by providing an integrated, outsourced solution for the design, consultation, sourcing, distribution and installation needs of their homebuyer customers. Through our 18 design centers, our designers work closely with homebuyers in the selection of a broad array of interior products and finishes, including flooring, cabinets, countertops, wall tile, and related interior items, primarily for newly constructed homes. We then coordinate the ordering, fulfillment and installation of many of these interior product categories to provide for the homebuyer. With our design centers and our product sourcing and installation capabilities, we enable our homebuilder customers to outsource critical aspects of their business to us, thereby increasing their sales, profitability, and return on capital. We also have leading market positions in the selection and importation of natural and engineered stone slabs for kitchen and bathroom countertops and specialty tiles through our other operating segment, Architectural Surfaces Group (which we refer to as “ASG”). ASG sources natural and engineered stone from a global supply base and markets these materials through a national network of 23 distribution centers and showrooms. In addition to serving the new residential and commercial construction markets with these materials, we also distribute them to the repair and remodel (which we refer to as “R&R”) market. Operating Segments We have defined each of our operating segments based on the nature of its operations and its management structure and product offerings. Our management decisions are made by our Chief Executive Officer, whom we have determined to be our Chief Operating Decision Maker. Our two reportable segments are described below. Residential Design Services RDS, our interior design and installation segment, is a service business that provides design center operation, interior design, product sourcing, and installation services to homebuilders, homeowners, general contractors and property managers. Products sold and installed by RDS include flooring, countertops, cabinets, and wall tile. New singlefamily and multifamily construction are the primary end markets, although we intend to explore growth opportunities in other markets, such as the R&R market. Architectural Surfaces Group ASG, our natural and engineered stone countertop distribution segment, distributes granite, marble, porcelain and quartz slabs for countertop and other uses, and ceramic and porcelain tile for flooring and backsplash and wall tile applications. Primary end markets are new residential and commercial construction and the R&R market. Key Factors Affecting Operating Results Our operating results are impacted by changes in the levels of new residential construction and of the demand for products and services in the R&R market. These are in turn affected by a broad range of macroeconomic factors including the rate of economic growth, unemployment, job and wage growth, interest rates, multifamily project financing, and residential mortgage lending conditions. Other important underlying factors include demographic variables such as household formation, immigration and aging trends, housing stock and vacant inventory levels, changes in the labor force, raw materials prices, the legal environment, and local and regional development and construction regulation. Material Costs The materials that we distribute and install are sourced through a wide array of quarries, manufacturers, and distributors located in North America, South America, Europe, Africa and Asia. As demand for these products continues to grow [/INST] Negative. </s>

Eventbrite, Inc.

2019-03-07

2018-12-31

Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations The following discussion and analysis of our financial condition and results of operations should be read in conjunction with the information set forth under "Selected Financial Data" and our consolidated financial statements and related notes included elsewhere in this Annual Report on Form 10-K.In addition to historical financial information, the following discussion and analysis contains forward-looking statements that are based upon current plans, expectations and beliefs that involve risks and uncertainties. Our actual results may differ materially from those anticipated in these forward-looking statements as a result of various factors, including those set forth under “Risk Factors” in this Annual Report on Form 10-K. Our fiscal year ends December 31. Our Business We built a powerful, broad technology platform to enable creators to solve the challenges associated with creating live experiences. Our platform integrates components needed to seamlessly plan, promote and produce live events, thereby allowing creators to reduce friction and costs, increase reach and drive ticket sales. By reducing risk and complexity, we allow creators to focus their energy on producing compelling and successful events. We charge creators on a per-ticket basis when an attendee purchases a paid ticket for an event. We grow with creators as their attendance grows and as they plan, promote and produce more events. In 2018, we helped more than 790,000 creators issue approximately 265 million tickets across approximately 3.8 million events in over 170 countries. We derive substantially all of our revenue from fees associated with the sale of tickets on our platform, inclusive of payment processing. Our fee structure typically consists of a fixed fee and a percentage of the price of each ticket sold by a creator. Fees associated with the sale of tickets on our platform are gross ticket fees, which we define as the total fees generated from paid ticket sales, before adjustments for refunds, credits and amortization of non-recoupable creator signing fees. Our Business Model The key elements of our business model are: Efficiently Acquire Creators We are highly focused on creating a seamless experience that attracts creators to our platform organically. More than 98% of creators who used our platform in 2018 signed themselves up for Eventbrite and in 2018, we derived 56% of our net revenue from these creators. We attract creators to our platform through multiple means, including prior experience as attendees, word of mouth from other creators, our prominence in search engine results, the ability to try our platform for free events and our library of content. We augment these channels with a highly-targeted direct sales effort that focuses on acquiring creators with events in specific categories or countries. We leverage this efficient customer acquisition model to attract a wide range of creators to Eventbrite while keeping our sales and marketing costs low. Substantially all creators go on to create and manage events with little service or support. Provide High-Quality Solutions at a Cost Advantage We deliver our solutions on a cloud-based architecture that allows us to serve a wide variety of creators on a single global system, thereby reducing our operating and support costs. Our cloud-based platform does not require us to own or operate data centers or proprietary on-premises equipment. Additionally, our highly-automated platform requires limited service and support staff. All of this frees up capital and other resources to dedicate to enhancing our platform and growing our business. Our platform is extensible and modular, allowing us to efficiently improve and expand our services, as well as partner with third parties to deliver the best experience possible for creators. Drive Powerful Retention When creators enjoy success on Eventbrite, they continue to use our platform. This happens because we are able to meet their diverse and changing needs through a creator-focused approach. Our platform scales with creators, able to handle their smallest gatherings to their largest and most complex events. As creators’ needs evolve, our platform’s breadth and extensibility allow access to a full suite of solutions, enhanced by third-party integrated offerings. Further, we continually invest to deliver new and enhanced functionality. Our success in serving creators is reflected in our retention rate, which was 100%, 97% and 93% in 2018, 2017 and 2016, respectively. Enhance Growth and Monetization We believe that there are many opportunities within the fragmented event management market to expand both core ticketing and complementary solutions. We designed our business model and technology platform to take advantage of this opportunity by ensuring we can support the addition of new event categories and countries for ticketing, as well as new revenue-generating solutions beyond ticketing. For example, we evolved our platform to meet the needs of music creators, helping to grow music venues on our platform from less than 100 in 2012 to over 1,000 in 2018, inclusive of acquisitions. Similarly, after making enhancements across our platform, net revenue from outside of the United States grew from 18% to 30% from 2012 to 2017, and was 27.4% in 2018. Finally, EPP uses multiple external vendors to provide a single, seamless payments option for creators and attendees, and has expanded to allow the use of multiple local payment methods like Boleto in Brazil and iDeal in the Netherlands. This offering has grown to support approximately 90% of paid tickets in both 2017 and 2018. We believe that our ability to extend into new event categories and countries and add new revenue streams differentiates us from our competitors. Our Attractive Cohort Economics The revenue we have generated from new creators has increased over time. We evaluate this trend by tracking annual cohorts of new creators. Each creator cohort consists of creators that first paid us a fee in a specific year. The gross ticket fees we have generated for the first year of each creator cohort has more than doubled from 2013 to 2018. We have demonstrated a consistent track record of retaining gross ticket fees from creator cohorts over time. For example, we retained 81% of the gross ticket fees from our 2014 creator cohort in 2018. Key Factors Affecting Our Performance We believe that the growth of our business and our future success are dependent upon many factors. While each of these areas presents significant opportunities for us, they also pose important challenges that we must successfully address in order to sustain the growth of our business and improve our results of operations. Attract New Creators and Retain Existing Creators Attracting new creators to our platform and retaining existing creators drives our revenue growth. We expect to continue to invest in our brand and marketing to attract more new creators, while simultaneously developing our platform to delight and retain existing creators. Our ability to attract new creators and retain existing creators is impacted by how our features and functionality develop, our pricing, the creator and attendee experience on our platform, our brand awareness among the professional creator community, our search engine prominence, the quality and audience for our professional content, the continued transition of creators from using our platform for free events to paid events and solutions and the effectiveness of our direct sales efforts. We must continue to attract new creators and retain existing creators to maintain our current business as well as continue to drive growth in the future. Enhance and Expand Our Technical Platform We strive to provide a platform that provides creators with a seamless experience both to sign up for and publish live events. We initially started with a core ticketing platform and over time we have added meaningful capabilities to our platform, such as expansion into new categories or countries, packages that better target particular creator types, and new solutions like payment processing, custom-designed websites and proprietary technology for the day of the event. We intend to continue to invest in our platform to develop additional functionality and solutions. If we do not enhance our platform with the functionalities that are desired by creators and if we are not able to provide easy-to-use solutions required by creators in an efficient manner, our ability to attract and retain creators will be harmed. Invest Capital to Drive Additional Growth Opportunities We have and will continue to invest in our business, including solutions on our platform separate from generating fees from the sale and processing of tickets, such as web presence, promoted listing and on-site services and equipment. These efforts target both expanding how we serve creators as well as enhancing the benefits of our platform for attendees. We have invested $18.4 million, $10.6 million and $4.8 million in 2018, 2017 and 2016, respectively, in these complementary solutions on our platform and have generated less than five percent of our net revenue from such solutions during these periods. While our investments are based on a careful and deliberate planning process, there is no guarantee that we will choose the right investments, or that those investments pay off for us. If we are unable to effectively invest in developing new solutions, our business may be harmed. Competitive Landscape We operate in a space that is fragmented with many types of competitors, including traditional offline alternatives, internal systems, category-based competitors who operate in a single geography or region, and smaller platform providers. While we believe we have differentiated our business from these competitors by building a powerful and broad technology platform for creators, we must continue to respond to competitive pressures. Consequently, we will need to continue to invest in this platform to differentiate our business and remain competitive, as well as respond to shifts in industry pricing levels, revenue models or business practices. Further, our industry is evolving and our business may be impacted if we face additional competition from new entrants into the market, such as large advertising or e-commerce providers. International Expansion Our paid tickets for events outside of the United States represented 34.1%, 36.0% and 30.3% of our total paid tickets in 2018, 2017 and 2016, respectively. Net revenue outside the United States during 2018, 2017 and 2016 was 27.4%, 30.0% and 27.0%, respectively, of our total net revenue. As we deepen our global penetration, we believe international demand for our platform and solutions will continue to increase. Accordingly, we believe there is significant opportunity to grow our international business. We have invested, and plan to continue to invest, in the adoption of our platform and solutions internationally, including localization of our platform and the addition of critical capabilities to our platform required to serve those local markets. Further, our international business delivers higher gross margins, primarily because of lower payment processing expenses. If we are not able to effectively address the risk associated with international expansion, such as product-market fit in a given geography, currency fluctuation or unique factors in a specific market, our business and results of operations may be harmed. Acquisitions In January 2017, we acquired 100% of the outstanding equity of TSTM Group Limited (ticketscript), a Dutch ticketing company with operations throughout Europe. We acquired ticketscript in order to enhance our ticketing solutions. The acquisition date fair value of the consideration transferred was $33.4 million, which consisted of $7.7 million in cash, $7.5 million in promissory notes and 2.7 million shares of our common stock and options to purchase 0.3 million shares of our common stock. These promissory notes were allowed to be prepaid at any time and we repaid the promissory notes in full, including accrued interest, in August 2017. In September 2017, we acquired 100% of the outstanding equity of Ticketfly, LLC (Ticketfly), a subsidiary of Pandora Media, Inc. We acquired Ticketfly in order to expand our solutions for music-related events. The acquisition date fair value of the consideration transferred was $201.1 million, which consisted of $151.1 million in cash and $50.0 million in the form of convertible promissory notes which were paid and issued, respectively, at the closing of the transaction. We repaid these notes in March 2018. In April 2018, we acquired Ticketea S.L. (Ticketea), a leading Spanish ticketing provider. We acquired Ticketea in order to enhance our ticketing solutions and expand in the Spanish market. The acquisition of Ticketea has been accounted for as a business combination. The acquisition date fair value of the consideration transferred was $11.4 million, which consisted of $3.6 million in cash and 0.7 million shares of our common stock. Of the 0.7 million shares, 0.1 million shares are being held in escrow for adjustments related to working capital requirements and breaches of representations, warranties and covenants. These escrowed shares will be released approximately 18 months from the acquisition date, net of any adjustments. In August 2018, we acquired Picatic E-Ticket Inc. (Picatic), a Vancouver-based ticketing and event registration platform, for a purchase price of CAD $1.8 million in cash and 0.1 million shares of our common stock, less certain adjustments and holdbacks, including adjustments related to working capital requirements and breaches of representations, warranties and covenants. For more information regarding our acquisitions of ticketscript, Ticketfly, Ticketea and Picatic, refer to Note 3 of our Notes to our Consolidated Financial Statements included in Part II, Item 8, "Financial Statements and Supplementary Data" of this Annual Report on Form 10-K. Key Business Metrics We monitor the following key metrics to help us evaluate our business, identify trends affecting our business, formulate business plans and make strategic decisions. Paid Tickets Our success in serving creators is measured in large part by the number of tickets that generate ticket fees. We consider this an important indicator of the underlying health of the business. We refer to these tickets as paid tickets. The below table sets forth the number of paid tickets for the periods indicated: Retention Rate When creators experience success on our platform, they continue to organize events with us. We monitor retention of our gross ticket fees to measure our ability to retain creators on our platform. To obtain our retention rate, we determine (i) the gross ticket fees generated by all creators in the year prior to the year of measurement (Prior Year Gross Ticket Fees) and (ii) the gross ticket fees those creators generated in the applicable year of measurement (Measurement Year Gross Ticket Fees). We calculate our retention rate for a measurement year by dividing the Measurement Year Gross Ticket Fees by the Prior Year Gross Ticket Fees. We calculate retention rate on an annual basis only. While we have seen a strong retention rate from creators, this measure may fluctuate from period to period based on the success of creators and the events that they produce. Non-GAAP Financial Measures Adjusted EBITDA Adjusted EBITDA is a key performance measure that our management uses to assess our operating performance. Because Adjusted EBITDA facilitates internal comparisons of our historical operating performance on a more consistent basis, we use this measure for business planning purposes and in evaluating acquisition opportunities. We calculate Adjusted EBITDA as net loss attributable to common stockholders adjusted to exclude depreciation and amortization, stock-based compensation expense, interest expense, the change in fair value of our redeemable convertible preferred stock warrant liability, gain on extinguishment of promissory note, direct and indirect acquisition-related costs, income tax provision (benefit) and other income (expense), which consisted of interest income and foreign exchange rate gains and losses. Adjusted EBITDA should not be considered as an alternative to net loss or any other measure of financial performance calculated and presented in accordance with GAAP. The following table presents our Adjusted EBITDA for the years ended December 31, 2018, 2017 and 2016: For more information about Adjusted EBITDA, including the limitations of such measure, and a reconciliation to net loss, see Item 6, "Selected Financial Data" included in Part II of this Annual Report on Form 10-K. Free Cash Flow Free cash flow is a key performance measure that our management uses to assess our overall performance. We consider free cash flow to be a liquidity measure that provides useful information to management and investors about the amount of cash generated by our business that can be used for strategic opportunities, including investing in our business, making strategic acquisitions and strengthening our financial position. We calculate free cash flow as cash flow from operating activities less purchases of property and equipment and capitalized internal-use software development costs, over a trailing twelve-month period. Because quarters are not uniform in terms of cash usage, we believe a trailing twelve-month view provides the best understanding of the underlying trends of the business. The following table presents our free cash flow for the years ended December 31, 2018, 2017 and 2016: For more information about free cash flow, including the limitations of such measure, and a reconciliation to operating cash flow, see Item 6, "Selected Financial Data" included in Part II of this Annual Report on Form 10-K. Components of Results of Operations Net Revenue We generate substantially all of our net revenue through the sale of paid tickets on our platform. Our fee structure typically consists of a fixed fee and a percentage of the price of each ticket sold by a creator. Net revenue is recognized as tickets are sold. Net revenue excludes sales taxes and value added taxes (VAT) and is presented net of estimated customer refunds, chargebacks and amortization of creator signing fees. We also generate a small portion of our net revenue from complementary solutions, such as day-of-event on-site product and services, web presence development and branding, software solutions to manage event venue administration and marketing services, that we provide to creators. These complementary solutions represented less than five percent of our net revenue in the aggregate in each of the years ended December 31, 2018, 2017 and 2016. We treat net revenue and paid tickets from an acquired business after the one-year anniversary of the completion of such acquisition as being transacted on the Eventbrite platform. For example, the acquisition of Ticketfly closed on September 1, 2017, and as such, we considered any net revenue and paid tickets transacted on the Ticketfly platform on or after September 1, 2018 as being net revenue and paid tickets on the Eventbrite platform. Cost of Net Revenue Cost of net revenue consists primarily of payment processing fees, expenses associated with the operation and maintenance of our platform, including website hosting fees and platform infrastructure costs, amortization of capitalized software development costs, onsite operations costs and allocated customer support costs. Cost of net revenue also includes the amortization expense related to our acquired developed technology assets. We expect to continue to incur amortization expense related to our acquired developed technology assets through the end of 2018 for prior acquisitions. We may incur such expense related to future acquisitions in future periods. We expect cost of revenue as a percentage of revenue to fluctuate in the near- to mid-term primarily as a result of our geographical revenue mix. Our payment processing costs for credit and debit card payments are generally lower outside of the United States due to a number of factors, including lower card network fees and lower cost alternative payment networks. Consequently, if we grow more rapidly internationally than in the United States, we expect that our payment processing costs will decline as a percentage of revenue. Thus, in the long-term, we expect cost of revenue to grow in absolute dollars but decrease as a percentage of revenue. Operating Expenses Operating expenses consist of product development, sales, marketing and support and general and administrative expenses. Direct and indirect personnel costs, including stock-based compensation expense, are the most significant component of operating expenses. We also include sublease income as a reduction of our operating expenses. Product development. Product development expenses consist primarily of costs associated with our employees in product development and product engineering activities. We expect our product development expenses to continue to increase in absolute dollars over time. In the near-term, we anticipate our product development expenses will increase as a percentage of net revenue as we focus our product development efforts on enhancing, improving and expanding the capabilities of our platform. We expect that we will continue to invest in building employee and system infrastructure to enhance and support development of new technologies and to integrate acquired businesses and technologies. We expect that the addition of our Madrid and Vancouver creative hubs in 2018, resulting from the Ticketea and Picatic acquisitions, respectively, will contribute to higher product development expenses in absolute dollars and as a percentage of revenue in the near-term, but over the long-term, we anticipate that it will decrease as a percentage of net revenue as our revenue grows and as we continue to grow our development staff in lower cost markets. Sales, marketing and support. Sales, marketing and support expenses consist primarily of costs associated with our employees involved in selling and marketing our products, public relations and communication activities, marketing programs, travel and customer support costs associated with free events on our platform. For our sales teams, this also includes commissions. We also classify certain organizer related expenses, such as refunds of the ticket price paid by us on behalf of a creator as sales, marketing and support expense. Sales, marketing and support expenses are driven by investments to grow and retain creators and attendees on our platform. We expect sales, marketing and support expenses to increase in absolute dollars over time. In the near-term, we anticipate sales, marketing and support expenses will fluctuate as a percentage of net revenue, but over the long-term we anticipate that it will decrease as a percentage of net revenue as we expect to see continued growth in net revenue generated from creators that signed up with us through our efficient customer acquisition channels, such as word of mouth referrals, converting free creators to paid creators and converting attendees into creators. We spend a comparatively small portion of our sales, marketing and support costs on these customer acquisition channels. We believe that, in the long-term, our sales, marketing and support expenses will decrease as a percentage of net revenue as we continue to drive sales through these efficient customer acquisition channels. General and administrative. General and administrative expenses consist of personnel costs for finance, accounting, legal, risk, human resources and administrative personnel. It also includes professional fees for legal, accounting, finance, human resources and other corporate matters. Our general and administrative expenses currently include two large non-compensation items: (i) amortization of acquired customer relationship and trade names assets and (ii) reserves for sales tax and VAT accrued on behalf of creators. Our general and administrative expenses have increased on an actual dollar basis over time and we expect general and administrative expenses to continue to increase in absolute dollars over time, however, we do anticipate general and administrative expenses will fluctuate as a percentage of net revenue as we expect to incur additional expenses to support our growth as we mature as a publicly-traded company and as we scale our business. Interest Expense Interest expense relates to our build-to-suit lease financing obligation and outstanding debt. As a result of our build-to-suit lease accounting, a portion of our cash rent payments related to our San Francisco office are classified as interest expense for GAAP reporting purposes. We reported interest expense of $3.4 million, $3.5 million and $3.5 million for each of the years ended December 31, 2018, 2017 and 2016 related to build-to-suit accounting. Other outstanding debt has been historically related to acquisitions, either as part of consideration or to finance cash consideration for an acquisition. In January 2017, we issued $7.5 million in promissory notes in connection with the ticketscript acquisition. These promissory notes plus accrued interest were fully repaid in August 2017. In September 2017, we issued $50.0 million subordinated convertible notes in connection with the Ticketfly acquisition. Also, in September 2017, we borrowed $30.0 million under the First WTI Loan Facility. The subordinated convertible notes were repaid in March 2018 at a discount to issuance, funded in part by an additional draw of $30.0 million against our First WTI Loan Facility. We drew an additional $15.0 million under the Second WTI Loan Facility in May 2018. The amounts borrowed under the WTI Loan Facilities were fully repaid in September 2018 and the underlying agreements were terminated. Also in September 2018, we borrowed $75.0 million in New Term Loans under our Credit Agreement. Change in Fair Value of Redeemable Convertible Preferred Stock Warrant Liability The redeemable convertible preferred stock warrant is classified as a liability on our consolidated balance sheet and remeasured to fair value at each balance sheet date with the corresponding charge recorded as a change in fair value of redeemable convertible preferred stock warrant liability on the consolidated statements of operations. In connection with our IPO, all warrants were automatically exercised for no consideration, thus we will not have a redeemable convertible preferred stock warrant liability in future periods subject to fair value adjustment. Loss on debt extinguishment Loss on debt extinguishment consists of amounts recorded related to our accounting for the retirement of our debt obligations. Other Income (Expense), Net Other income (expense), net consists of interest income, foreign exchange rate remeasurement gains and losses recorded from consolidating our subsidiaries each period-end and changes in fair value of the term loan embedded derivatives. Income Tax Provision (Benefit) Income tax provision (benefit) consists primarily of U.S. federal and state income taxes and income taxes in certain foreign jurisdictions in which we conduct business. The differences in the tax provision and benefit for the periods presented and the U.S. federal statutory rate is primarily due to foreign taxes in profitable jurisdictions and the recording of a full valuation allowance on our deferred tax assets and certain foreign losses which benefit from rates lower than the U.S. federal statutory rate. We apply the discrete method provided in ASC 740 to calculate our interim tax provision. Results of Operations The results of operations presented below should be reviewed in conjunction with the consolidated financial statements and notes included elsewhere in this Annual Report. The following tables set forth our consolidated results of operations data and such data as a percentage of net revenue for the periods presented: Comparison of 2018 and 2017 Net revenue The increase in net revenue during 2018 compared to 2017 was driven primarily by growth in paid ticket volume, which increased by 37% during 2018 compared to 2017, from 71.0 million to 97.3 million. We measure acquired revenue as revenue generated from an acquired business in the first twelve months subsequent to the acquisition date. Acquired revenue increased to $36.0 million in 2018 compared to $27.5 million in 2017, driven by paid ticket volume growth from acquired businesses. Our revenue growth was strengthened by the impact of our packages launch in the fourth quarter of 2017 and by our successful migration of clients from acquired platforms to the Eventbrite platform. Net revenue per paid ticket increased during 2018 compared to 2017 from $2.84 per paid ticket to $3.00 per paid ticket. This was driven by the launch of pricing packages in our self sign-on channels, improvements in fees per ticket in our sales channels and the impact of acquired businesses. Cost of net revenue The increase in cost of net revenue during 2018 compared to 2017 was primarily due to an increase in payment processing costs of $20.7 million driven by our paid ticket growth. Additionally, there was an increase in amortization of acquired developed technology of $6.8 million, primarily resulting from the Ticketfly acquisition, and increases in platform operations costs of $3.1 million, onsite operations costs of $3.1 million and allocated customer support costs of $2.8 million. The Ticketfly acquired developed technology asset was fully amortized in the fourth quarter of 2018, which will benefit our gross margin moving forward. Operating expense Product development The increase in product development expense during 2018 compared to 2017 was primarily due to increased personnel costs of $14.2 million, including $2.6 million of stock-based compensation, resulting from our ongoing hiring efforts and an increase in headcount as a result of the Ticketfly, Ticketea and Picatic acquisitions. Sales, marketing and support The increase in sales, marketing and support expenses during 2018 compared to 2017 was primarily due to increased personnel-related expenses of $13.9 million, including $1.4 million of stock-based compensation, driven by higher headcount. There was also an increase of $1.9 million in creator related expenses. These increases were partially offset by lower direct marketing spend in 2018 compared to 2017. General and administrative The increase in general and administrative expenses during 2018 compared to 2017 was a result of several factors. Personnel costs increased by $25.8 million, including $14.8 million of stock-based compensation, driven by increased headcount during 2018 compared to 2017. Amortization of acquired intangible assets increased $6.3 million primarily stemming from the Ticketfly acquisition. Contractor costs increased $2.2 million primarily for accounting services. These increases were partially offset by a decrease of $14.1 million from the reversal of sales tax reserves due to cumulative reserve remeasurements in the year ended December 31, 2018. We also recorded $6.6 million related to insurance proceeds to be received from the Ticketfly cyber incident as a reduction of expense in the year ended December 31, 2018. Interest expense The increase in interest expense during 2018 compared to 2017 was driven by higher amounts of interest bearing debt that was outstanding related to the WTI loan facilities and the JPM syndicate loan. Change in fair value of redeemable convertible preferred stock warrant liability The change in fair value of our redeemable convertible preferred stock warrant liability during 2018 compared to 2017 was due to a higher increase in the underlying fair value of our redeemable convertible preferred stock from January 1, 2018 to September 20, 2018 compared to June 1, 2017 to December 31, 2017. In connection with our IPO, the redeemable convertible preferred stock warrants were automatically converted into shares of our Class B common stock. Loss on debt extinguishment ________ * Not meaningful The loss on debt extinguishment recorded in the year ended December 31, 2018 was due to a gain of $17.0 million related to the extinguishment of the Pandora promissory notes offset by a loss of $17.2 million related to the retirement all outstanding debt under the WTI Loan Facilities. We retired no debt in 2017. Other income (expense), net The decrease in other income (expense), net during 2018 compared to 2017 was driven by foreign currency rate measurement fluctuations. We recognized foreign currency rate measurement gains during 2017 as a result of the weakening of the U.S. dollar compared to the currencies with which we operate and process transactions. We recognized foreign currency rate measurement losses during 2018 as a result of the overall strengthening of the U.S. dollar compared to the currencies with which we operate and process transactions. Partially offsetting these losses, we recognized a gain on the change in fair value of the term loan embedded derivative of $2.1 million in the year ended December 31, 2018. Income tax provision (benefit) ________ * Not meaningful The provision for income taxes increased $1.2 million in 2018 compared to 2017 and was primarily attributable to changes in our jurisdictional mix of earnings and tax amortization on indefinite-lived intangible assets recorded in connection with the Ticketfly acquisition, which was completed in September 2017. Comparison of 2017 and 2016 Net revenue The increase in net revenue during 2017 compared to 2016 was driven primarily by growth in paid ticket volume, which increased by 59.4% during 2017, from 44.6 million to 71.0 million in part due to ticket volume from acquired companies. Net revenue increased $27.5 million as a result of the Ticketfly and ticketscript acquisitions, which were completed in September 2017 and January 2017, respectively, and the remaining $40.6 million of growth was due to paid ticket growth on the Eventbrite platform. While net revenue and paid tickets increased year-over-year, net revenue per paid ticket decreased from $3.00 in 2016 to $2.84 in 2017. This decrease was driven by our pricing adjustments made in certain markets, which resulted in additional paid ticket volume, as well as an increase in the proportion of lower price tickets as our fees are partially based on the price of the tickets that creators sell to their events. Cost of net revenue The increase in cost of net revenue during 2017 compared to 2016 was primarily due to an increase in payment processing costs of $17.0 million driven by paid ticket growth on the Eventbrite platform and paid ticket volume from acquired businesses, and increased amortization of acquired developed technology of $4.6 million, resulting from the Ticketfly and ticketscript acquisitions. We also incurred increases in platform operational costs, onsite operations costs and allocated customer support costs. Operating expenses Product development The increase in product development expense during 2017 compared to 2016 was primarily due to increased personnel costs of $8.0 million, resulting from organic hiring efforts and an increase in headcount as a result of the Ticketfly and ticketscript acquisitions. Sales, marketing and support The increase in sales, marketing and support expenses during 2017 compared to 2016 was driven by increased personnel-related expenses of $7.4 million, driven by higher headcount, offset by lower professional services costs, creator related expenses and advertising spend as we leveraged our low-cost customer acquisition channels, such as word of mouth referrals, converting free creators to paid creators and converting attendees into creators. General and administrative The increase in general and administrative expenses during 2017 compared to 2016 was a result of several factors. Third-party legal, finance, tax and business development costs increased $5.2 million, driven by acquisitions we completed in 2017 as well as costs incurred as we prepared to become a publicly-traded company. We also incurred direct and indirect acquisitions-related expenses of $7.3 million related to the Ticketfly and ticketscript acquisitions. The increase was also attributable to higher depreciation and amortization of $5.7 million, of which $4.8 million related to acquired intangible assets. There was also an increase in accrued sales taxes and VAT of $4.8 million driven by higher paid ticket volume in 2017 compared to 2016. Interest expense The increase in interest expense during 2017 compared to 2016 was entirely driven interest bearing debt that was outstanding during 2017, related to promissory notes issued in connection with acquisitions and the term-debt draw under our WTI credit facilities. We did not have any outstanding debt prior to 2017. The interest expense recorded in 2016 is entirely related to our build-to-suit lease accounting for our office lease in San Francisco, California. Change in fair value of redeemable convertible preferred stock warrant liability ________ * Not meaningful The change in fair value of our redeemable convertible preferred stock warrant liability in 2017 was due to an increase in the underlying fair value of our redeemable convertible preferred stock. We did not have any redeemable convertible preferred stock warrants outstanding in 2016. Other income (expense), net ________ * Not meaningful The increase in other income (expense), net during 2017 compared to 2016 was driven by foreign currency rate measurement fluctuations. We recognized foreign currency rate measurement losses during 2016 as a result of an overall strengthening U.S. dollar compared to the currencies in which we operate and process transactions. During 2017, we recognized foreign currency rate measurement gains as a result of an overall weakening U.S. dollar compared to the currencies in which we operate and process transactions. Quarterly Results of Operations Data The following tables set forth our unaudited quarterly statements of operations data for each of the eight quarters in the period ended December 31, 2018. The information for each quarter has been prepared on a basis consistent with our audited consolidated financial statements included in this Annual Report on Form 10-K, and, in the opinion of management, includes all adjustments, which consist only of normal recurring adjustments, necessary for the fair statement of the results of operations for these periods. This data should be read in conjunction with our audited consolidated financial statements and related notes included in this Annual Report on Form 10-K. These quarterly results of operations are not necessarily indicative of the results we may achieve in any future period. The following table presents our paid ticket volume for each of the periods indicated: The following table presents a reconciliation of net income (loss) to Adjusted EBITDA for each of the periods indicated: The following table presents a reconciliation of free cash flow, which is computed on a trailing twelve-month basis, from net cash provided by operating activities for each of the periods indicated: Quarterly Trends Net revenue Our quarterly net revenue increased sequentially for all periods presented, except the second quarter of 2018, primarily due to increases in paid ticket volume, including the impact of our acquisitions. Historically, excluding the impact of acquired businesses, we have experienced a higher increase in sequential net revenue growth in the first quarter of a year compared to the sequential net revenue growth in other quarters of that year. We acquired Ticketscript in the first quarter of 2017 and Ticketfly in the third quarter of 2018. The decrease in quarterly net revenue in the second quarter of 2018 was a result of the contra-revenue amount of $6.3 million which we recognized related to the Ticketfly cyber incident. Cost of net revenue Our quarterly cost of net revenue increased for all periods presented, except the fourth quarter of 2018, primarily due to increases in payment processing costs resulting from our paid ticket volume growth. Operating expenses Our operating expenses increased for all periods presented, except for the first and fourth quarters of 2018, primarily due to increases in compensation and benefits driven by increases in headcount. In the fourth quarter of 2017, we recognized higher stock-based compensation expense across all operating expense categories as a result of the immediate vesting of certain awards granted to employees hired in connection with the Ticketfly acquisition, which was the primary driver of the decrease in operating expenses from the fourth quarter of 2017 to the first quarter of 2018.In the third quarter of 2018, we recognized $6.9 million in stock-based compensation expense related to the vesting of a stock award as a result of our IPO, which was the primary driver of the decrease in operating expenses from the third quarter of 2018 to the fourth quarter of 2018. Liquidity and Capital Resources As of December 31, 2018, we had cash of $437.9 million and funds receivable of $58.7 million. Our cash includes bank deposits held by financial institutions and is held for working capital purposes. Our funds receivable represents cash-in-transit from credit card processors that is received to our bank accounts within five business days of the underlying ticket transaction. Collectively, our cash and funds receivable balances represent a mix of cash that belongs to us and cash that is due to the creator. The amounts due to creators, which was $272.2 million as of December 31, 2018, are captioned on our consolidated balance sheets as accounts payable, creators. We also make payments to creators to provide the creator with short-term liquidity in advance of ticket sales. These are classified as creator advances, net, on our consolidated balance sheets. Creator advances are recovered by us as tickets are sold by the respective creator, and are expected to be recovered within 12 months of the payment date. We maintain an allowance for estimated creator advances that are not recoverable and nets this against the balance shown in assets. Creator advances, net was $21.3 million and $17.6 million as of December 31, 2018 and 2017, respectively. Creator advances that are not expected to be recovered within 12 months are classified as creator advances, noncurrent. Such balances were $1.9 million and $2.4 million as of December 31, 2018 and 2017, respectively. In September 2018, upon the completion of our IPO, we received aggregate proceeds of $246.0 million, net of underwriter discounts and commissions, before deducting offering costs of $5.5 million, net of reimbursements. Since our inception, and prior to our IPO, we financed our operations and capital expenditures primarily through the issuance of unregistered redeemable convertible preferred stock and common stock, cash flows generated by operations and issuances of debt. In September 2018, we entered into the New Credit Facilities. The New Term Loans were fully funded in September 2018 and we received cash proceeds of $73.6 million, net of arrangement fees of $1.1 million and upfront fees of $0.3 million. We have made no draw on the revolving credit line as of December 31, 2018. The New Term Loans amortizes at a rate of 7.5% per annum for the first two years of the New Credit Facilities, 10.0% per annum for the third and fourth years and the first three quarters of the fifth year of the New Credit Facilities, with the balance due at maturity. The New Term Loans and the New Revolving Credit Facility are each expected to mature on the fifth anniversary of the effectiveness of the New Credit Facilities. The New Revolving Credit Facility has a commitment fee, which currently accrues at 0.40% on the daily unused amount of the aggregate revolving commitments of the lenders. Borrowings under the New Credit Facilities bear interest at a rate equal to an applicable margin between 2.25% and 2.75% in the case of eurocurrency loans or between 1.25% and 1.75% in the case of base rate loans, in each case determined on a quarterly basis based on our consolidated total leverage ratio, plus, at our option, either a base rate or a eurocurrency rate calculated in a customary manner. The New Credit Facilities contain customary conditions to borrowing, events of default, and covenants. Financial covenants include maintaining a (i) maximum total leverage ratio; (ii) minimum consolidated interest coverage ratio; and (iii) minimum liquidity ratio. These financial covenants will first be tested for the three months ending December 31, 2018. We believe that our existing cash, together with cash generated from operations and amounts available under our New Revolving Credit Facility, will be sufficient to meet our anticipated cash needs for at least the next 12 months. However, our liquidity assumptions may prove to be incorrect, and we could exhaust our available financial resources sooner than we currently expect. We may seek to raise additional funds at any time through debt, equity and equity-linked arrangements. As of December 31, 2018, approximately 37.1% of our cash was held outside of the United States, which was held primarily on behalf of, and to be remitted to, creators and to fund our foreign operations. We do not expect to incur significant taxes related to these amounts. Cash Flows Our cash flow activities were as follows for the periods presented: Comparison of Years Ended December 31, 2018, 2017 and 2016 Cash Flows from Operating Activities The net cash provided by operating activities of $7.2 million for the year ended December 31, 2018 was due primarily to a net loss of $64.1 million with adjustments for depreciation and amortization of $34.6 million, stock-based compensation expense of $30.2 million, amortization of creator signing fees of $7.1 million, change in fair value of redeemable convertible preferred stock warrant liability of $9.6 million and a change in fair value of term loan embedded derivatives of $2.1 million. Additionally, there was an increase in accounts payable to creators of $24.5 million due to increases in paid tickets, an increase in other accrued liabilities of $4.3 million, partially offset by a decrease in accrued taxes of $9.4 million, an increase in creator signing fees, net of $16.0 million and an increase in creator advances, net of $5.3 million. The increases in creator signing fees, net, and creator advances, net, are due to increases in our sales contracting with creators. The net cash provided by operating activities of $29.8 million for the year ended December 31, 2017 was due primarily to a net loss of $38.5 million with adjustments for depreciation and amortization of $19.4 million, stock-based compensation expense of $10.9 million and amortization of creator signing fees of $4.3 million. Additionally, there was an increase in accounts payable to creators of $52.8 million due to increases in paid tickets, an increase in accrued taxes of $10.7 million, partially offset by an increase in funds receivable of $18.1 million, increases in creator signing fees, net of $8.6 million and creator advances, net of $5.8 million. The increases in creator signing fees, net, and creator advances, net, are due to increases in our sales contracting with creators. The net cash provided by operating activities of $2.8 million for the year ended December 31, 2016 was due primarily to a net loss of $40.4 million with adjustments for depreciation and amortization of $7.6 million, stock-based compensation expense of $8.5 million and amortization of creator signing fees of $2.7 million. Additionally, there was an increase in accounts payable to creators of $37.1 million due to increases in paid tickets, an increase in accrued taxes of $3.7 million, partially offset by an increase in funds receivable of $9.9 million, increases in creator signing fees, net of $6.0 million and creator advances, net of $4.6 million. The increases in creator signing fees, net, and creator advances, net, are due to increases in our sales contracting with creators. Cash Flows from Investing Activities The net cash used in investing activities of $39 thousand for the year ended December 31, 2018 was due to net cash provided from acquisitions of $12.6 million, driven by net cash acquired from Ticketea of $13.9 million, partially offset by capitalized software development costs of $7.2 million and purchases of property and equipment of $5.4 million. The net cash used in investing activities of $140.7 million for the year ended December 31, 2017 was due to $132.0 million net cash paid for the acquisitions of ticketscript and Ticketfly, capitalized software development costs of $6.1 million and $2.5 million paid for purchases of property and equipment. The net cash used in investing activities of $10.2 million for the year ended December 31, 2016 was due to $1.7 million net cash paid for the acquisitions of ticketscript and Ticketfly, capitalized software development costs of $5.5 million and $3.0 million paid for purchases of property and equipment. Cash Flows from Financing Activities The net cash provided by financing activities of $240.1 million during the year ended December 31, 2018 was due primarily to $241.0 million in aggregate proceeds from the completion of our IPO, net of underwriters' discounts and offering costs, $118.6 million in proceeds from term loans and $8.1 million in proceeds from exercise of stock options. These inflows were offset by $111.1 million in principal payments on our debt obligations, $6.8 million in prepayment penalties resulting from the extinguishment of our WTI Loan Facilities and $9.0 million in taxes paid related to the net share settlement of equity awards. The net cash provided by financing activities totaled $159.5 million during the year ended December 31, 2017 and was driven by $133.9 million received related to the issuance of our Series G redeemable convertible preferred stock, net of issuance costs, $30.0 million in proceeds from drawing funds under our First WTI Loan Facility, $2.3 million excess tax benefit from stock-based compensation awards, $1.8 million cash proceeds from stock option exercises, partially offset by principal payments on debt obligations of $7.8 million. The net cash provided by financing activities totaled $2.3 million during the year ended December 31, 2016 was due to, $2.9 million cash proceeds from stock option exercises. Concentrations of Credit Risk As of December 31, 2018 and December 31, 2017, there were no customers that represented 10% or more of our accounts receivable balance. There were no customers that individually exceeded 10% of our net revenue during the years ended December 31, 2018 and 2017. Contractual Obligations and Commitments Our principal commitments consist of debt, capital commitments to creators, rental payments under our build-to-suit lease, operating leases, purchase commitments and capital leases. The following table summarizes our commitments to settle contractual obligations as of December 31, 2018: Term Loans In September 2018, we fully repaid the WTI Loan Facilities and extinguished the existing debt for a total cash payment of $81.6 million. As of December 31, 2018, there are no amounts outstanding under the WTI Loan Facilities and all underlying agreements have been terminated. In September 2018, we entered into the New Credit Facilities. The New Term Loans were fully funded in September 2018 and we received cash proceeds of $73.6 million, net of arrangement fees of $1.1 million and upfront fees of $0.3 million. We have made no draw on the revolving credit line as of December 31, 2018. The New Term Loans amortizes at a rate of 7.5% per annum for the first two years of the New Credit Facilities, 10.0% per annum for the third and fourth years and the first three quarters of the fifth year of the New Credit Facilities, with the balance due at maturity. The New Term Loans and the New Revolving Credit Facility are each expected to mature on the fifth anniversary of the effectiveness of the New Credit Facilities. Lease Commitments We have entered into various non-cancelable leases for certain offices with contractual lease periods expiring between 2018 and 2023. In 2014, we undertook a series of structural improvements to the floors that we occupied in our corporate headquarters in San Francisco. As a result of the requirement to fund construction costs and due to certain structural improvements that were made by us, we were considered the deemed owner of the leased floors for accounting purposes. Due to the presence of a standby letter of credit as a security deposit, we were deemed to have continuing involvement after the construction period. As such, we accounted for this arrangement as owned real estate. Legally, we do not own the floors that we have leased in the building, the property owner owns the floors. However, accounting rules require that we record an imputed financing obligation for our obligation to the legal owners as well as an asset for the fair value of the leased floors. Under these accounting rules, our monthly rental payments are allocated to (1) interest expense, (2) ground rent expense and (3) a reduction of the principal of the imputed financing obligation. We recorded interest expense related to this financing obligation for each of the years ended December 31, 2018 and 2017. The lease financing obligation was $28.5 million and $29.5 million as of December 31, 2018 and 2017, respectively, and the net book value of the asset as of those dates was $28.4 million and $29.2 million, respectively. See Note 9 to our consolidated financial statements for additional details. In May 2018, we entered into a ten year lease for office space in Cork, Ireland. Monthly rent payments are due beginning in January 2019 and will total approximately $0.4 million per year and are included in the table above. The lease expires in 2028. Off-Balance Sheet Arrangements We do not currently have any off-balance sheet arrangements and did not have any such arrangements during 2017 or during the year ended December 31, 2018. Critical Accounting Policies and Estimates Our discussion and analysis of our financial condition and results of operations are based upon our consolidated financial statements, which have been prepared in accordance with GAAP. GAAP requires us to make certain estimates and judgments that affect the amounts reported in our consolidated financial statements related disclosures. Our estimates are based on historical experience and various other assumptions that we believe to be reasonable under the circumstances. We evaluate our estimates and assumptions on an ongoing basis and our actual results could differ from these estimates. There have been no material changes to our critical accounting policies and significant judgments as compared to the critical accounting policies and estimates disclosed in the Prospectus. Recent Accounting Pronouncements Refer to Note 2 of our Notes to our Consolidated Financial Statements included in Part II, Item 8, "Financial Statements and Supplementary Data" of this Annual Report on Form 10-K for more information.

<s>[INST] Our Business We built a powerful, broad technology platform to enable creators to solve the challenges associated with creating live experiences. Our platform integrates components needed to seamlessly plan, promote and produce live events, thereby allowing creators to reduce friction and costs, increase reach and drive ticket sales. By reducing risk and complexity, we allow creators to focus their energy on producing compelling and successful events. We charge creators on a perticket basis when an attendee purchases a paid ticket for an event. We grow with creators as their attendance grows and as they plan, promote and produce more events. In 2018, we helped more than 790,000 creators issue approximately 265 million tickets across approximately 3.8 million events in over 170 countries. We derive substantially all of our revenue from fees associated with the sale of tickets on our platform, inclusive of payment processing. Our fee structure typically consists of a fixed fee and a percentage of the price of each ticket sold by a creator. Fees associated with the sale of tickets on our platform are gross ticket fees, which we define as the total fees generated from paid ticket sales, before adjustments for refunds, credits and amortization of nonrecoupable creator signing fees. Our Business Model The key elements of our business model are: Efficiently Acquire Creators We are highly focused on creating a seamless experience that attracts creators to our platform organically. More than 98% of creators who used our platform in 2018 signed themselves up for Eventbrite and in 2018, we derived 56% of our net revenue from these creators. We attract creators to our platform through multiple means, including prior experience as attendees, word of mouth from other creators, our prominence in search engine results, the ability to try our platform for free events and our library of content. We augment these channels with a highlytargeted direct sales effort that focuses on acquiring creators with events in specific categories or countries. We leverage this efficient customer acquisition model to attract a wide range of creators to Eventbrite while keeping our sales and marketing costs low. Substantially all creators go on to create and manage events with little service or support. Provide HighQuality Solutions at a Cost Advantage We deliver our solutions on a cloudbased architecture that allows us to serve a wide variety of creators on a single global system, thereby reducing our operating and support costs. Our cloudbased platform does not require us to own or operate data centers or proprietary onpremises equipment. Additionally, our highlyautomated platform requires limited service and support staff. All of this frees up capital and other resources to dedicate to enhancing our platform and growing our business. Our platform is extensible and modular, allowing us to efficiently improve and expand our services, as well as partner with third parties to deliver the best experience possible for creators. Drive Powerful Retention When creators enjoy success on Eventbrite, they continue to use our platform. This happens because we are able to meet their diverse and changing needs through a creatorfocused approach. Our platform scales with creators, able to handle their smallest gatherings to their largest and most complex events. As creators’ needs evolve, our platform’s breadth and extensibility allow access to a full suite of solutions, enhanced by thirdparty integrated offerings. Further, we continually invest to deliver new and enhanced functionality. Our success in serving creators is reflected in our retention rate, which was 100%, 97% and 93% in 2018, 2017 and 2016, respectively. Enhance Growth and Monetization We believe that there are many opportunities within the fragmented event management market to expand both core ticketing and complementary solutions. We designed our business model and technology platform to take advantage of this opportunity by ensuring we can support the addition of new event categories and countries for ticketing, as well as new revenuegenerating solutions beyond ticketing. For example, we evolved our platform to meet the needs of music creators, helping to grow music venues on our platform from less than 100 in 2012 to over 1,000 in 2018, inclusive of acquisitions. Similarly, after making enhancements across our platform, net revenue from outside of the United States grew from 18% to 3 [/INST] Negative. </s>

Eventbrite, Inc.

2020-03-02

2019-12-31

Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations The following discussion and analysis of our financial condition and results of operations should be read in conjunction with the information set forth under "Selected Financial Data" and our consolidated financial statements and related notes included elsewhere in this Annual Report on Form 10-K. In addition to historical financial information, the following discussion and analysis contains forward-looking statements that are based upon current plans, expectations and beliefs that involve risks and uncertainties. Our actual results may differ materially from those anticipated in these forward-looking statements as a result of various factors, including those set forth under “Risk Factors” in this Annual Report on Form 10-K. Our fiscal year ends December 31. Overview We built a powerful, broad technology platform to enable event creators to solve the challenges associated with creating live experiences. Our platform integrates components needed to seamlessly plan, promote and produce live events, thereby allowing event creators to reduce friction and costs, increase reach and drive ticket sales. We were founded in 2006 with a mission to bring the world together through live experiences. We succeed when our creators succeed. We charge creators on a per-ticket basis when an attendee purchases a paid ticket for an event. We grow with creators as they plan, promote and produce more events and grow attendance. In 2019, we helped more than 949,000 creators issue approximately 309 million free and paid tickets across approximately 4.7 million events in over 180 countries. Our platform meets the complex needs of creators through a modular and extensible design. It can be accessed from Eventbrite.com, our mobile apps and through other websites, and can be used without training, support or professional services. This modularity facilitates product development and allows third-party developers to integrate features and functionality from Eventbrite into their environment. Our platform also allows developers to seamlessly integrate services from third-party partners such as Salesforce, Facebook and HubSpot. This platform approach has allowed us to pioneer a powerful business model that drives our go-to-market strategy and allows us to efficiently serve a large number and variety of creators. To reach new creators, we plan to capitalize on creators' experiences as attendees, word of mouth from other creators, our prominence across the live events landscape and our presence in search engine results, as well as targeted marketing and outbound sales. We intend to strategically grow our business by attracting new creators to our event enablement platform and retaining creators as they succeed. We have invested and we expect to continue to invest, in our product development efforts to deliver additional compelling features and functionality to address our creators' evolving and widespread needs. We also expect to continue to invest in the adoption of our platform and solutions internationally, including localization of our platform and the addition of critical capabilities required to serve those local markets. We are also investing in our employees to service our growing customer base. We believe our investments in technology, creators and our people will drive continued revenue growth. Key Business Metrics We monitor the following key metrics to help us evaluate our business, identify trends affecting our business, formulate business plans and make strategic decisions. Paid Ticket Volume Our success in serving creators is measured in large part by the number of tickets sold on our platform that generate ticket fees, referred to as paid ticket volume. We consider paid ticket volume an important indicator of the underlying health of the business. We have previously referred to this metric as 'paid tickets' and we calculate and report paid ticket volume in the same manner as we calculated and reported paid tickets. The table below sets forth the paid ticket volume for the periods indicated: Our paid ticket volume for events outside of the United States represented 36.1%, 34.1% and 36.0% for the years ended December 31, 2019, 2018 and 2017, respectively. Retention Rate To obtain our retention rate, we calculate, on a calendar year basis, the gross ticket fees generated by creators on the Eventbrite platform who sold their first ticket in the calendar year prior to the year of measurement (Prior Year Gross Ticket Fees). This calculation includes creators on the Eventbrite platform only and does not include creators acquired or migrated as part of the Ticketfly or ticketscript acquisitions. We then calculate the gross ticket fees that the creator cohort generated in the applicable calendar year of measurement (Measurement Year Gross Ticket Fees). Finally, to calculate our retention rate for a measurement year we divide the Measurement Year Gross Ticket Fees by the Prior Year Gross Ticket Fees. Fees associated with the sale of tickets on our platform are gross ticket fees, which are the total fees generated from paid ticket sales, before adjustments for refunds, credits and amortization of non-recoupable creator signing fees. Because the retention rate definition is limited to creators acquired organically, is bound by the calendar year, and is calculated on an annual basis only, we use the retention rate calculation solely for informational purposes, not as a key metric for operational decision making. We are evaluating new retention rate methodologies for future disclosure. Non-GAAP Financial Measures Adjusted EBITDA Adjusted EBITDA is a key performance measure that our management uses to assess our operating performance. We calculate Adjusted EBITDA as net income (loss) adjusted to exclude depreciation and amortization, stock-based compensation expense, interest expense, the change in fair value of our redeemable convertible preferred stock warrant liability, loss on debt extinguishment, direct and indirect acquisition-related costs, employer taxes related to employee equity transactions, other income (expense), which consisted of interest income, foreign exchange rate gains and losses and changes in fair value of term loan embedded derivatives, and income tax provision (benefit). Adjusted EBITDA should not be considered as an alternative to net loss or any other measure of financial performance calculated and presented in accordance with GAAP. The following table presents our Adjusted EBITDA for the periods indicated: For more information about Adjusted EBITDA, including the limitations of such measure, and a reconciliation to net loss, see Item 6, "Selected Financial Data" included in Part II of this Annual Report on Form 10-K. Free Cash Flow Free cash flow is a key performance measure that our management uses to assess our overall performance. We calculate free cash flow as cash flow from operating activities less purchases of property and equipment and capitalized internal-use software development costs, over a trailing twelve-month period. Because quarters are not uniform in terms of cash usage, we believe a trailing twelve-month view provides the best understanding of the underlying trends of the business. The following table presents our free cash flow for the periods indicated: For more information about free cash flow, including the limitations of such measure, and a reconciliation to net cash provided by operating activities, see Item 6, "Selected Financial Data" included in Part II of this Annual Report on Form 10-K. Components of Results of Operations Net Revenue On January 1, 2019, we adopted Accounting Standards Codification (ASC) Topic 606 (ASC 606) using the modified retrospective method applied to contracts which were not completed as of the adoption date. Results for reporting periods beginning on or after January 1, 2019 are presented under ASC 606, while prior period amounts are not adjusted and continue to be reported in accordance with historical accounting guidance. See Part II, Item 8, Note 2, "Summary of Significant Accounting Policies" included in this Annual Report on Form 10-K for additional details, including a description of our revenue recognition policies under ASC 606. The adoption of ASC 606 did not have a material impact on our results of operations, financial position or cash flows. We generate revenues primarily from service fees and payment processing fees from the sale of paid tickets on our platform. We also generate revenues from fees for providing certain creators with account management services and customer support services. Our fee structure typically consists of a fixed fee and a percentage of the price of each ticket sold by a creator. Revenue is recognized when control of promised goods or services is transferred to the creator, which for service fees and payment processing fees is when the ticket is sold. For account management services and customer support, revenue is recognized over the period from the date of the sale of the ticket to the date of the event. Net revenue excludes sales taxes and value added taxes (VAT) and is presented net of estimated customer refunds, chargebacks and amortization of creator signing fees. We also generate a small portion of our net revenue from complementary solutions, such as day-of-event on-site product and services, web presence development and branding, software solutions to manage event venue administration and marketing services that we provide to creators. These complementary solutions represented less than five percent of our net revenue in the aggregate in each of the years ended December 31, 2019, 2018 and 2017. Cost of Net Revenue Cost of net revenue consists primarily of payment processing fees, expenses associated with the operation and maintenance of our platform, including website hosting fees and platform infrastructure costs, amortization of capitalized software development costs, onsite operations costs and allocated customer support costs. Cost of net revenue also includes the amortization expense related to our acquired developed technology assets. We may incur such expense related to future acquisitions in future periods. We expect cost of net revenue to fluctuate as a percentage of net revenue in the near- to mid-term primarily as a result of our geographical revenue mix. Our payment processing costs for credit and debit card payments are generally lower outside of the United States due to a number of factors, including lower card network fees and lower cost alternative payment networks. Consequently, if we grow more rapidly internationally than in the United States, we expect that our payment processing costs will decline as a percentage of revenue. In the long-term, we expect cost of revenue to grow in absolute dollars but decrease as a percentage of revenue. Operating Expenses Operating expenses consist of product development, sales, marketing and support and general and administrative expenses. Direct and indirect personnel costs, including stock-based compensation expense, are the most significant component of operating expenses. We also include sublease income as a reduction of our operating expenses. On January 1, 2019, as a result of our adoption of ASC Topic 842 (ASC 842), we began recognizing lease costs in operating expense related to our San Francisco office lease, which was previously accounted for as a build-to-suit lease under ASC Topic 840 (ASC 840). The adoption of ASC 842 resulted in additional lease operating expense of $3.7 million and decreased depreciation expense of $0.5 million during the year ended December 31, 2019 compared to each of the years ended December 31, 2018 and 2017, respectively, driven by the accounting treatment for our San Francisco office lease. Refer to the interest expense section below for a discussion of the impact of the ASC 842 adoption on interest expense. As we adopted and reported under ASC 842 for the first time in this Annual Report on Form 10-K, our 2019 quarterly interim filings reported on Form 10-Q do not reflect accounting under ASC 842 and thus do not reflect this reclassification from interest expense and depreciation expense to lease operating expense. Product development. Product development expenses consist primarily of costs associated with our employees in product development and product engineering activities. We expect our product development expenses to continue to increase in absolute dollars over time. In the near-term, we anticipate our product development expenses will increase as a percentage of net revenue as we focus on enhancing, improving and expanding the capabilities of our platform. We also expect to continue investing in building Eventbrite's infrastructure to enhance and support development of new technologies. Over the long-term, we anticipate that product development expenses will decrease as a percentage of net revenue as our revenue grows and as we continue to expand our development staff in lower cost markets. Sales, marketing and support. Sales, marketing and support expenses consist primarily of costs associated with our employees involved in selling and marketing our products, public relations and communication activities, marketing programs, travel and customer support costs associated with free events on our platform. For our sales teams, this also includes commissions. We also classify certain creator-related expenses, such as refunds of the ticket price paid by us on behalf of a creator as sales, marketing and support expense. Our sales, marketing and support expenses also includes the amortization of acquired customer relationship intangible assets, which was $10.4 million, $10.2 million and $4.6 million for the years ended December 31, 2019, 2018 and 2017, respectively. Sales, marketing and support expenses are driven by investments to grow and retain creators and attendees on our platform. We expect sales, marketing and support expenses to increase in absolute dollars over time. In the near-term, we anticipate sales, marketing and support expenses will fluctuate as a percentage of net revenue, but over the long-term we anticipate that it will decrease as a percentage of net revenue. General and administrative. General and administrative expenses consist of personnel costs, including stock-based compensation, for finance, accounting, legal, risk, human resources and administrative personnel. It also includes professional fees for legal, accounting, finance, human resources and other corporate matters. Our general and administrative expenses also include accruals for sales tax and VAT, as well as impairment charges related to creator upfront payments. Our general and administrative expenses have increased on an actual dollar basis over time and we expect general and administrative expenses to continue to increase in absolute dollars over time. However, over the long-term, we anticipate general and administrative expenses to decline as a percentage of net revenue as we continue to grow and scale our business and as we mature as a public company. Interest Expense Interest expense relates primarily to our outstanding debt, which historically has been related to acquisitions, either as part of consideration or to finance cash consideration. During 2018, we had up to $75.0 million in outstanding debt related to our credit facilities with Western Technology Investments (WTI Loan Facilities). In September 2018, we entered into a senior secured credit facility with a syndicate of banks consisting of $75.0 million aggregate principal amount of term loans (the New Term Loans), which was fully repaid in September 2019. In 2018 and 2017, we recognized interest expense related to our build-to-suit lease financing obligation. As a result of our adoption of ASC 842, we did not recognize interest expense related to the build-to-suit lease in 2019. We reported interest expense of $3.4 million and $3.5 million for the years ended December 31, 2018 and 2017, respectively, related to build-to-suit lease accounting. We expect to incur minimal interest expense in the near-term as we had no outstanding debt as of December 31, 2019 and we are no longer recording interest expense related to build-to-suit lease accounting. If we do issue debt in the future, we would expect to record interest expense related to such debt. Change in Fair Value of Redeemable Convertible Preferred Stock Warrant Liability We have issued redeemable convertible preferred stock warrants in connection with debt facilities. The redeemable convertible preferred stock warrants were classified as a liability on our consolidated balance sheet and remeasured to fair value at each balance sheet date with the corresponding charge recorded as a change in fair value of redeemable convertible preferred stock warrant liability on the consolidated statements of operations. In connection with our IPO, all warrants were automatically exercised for no consideration, and, as such, we do not have any redeemable convertible preferred stock warrant liability at December 31, 2019 or 2018. Loss on Debt Extinguishment Loss on debt extinguishment consists of amounts recorded related to our accounting for the retirement of our debt obligations. Other Income (Expense), Net Other income (expense), net consists of interest income, foreign exchange rate remeasurement gains and losses recorded from consolidating our subsidiaries each period-end and changes in fair value of term loan embedded derivatives. Income Tax Provision (Benefit) Income tax provision (benefit) consists primarily of U.S. federal and state income taxes and income taxes in certain foreign jurisdictions in which we conduct business. The differences in the tax provision and benefit for the periods presented and the U.S. federal statutory rate is primarily due to foreign taxes in profitable jurisdictions and the recording of a full valuation allowance on our deferred tax assets and certain foreign losses which benefit from rates lower than the U.S. statutory rate. We apply the discrete method provided in ASC Topic 740 to calculate our interim tax provision. Results of Operations The results of operations presented below should be reviewed in conjunction with the consolidated financial statements and notes included in Part II, Item 8, "Financial Statements and Supplementary Data" of this Annual Report on Form 10-K. The Company has reclassified $13.6 million and $4.6 million of expenses for the years ended December 31, 2018 and 2017, respectively, to make the presentation consistent with the current year. There was no change to total operating expenses, loss from operations, loss before income taxes or net loss for the years ended December 31, 2018 or 2017 as a result of these reclassifications. For a discussion and comparison of the years ended December 31, 2018 and 2017, please refer to Part II, Item 7, "Management's Discussion and Analysis of Financial Condition and Results of Operations" of the 2018 Annual Report on Form 10-K filed with the SEC on March 7, 2019. The following tables set forth our consolidated results of operations data and such data as a percentage of net revenue for the periods presented: Comparison of the years ended December 31, 2019 and 2018 Net revenue The increase in net revenue during 2019 compared to 2018 was driven primarily by growth in paid ticket volume, which increased by 12.5% from 2018 to 2019, from 97.3 million paid tickets to 109.4 million paid tickets. Net revenue per paid ticket of $2.99 in 2019 remained consistent with net revenue per paid ticket in 2018 of $3.00. Cost of net revenue The increase in cost of net revenue during 2019 compared to 2018 was primarily due to an increase in payment processing costs of $10.3 million, driven by our paid ticket volume growth, an increase in platform fees and operating costs of $3.7 million and smaller increases in allocated customer support costs and field operations costs. These increases were offset by a decrease in amortization of acquired developed technology as the ticketscript and Ticketfly developed technology assets, which were acquired in January 2017 and September 2017, respectively, became fully amortized in 2018. This helped improve our gross margin in 2019 compared to 2018. Operating expense Product development The increase in product development expense during 2019 compared to 2018 was primarily due to increased personnel costs of $15.1 million, including $5.3 million of stock-based compensation, resulting from our ongoing hiring efforts and increased average headcount in 2019 compared to 2018. There was also an increase of $1.8 million in operating lease expense driven by the adoption of ASC 842 and the recognition of our San Francisco office lease as an operating lease in 2019 compared to a build-to-suit lease in 2018. Sales, marketing and support The increase in sales, marketing and support expenses during 2019 compared to 2018 was primarily due to an increase of $8.5 million in creator-related expenses, driven by event cancellations whereby we refunded the face value of tickets to attendees on behalf of creators. We also incurred increased direct and discretionary marketing expenses of $3.3 million and increased personnel-related expenses of $2.8 million, including $1.9 million of stock-based compensation. The remainder of the increase was made up of multiple smaller increases, including increased lease expense as a result of ASC 842 and the accounting treatment of our San Francisco office lease. General and administrative The increase in general and administrative expenses during 2019 compared to 2018 was a result of several factors, including two contra-expense items recorded in 2018. First, tax expense increased by $6.3 million in 2019 compared to 2018 primarily due to the reversal of sales tax reserves due to cumulative reserve remeasurements recorded in 2018. Second, we recorded $6.6 million of insurance proceeds as a reduction of general and administrative expense in 2018, stemming from the Ticketfly cyber incident, which occurred in June 2018. Additionally, in 2019, we incurred increased professional services spend of $6.0 million due to our strategic realignment initiatives and increased impairment charges of $4.1 million related to creator upfront payments. We also recognized increased lease operating expense as a result of ASC 842 and the accounting treatment of our San Francisco office lease. Interest expense The decrease in interest expense during 2019 compared to 2018 was driven by smaller amounts of lower-interest bearing outstanding debt in 2019 compared to 2018. The WTI Loan Facilities, which were outstanding for the first three quarters of 2018 bore interest at a rate higher than the New Term Loans, which were outstanding for the fourth quarter of 2018 and the first three quarters of 2019. We fully repaid the WTI Loan Facilities in September 2018 and terminated the underlying agreements. In September 2019, we repaid the New Term Loans in full and we terminated the underlying agreements. As of December 31, 2019, we had no outstanding debt. Additionally, we recognized $3.4 million of interest expense in 2018 related to our build-to-suit lease financing obligation, which was derecognized on January 1, 2019 in connection with our adoption of ASC 842. No interest expense related to the build-to-suit lease financing obligation was recorded in 2019. Change in fair value of redeemable convertible preferred stock warrant liability The change in fair value of our redeemable convertible preferred stock warrant liability during 2018 was due to an increase in the underlying fair value of our redeemable convertible preferred stock from January 1, 2018 to September 20, 2018. In connection with our IPO, which occurred on September 20, 2018, the redeemable convertible preferred stock warrants were automatically exercised into shares of our Class B common stock following which the warrants ceased to be outstanding. As a result, there was no change in fair value recorded during the year ended December 31, 2019. Loss on debt extinguishment ________ * Not meaningful In September 2019, we repaid the New Term Loans in full making payments of $62.2 million of principal and $0.8 million of accrued interest and fees, and we terminated the New Term Loans. We recorded a loss on debt extinguishment of $1.7 million related to the write-off of unamortized debt issuance costs. The loss on debt extinguishment recorded in 2018 was due to a loss of $17.2 million related to the extinguishment of all outstanding debt under our WTI Loan Facilities in September 2018, offset by a gain of $17.0 million related to the retirement of our outstanding promissory note in March 2018, which was originally issued in connection with the Ticketfly acquisition. Other income (expense), net The increase in other income (expense), net during 2019 compared to 2018 was driven by foreign currency rate measurement fluctuations. We recognized foreign currency rate measurement losses during 2018 as a result of the strengthening of the U.S. dollar compared to the currencies with which we operate and process transactions. We recognized foreign currency rate measurement gains during 2019 as a result of the overall weakening of the U.S. dollar compared to the currencies with which we operate and process transactions. Partially offsetting these losses in 2018 was a $2.1 million gain recognized from the change in fair value of our term loan embedded derivatives. We also recognize interest income of $4.6 million in 2019 compared to $1.4 million in 2018. Income tax provision (benefit) The benefit from income taxes increased $1.3 million in 2019 compared to 2018 and was primarily attributable to the change in our year-over-year jurisdictional earnings mix and the recognition of tax attributes in our non-U.S. subsidiaries. 
 Quarterly Results of Operations Data The following tables set forth our unaudited quarterly statements of operations data for each of the eight quarters in the period ended December 31, 2019. The information for each quarter has been prepared on a basis consistent with our audited consolidated financial statements included in this Annual Report on Form 10-K, and, in the opinion of management, includes all adjustments, which consist only of normal recurring adjustments, necessary for the fair statement of the results of operations for these periods. This data should be read in conjunction with our audited consolidated financial statements and related notes included in this Annual Report on Form 10-K. These quarterly results of operations are not necessarily indicative of the results we may achieve in any future period. The following table presents our paid ticket volume for each of the periods indicated: The following table presents a reconciliation of net income (loss) to Adjusted EBITDA for each of the periods indicated: The following table presents a reconciliation of free cash flow, which is computed on a trailing twelve-month basis, from net cash provided by operating activities for each of the periods indicated: Liquidity and Capital Resources As of December 31, 2019, we had cash and cash equivalents of $420.7 million and funds receivable of $54.9 million. Our cash and cash equivalents includes bank deposits and money market funds held by financial institutions and is held for working capital purposes. Our funds receivable represents cash-in-transit from credit card processors that is received to our bank accounts within five business days of the underlying ticket transaction. Collectively, our cash, cash equivalents and funds receivable balances represent a mix of cash that belongs to us and cash that is due to the creator. The amounts due to creators, which was $308.4 million as of December 31, 2019, are captioned on our consolidated balance sheets as accounts payable, creators. We also make payments to creators to provide the creator with short-term liquidity in advance of ticket sales. These amounts are recovered by us as tickets are sold by the respective creator, and are typically expected to be recovered within 12 months of the payment date. Amounts expected to be recovered within 12 months of the balance sheet date are classified as creator advances, net, and any remaining amounts are classified as creator advances, noncurrent. We maintain an allowance for estimated creator advances that are not recoverable and present the creator advances balances net on our consolidated balance sheets. Creator advances, net was $22.3 million and $21.3 million as of December 31, 2019 and 2018, respectively, and creator advances, noncurrent was $0.9 million and $1.9 million as of December 31, 2019 and 2018, respectively. Since our inception, and prior to our IPO, we financed our operations and capital expenditures primarily through the issuance of unregistered redeemable convertible preferred stock and common stock, cash flows generated by operations and issuances of debt. In September 2018, upon the completion of our IPO, we received aggregate proceeds of $246.0 million, net of underwriter discounts and commissions, before deducting offering costs of $5.5 million, net of reimbursements. Also in September 2018, we entered into the New Term Loans and a $75.0 million revolving credit facility (the New Revolving Credit Facility, and together with the New Term Loans, the New Credit Facilities). The New Term Loans were fully funded in September 2018 and we received cash proceeds of $73.6 million, net of arrangement fees of $1.1 million and upfront fees of $0.3 million. In September 2019, we elected to prepay the outstanding principal balance of the New Term Loans in its entirety and terminate the New Credit Facilities. We paid $63.0 million, which consisted of $62.2 million of outstanding principal and $0.8 million of accrued interest and fees. We recorded a loss on debt extinguishment of $1.7 million during the year ended December 31, 2019 related to the repayment of the New Term Loans. We believe that our existing cash, together with cash generated from operations, will be sufficient to meet our anticipated cash needs for at least the next 12 months. However, our liquidity assumptions may prove to be incorrect, and we could exhaust our available financial resources sooner than we currently expect. We may seek to raise additional funds at any time through debt, equity and equity-linked arrangements. As of December 31, 2019, approximately 55.3% of our cash was held outside of the United States, which was held primarily on behalf of, and to be remitted to, creators and to fund our foreign operations. We do not expect to incur significant taxes related to these amounts. Cash Flows Our cash flow activities were as follows for the periods presented: For a discussion and comparison of the years ended December 31, 2018 and 2017, please refer to Part II, Item 7, "Management's Discussion and Analysis of Financial Condition and Results of Operations" of the 2018 Annual Report on Form 10-K filed with the SEC on March 7, 2019. Comparison of Years Ended December 31, 2019 and 2018 Cash Flows from Operating Activities The net cash provided by operating activities of $28.7 million for the year ended December 31, 2019 was due primarily to a net loss of $68.8 million with adjustments for depreciation and amortization of $24.3 million, stock-based compensation expense of $37.6 million, amortization of creator signing fees of $10.9 million, impairment charges of $5.7 million, provision for bad debt and creator advances of $2.4 million and loss on debt extinguishment of $1.7 million. Additionally, there was an increase in accounts payable to creators of $36.2 million due to increases in paid ticket volume, a decrease in funds receivable of $3.8 million and an increase in other accrued liabilities of $2.2 million. These items were partially offset by an increase in creator signing fees paid of $21.2 million, an increase in creator advances, net of $5.7 million and a decrease in accrued taxes of $2.8 million. The increases in creator signing fees, net, and creator advances, net, were due to increases in our sales contracting with creators. The net cash provided by operating activities of $7.2 million for the year ended December 31, 2018 was due primarily to a net loss of $64.1 million with adjustments for depreciation and amortization of $34.6 million, stock-based compensation expense of $30.2 million, amortization of creator signing fees of $7.1 million, change in fair value of redeemable convertible preferred stock warrant liability of $9.6 million and a change in fair value of term loan embedded derivatives of $2.1 million. Additionally, there was an increase in accounts payable to creators of $24.5 million due to increases in paid ticket volume and an increase in other accrued liabilities of $4.3 million. These items were partially offset by a decrease in accrued taxes of $9.4 million, an increase in creator signing fees paid of $16.0 million, an increase in creator advances, net of $5.3 million and an increase in funds receivable of $6.8 million. The increases in creator signing fees paid and creator advances, net, were due to increases in our sales contracting with creators and the increase in funds receivable was due to increases in paid ticket volume. Cash Flows from Investing Activities The net cash used in investing activities of $13.6 million for the year ended December 31, 2019 was due to capitalized software development costs of $7.7 million and purchases of property and equipment of $5.9 million. The net cash used in investing activities of $39 thousand for the year ended December 31, 2018 was due to net cash provided from acquisitions of $12.6 million, driven by net cash acquired from the Ticketea acquisition, which occurred in April 2018, partially offset by capitalized software development costs of $7.2 million and purchases of property and equipment of $5.4 million. Cash Flows from Financing Activities The net cash used in financing activities of $31.5 million during the year ended December 31, 2019 was due primarily to $73.6 million in principal payments on our debt obligations and $1.1 million in taxes paid related to the net share settlement of equity awards. These cash outflows were offset by $40.7 million in proceeds from exercise of stock options and $3.6 million of proceeds from the issuance of common stock under our Employee Stock Purchase Plan (ESPP). The net cash provided by financing activities of $240.1 million during the year ended December 31, 2018 was due primarily to $241.0 million in aggregate proceeds from the completion of our IPO, net of underwriters' discounts and offering costs, $118.6 million in proceeds from term loans and $8.1 million in proceeds from exercise of stock options. These cash inflows were offset by $111.1 million in principal payments on our debt obligations, $6.8 million in prepayment penalties resulting from the extinguishment of our WTI Loan Facilities and $9.0 million in taxes paid related to the net share settlement of equity awards. Concentrations of Credit Risk As of December 31, 2019 and December 31, 2018, there were no customers that represented 10% or more of our accounts receivable balance. There were no customers that individually exceeded 10% of our net revenue during the years ended December 31, 2019 and 2018. Contractual Obligations and Commitments We had no outstanding debt as of December 31, 2019. Our principal commitments consist of our operating lease obligations (partially offset by sublease income), capital commitments to creators and purchase commitments. The following table summarizes our consolidated principal contractual cash obligations and rights as of December 31, 2019 (in thousands): Off-Balance Sheet Arrangements We do not currently have any off-balance sheet arrangements and did not have any such arrangements during each of the years ended December 31, 2019, 2018 or 2017. Critical Accounting Policies and Estimates Our discussion and analysis of our financial condition and results of operations are based upon our consolidated financial statements, which have been prepared in accordance with accounting principles generally accepted in the United States of America (GAAP). Use of Estimates In order to conform with GAAP, we are required to make certain estimates, judgments and assumptions when preparing our consolidated financial statements. These estimates, judgments and assumptions affect the reported assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements, as well as the reported amounts of revenue and expenses during the reported periods. These estimates include, but are not limited to, the recoverability of creator signing fees and creator advances, the capitalization and estimated useful life of internal-use software, certain assumptions used in the valuation of equity awards, determining the fair value of the redeemable convertible preferred stock warrant liability prior to the IPO, fair value of the term loan derivative liability, assumptions used in determining the fair value of business combinations, the allowance for doubtful accounts, indirect tax reserves and contra-revenue amounts related to fraudulent events, customer disputed transactions and refunds. We evaluate these estimates on an ongoing basis. Actual results could differ from those estimates and such differences could be material to our consolidated financial statements. Revenue Recognition We adopted ASU 2014-09, Revenue from Contracts with Customers (Topic 606) and Other Assets and Deferred Costs-Contracts with Customers (Subtopic 340-40) (ASC 606) on January 1, 2019. We determine revenue recognition through the following steps: i. Identification of the contract, or contracts, with a customer ii. Identification of the performance obligations in the contract iii. Determination of the transaction price iv. Allocation of the transaction price to the performance obligations in the contract v. Recognition of revenue, when, or as, we satisfy the performance obligation We derive our revenues primarily from service fees and payment processing fees charged at the time a ticket for an event is sold. We also derive revenues from providing certain creators with account management services and customer support. Our customers are event creators who use our platform to sell tickets to attendees. Revenue is recognized when or as control of the promised goods or services is transferred to customers, in an amount that reflects the consideration we expect to receive in exchange for those goods or services. We allocate the transaction price by estimating a standalone selling price for each performance obligation using an expected cost plus a margin approach. For service fees and payment processing fees, revenue is recognized when the ticket is sold. For account management services and customer support, revenue is recognized over the period from the date of the sale of the ticket to the date of the event. The event creator has the choice of whether to use Eventbrite Payment Processing (EPP) or to use a third-party payment processor, referred to as Facilitated Payment Processing (FPP). Under the EPP option, we are the merchant of record and are responsible for processing the transaction and collecting the face value of the ticket and all associated fees at the time the ticket is sold. We are also responsible for remitting these amounts collected, less our fees, to the event creator. Under the FPP option, we are not responsible for processing the transaction or collecting the face value of the ticket and associated fees. In this case, we invoice the creator for all of our fees. We evaluate whether it is appropriate to recognize revenue on a gross or net basis based upon our evaluation of whether we obtain control of the specified goods or services by considering if we are primarily responsible for fulfillment of the promise, have inventory risk, and have the latitude in establishing pricing and selecting suppliers, among other factors. We determined the event creator is the party responsible for fulfilling the promise to the attendee, as the creator is responsible for providing the event for which a ticket is sold, determines the price of the ticket and is responsible for providing a refund if the event is canceled. Our service provides a platform for the creator and event attendee to transact and our performance obligation is to facilitate and process that transaction and issue the ticket. The amount that we earn for our services is fixed. For the payment processing service, we determined that we are the principal in providing the service as we are responsible for fulfilling the promise to process the payment and we have discretion and latitude in establishing the price of our service. Based on our assessment, we record revenue on a net basis related to our ticketing service and on a gross basis related to our payment processing service. As a result, costs incurred for processing the transactions are included in cost of net revenues in the consolidated statements of operations. Revenue is presented net of indirect taxes, value-added taxes, creator royalties and reserves for customer refunds, payment chargebacks and estimated uncollectible amounts. If an event is cancelled by a creator, then any obligations to provide refunds to event attendees are the responsibility of that creator. If a creator is unwilling or unable to fulfill their refund obligations, we may, at our discretion, provide attendee refunds. Revenue is also presented net of the amortization of creator signing fees. The benefit we receive by securing exclusive ticketing and payment processing rights with certain creators from creator signing fees is inseparable from the customer relationship with the creator and accordingly these fees are recorded as a reduction of revenue in the consolidated statements of operations. Creator Signing Fees, Net Creator signing fees, net represent contractual amounts paid to creators pursuant to event ticketing and payment processing agreements. Creator signing fees are additional incentives paid by us to secure exclusive ticketing and payment processing rights with certain creators. These payments are amortized over the life of the contract to which they relate on a straight-line basis. Creator signing fees are presented net of reserves on the consolidated balance sheets. Reserves are recorded based on our assessment of various factors, including a creator's payment history, the frequency and size of historical and planned future events, and macro-economic conditions and current events that may impact a creator's ability to generate future ticket sales. Amortization of creator signing fees is recorded as a reduction of revenue in the consolidated statements of operations. Creator Advances, Net Creator advances, net represent contractual amounts paid to creators pursuant to event ticketing and payment processing agreements. Creator advances provide the creator with funds in advance of the event and are subsequently recovered by withholding amounts due to us from the sale of tickets until the creator advance has been fully recovered. Creator advances are presented net of reserves for potentially unrecoverable amounts on the consolidated balance sheets. Reserves are recorded based on our assessment of various factors, including a creator's payment history, the rate and timing of recovery for outstanding advances, the frequency and size of historical and planned future events, and macro-economic conditions and current events that may impact a creator's ability to generate future ticket sales. Business Combinations, Goodwill and Acquired Intangible Assets We allocate the fair value of purchase consideration to the tangible assets acquired, liabilities assumed and intangible assets acquired based on their estimated fair values. Such valuations require us to make significant estimates and assumptions, especially with respect to intangible assets. Significant estimates in valuing certain intangible assets include, but are not limited to, future expected cash flows from acquired users, acquired technology and trade names from a market participant perspective, useful lives and discount rates. Our estimates of fair value are based upon assumptions believed to be reasonable, but which are inherently uncertain and unpredictable and, as a result, actual results may differ from estimates. During the measurement period, which is one year from the acquisition date, we may record adjustments to the assets acquired and liabilities assumed, with the corresponding offset to goodwill. Upon the conclusion of the measurement period, any subsequent adjustments are recorded to earnings. Goodwill represents the excess of the aggregate fair value of the consideration transferred in a business combination over the fair value of the assets acquired, net of liabilities assumed. Goodwill is not amortized but the Company evaluates goodwill impairment of its single reporting unit annually in the fourth quarter, or more frequently if events or changes in circumstances indicate the goodwill may be impaired. Events or changes in circumstances which could trigger an impairment review include significant changes in the manner of our use of the acquired assets or the strategy for our overall business, significant negative industry or economic trends, significant underperformance relative to historical or projected future results of operations, a significant adverse change in the business climate, an adverse action or assessment by a regulator, unanticipated competition or a loss of key personnel. We have the option to first assess qualitative factors to determine whether the existence of events or circumstances leads to a determination that it is more likely than not that the fair value of the reporting unit is less than its carrying amount. If, after assessing the totality of events or circumstances, we determine it is not more likely than not that the fair value of the reporting unit is less than its carrying amount, then additional impairment testing is not required. However, if we conclude otherwise, then we are required to perform the first of a two-step impairment test. The first step involves comparing the estimated fair value of the reporting unit with its respective book value, including goodwill. If the estimated fair value exceeds book value, goodwill is considered not to be impaired and no additional steps are necessary. If, however, the fair value of the reporting unit is less than book value, then a second step is required that compares the carrying amount of the goodwill with its implied fair value. The estimate of implied fair value of goodwill may require valuations of certain internally-generated and unrecognized intangible and tangible net assets. If the carrying amount of goodwill exceeds the implied fair value of the goodwill, an impairment loss is recognized in an amount equal to the excess. Acquired intangible assets, net consists of identifiable intangible assets such as developed technology, customer relationships, and trade names resulting from our acquisitions. Acquired intangible assets are recorded at fair value on the date of acquisition and amortized over their estimated economic lives following the pattern in which the economic benefits of the assets will be consumed, which is straight-line. Acquired intangible assets are presented net of accumulated amortization in the consolidated balance sheets. We evaluate the recoverability of our acquired intangible assets for potential impairment whenever events or circumstances indicate that the carrying amount of such assets may not be recoverable. Recoverability of these assets is measured by a comparison of the carrying amounts to the future undiscounted cash flows the assets are expected to generate. If such review indicates that the carrying amount of intangible assets is not recoverable, the carrying amount of such assets is reduced to the fair value. Stock-Based Compensation Expense Stock-based compensation expense is measured based on the grant-date fair value of the awards and recognized in the consolidated statements of operations over the period during which the award recipient is required to perform services in exchange for the award (the vesting period of the award). We estimate the fair value of stock options granted using the Black-Scholes option pricing model. We measure the fair value of RSUs based on the fair value of the underlying shares on the date of grant. Compensation expense is recognized over the vesting period of the applicable award using the straight-line method. We estimate forfeitures in order to calculate stock-based compensation expense. Income Taxes We record income taxes using the asset and liability method, which requires the recognition of deferred tax assets and liabilities for the expected future tax consequences of events that have been recognized in the consolidated financial statements or tax returns. Deferred tax assets and liabilities are measured using enacted tax rates that are expected to apply to taxable income for the years in which those tax assets and liabilities are expected to be realized or settled. Valuation allowances are provided when necessary to reduce deferred tax assets to the amount expected to be realized. We recognize tax benefits from uncertain tax positions if it is more likely than not that the tax position will be sustained on examination by the taxing authorities based on the technical merits of the position. Although we believe we have adequately provided for its uncertain tax positions, we can provide no assurance that the final tax outcome of these matters will not be materially different. We adjust these allowances when facts and circumstances change, such as the closing of a tax audit or the refinement of an estimate. To the extent that the final tax outcome of these matters is different than the amounts recorded, such differences will affect the provision for income taxes in the period in which such determination is made and could have a material impact on our consolidated financial statements. Recent Accounting Pronouncements Refer to Note 2 of our Notes to our Consolidated Financial Statements included in Part II, Item 8, "Financial Statements and Supplementary Data" of this Annual Report on Form 10-K for more information.

<s>[INST] Overview We built a powerful, broad technology platform to enable event creators to solve the challenges associated with creating live experiences. Our platform integrates components needed to seamlessly plan, promote and produce live events, thereby allowing event creators to reduce friction and costs, increase reach and drive ticket sales. We were founded in 2006 with a mission to bring the world together through live experiences. We succeed when our creators succeed. We charge creators on a perticket basis when an attendee purchases a paid ticket for an event. We grow with creators as they plan, promote and produce more events and grow attendance. In 2019, we helped more than 949,000 creators issue approximately 309 million free and paid tickets across approximately 4.7 million events in over 180 countries. Our platform meets the complex needs of creators through a modular and extensible design. It can be accessed from Eventbrite.com, our mobile apps and through other websites, and can be used without training, support or professional services. This modularity facilitates product development and allows thirdparty developers to integrate features and functionality from Eventbrite into their environment. Our platform also allows developers to seamlessly integrate services from thirdparty partners such as Salesforce, Facebook and HubSpot. This platform approach has allowed us to pioneer a powerful business model that drives our gotomarket strategy and allows us to efficiently serve a large number and variety of creators. To reach new creators, we plan to capitalize on creators' experiences as attendees, word of mouth from other creators, our prominence across the live events landscape and our presence in search engine results, as well as targeted marketing and outbound sales. We intend to strategically grow our business by attracting new creators to our event enablement platform and retaining creators as they succeed. We have invested and we expect to continue to invest, in our product development efforts to deliver additional compelling features and functionality to address our creators' evolving and widespread needs. We also expect to continue to invest in the adoption of our platform and solutions internationally, including localization of our platform and the addition of critical capabilities required to serve those local markets. We are also investing in our employees to service our growing customer base. We believe our investments in technology, creators and our people will drive continued revenue growth. Key Business Metrics We monitor the following key metrics to help us evaluate our business, identify trends affecting our business, formulate business plans and make strategic decisions. Paid Ticket Volume Our success in serving creators is measured in large part by the number of tickets sold on our platform that generate ticket fees, referred to as paid ticket volume. We consider paid ticket volume an important indicator of the underlying health of the business. We have previously referred to this metric as 'paid tickets' and we calculate and report paid ticket volume in the same manner as we calculated and reported paid tickets. The table below sets forth the paid ticket volume for the periods indicated: Our paid ticket volume for events outside of the United States represented 36.1%, 34.1% and 36.0% for the years ended December 31, 2019, 2018 and 2017, respectively. Retention Rate To obtain our retention rate, we calculate, on a calendar year basis, the gross ticket fees generated by creators on the Eventbrite platform who sold their first ticket in the calendar year prior to the year of measurement (Prior Year Gross Ticket Fees). This calculation includes creators on the Eventbrite platform only and does not include creators acquired or migrated as part of the Ticketfly or ticketscript acquisitions. We then calculate the gross ticket fees that the creator cohort generated in the applicable calendar year of measurement (Measurement Year Gross Ticket Fees). Finally, to calculate our retention rate for a measurement year we divide the Measurement Year Gross Ticket Fees by the Prior Year Gross Ticket Fees. Fees associated with the sale of tickets on our platform are gross ticket fees, which are the total fees generated from paid ticket sales, before adjustments for refunds, credits and amortization of nonrecoupable creator signing fees. Because the retention rate definition is limited to creators acquired organically, is bound by the calendar year, and is calculated on an annual basis only, we use the retention rate calculation solely for informational purposes, not as [/INST] Negative. </s>

GreenSky, Inc.

2019-03-15

2018-12-31

ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS (Dollars in thousands, except per share data and unless otherwise indicated) You should read the following discussion and analysis of our financial condition and results of operations together with our Consolidated Financial Statements and related notes included in Item 8 of this Form 10-K. This discussion and analysis contains forward-looking statements based upon current plans, expectations and beliefs involving risks and uncertainties. Our actual results may differ materially from those anticipated in these forward-looking statements as a result of various important factors, including those set forth under Part I, Item 1A.“Risk Factors” in this Form 10-K. Organization GreenSky, Inc. was formed as a Delaware corporation on July 12, 2017. The Company was formed for the purpose of completing an IPO of its Class A common stock and certain Reorganization Transactions (as detailed below) in order to carry on the business of GS Holdings and its consolidated subsidiaries. GS Holdings, a holding company with no operating assets or operations, was organized in August 2017. On August 24, 2017, GS Holdings acquired a controlling interest in GSLLC, a Georgia limited liability company, which is an operating entity. Common membership interests of GS Holdings are referred to as "Holdco Units." See Note 1 to the Consolidated Financial Statements in Item 8 for a detailed discussion of the Reorganization Transactions, as defined in that note, and the IPO. Executive Summary For a Company overview, see Part I, Item 1. "Business." We have achieved significant growth in active merchants, transaction volume and total revenue, which has resulted in strong net income and Adjusted EBITDA. Our low-cost go-to-market strategy, coupled with our recurring revenue model, has helped us generate strong margins. Transaction volume (as defined below) was $5.0 billion during the year ended December 31, 2018, representing an increase of 34% from $3.8 billion during the year ended December 31, 2017, which in turn increased by 31% from $2.9 billion during the year ended December 31, 2016. Active merchants totaled 14,907 as of December 31, 2018, representing an increase of 37% from 10,891 as of December 31, 2017, which in turn represented an increase of 48% from 7,361 as of December 31, 2016. Our total revenue of $414.7 million during the year ended December 31, 2018 represented an increase of 27% from $325.9 million during the year ended December 31, 2017, which in turn represented an increase of 24% from $263.9 million during the year ended December 31, 2016. Our net income of $128.0 million during the year ended December 31, 2018 decreased by 8% from $138.7 million during the year ended December 31, 2017, which in turn increased by 11% from $124.5 million during the year ended December 31, 2016. The decrease in 2018 was primarily attributable to the fair value change in FCR liability, higher interest expense and, to a lesser extent, income tax expense in the current year. Our Adjusted EBITDA (as defined below) increased by 8% to $171.5 million during the year ended December 31, 2018 from $159.4 million during the year ended December 31, 2017, which in turn increased by 22% from $130.7 million during the year ended December 31, 2016. Information regarding our use of Adjusted EBITDA, a non-GAAP measure, and a reconciliation of Adjusted EBITDA to net income, the most comparable GAAP (as defined below) measure, is included in "Non-GAAP Financial Measures." Non-GAAP Financial Measures In addition to financial measures presented in accordance with United States generally accepted accounting principles (“GAAP”), we monitor Adjusted EBITDA to manage our business, make planning decisions, evaluate our performance and allocate resources. We define “Adjusted EBITDA” as net income before interest expense, taxes, depreciation and amortization, adjusted to eliminate equity-based compensation and payments and certain non-cash and non-recurring expenses. We believe that Adjusted EBITDA is one of the key financial indicators of our business performance over the long term and provides useful information regarding whether cash provided by operating activities is sufficient to maintain and grow our business. We believe that this methodology for determining Adjusted EBITDA can provide useful supplemental information to help investors better understand the economics of our business. Adjusted EBITDA has limitations as an analytical tool and should not be considered in isolation from, or as a substitute for, the analysis of other GAAP financial measures, such as net income. Some of the limitations of Adjusted EBITDA include: • It does not reflect our current contractual commitments that will have an impact on future cash flows; • It does not reflect the impact of working capital requirements or capital expenditures; and • It is not a universally consistent calculation, which limits its usefulness as a comparative measure. Management compensates for the inherent limitations associated with using the measure of Adjusted EBITDA through disclosure of such limitations, presentation of our financial statements in accordance with GAAP and reconciliation of Adjusted EBITDA to the most directly comparable GAAP measure, net income, as presented below. (1) Includes both corporate and non-corporate tax expense. Non-corporate tax expense is included within general and administrative expenses in our Consolidated Statements of Operations included in Item 8. Prior to the IPO and Reorganization Transactions, we did not have any corporate income tax expense. (2) Includes equity-based compensation to employees and directors, as well as equity-based payments to non-employees. (3) Includes the non-cash impact of the initial recognition of servicing liabilities and subsequent fair value changes in such servicing liabilities during the periods presented. See Note 3 to the Consolidated Financial Statements included in Item 8 for additional discussion of our servicing liabilities. (4) In 2018, non-recurring transaction expenses include certain costs associated with the Reorganization Transactions and our IPO, which were not deferrable against the proceeds of the IPO. Further, certain costs related to our March 2018 term loan upsizing were expensed as incurred, rather than deferred against the balance of the term loan and, therefore, are being added back to net income given the non-recurring nature of these expenses. In 2017, non-recurring transaction expenses include one-time fees paid to an affiliate of one of the members of the board of managers in conjunction with the August 2017 term loan transaction. Further, we utilize Pro Forma Net Income, which we define as consolidated net income, adjusted for non-recurring transaction expenses and incremental pro forma tax expense assuming all of our noncontrolling interests were subject to income taxation. Pro Forma Net Income is a useful measure because it makes our results more directly comparable to public companies that have the vast majority of their earnings subject to corporate income taxation. Pro Forma Net Income has limitations as an analytical tool and should not be considered in isolation from, or as a substitute for, the analysis of other GAAP financial measures, such as net income. Some of the limitations of Pro Forma Net Income include: • It makes assumptions about tax expense, which may differ from actual results; • It is not a universally consistent calculation, which limits its usefulness as a comparative measure. Management compensates for the inherent limitations associated with using the measure of Pro Forma Net Income through disclosure of such limitations, presentation of our financial statements in accordance with GAAP and reconciliation of Pro Forma Net Income to the most directly comparable GAAP measure, net income, as presented below. (1) In 2018, non-recurring transaction expenses include certain costs associated with the Reorganization Transactions and our IPO, which were not deferrable against the proceeds of the IPO. Further, certain costs related to our March 2018 term loan upsizing were expensed as incurred, rather than deferred against the balance of the term loan and, therefore, are being added back to net income given the non-recurring nature of these expenses. In 2017, non-recurring transaction expenses include one-time fees paid to an affiliate of one of the members of the board of managers in conjunction with the August 2017 term loan transaction. (2) Represents the incremental tax effect on net income, adjusted for non-recurring transaction expenses, assuming that all consolidated net income was subject to corporate taxation for the periods presented. For the years ended December 31, 2018, 2017 and 2016, we assumed effective tax rates of 19.7%, 38.4% and 38.6%, respectively. Business Metrics We review a number of operating and financial metrics to evaluate our business, measure our performance, identify trends, formulate plans and make strategic decisions, including the following. Active Merchants. We define active merchants as home improvement merchants and healthcare providers that have submitted at least one consumer application during the 12 months ended at the date of measurement. Because our transaction volume is a function of the size, engagement and growth of our merchant network, active merchants, in aggregate, are an indicator of future revenue and profitability, although they are not directly correlated. Transaction Volume. We define transaction volume as the dollar value of loans facilitated on our platform during a given period. Transaction volume is an indicator of revenue and overall platform profitability and has grown substantially in the past several years. Loan Servicing Portfolio. We define our loan servicing portfolio as the aggregate outstanding consumer loan balance (principal plus accrued interest and fees) serviced by our platform at the date of measurement. Our loan servicing portfolio is an indicator of our servicing activities. The average loan servicing portfolio for the years ended December 31, 2018, 2017 and 2016 was $6,303 million, $4,501 million and $3,156 million, respectively. Cumulative Consumer Accounts. We define cumulative consumer accounts as the aggregate number of consumer accounts approved on our platform since our inception, including accounts with both outstanding and zero balances. Although not directly correlated to revenue, cumulative consumer accounts is a measure of our brand awareness among consumers, as well as the value of the data we have been collecting from such consumers since our inception. We may use this data to support future growth by cross-marketing products and delivering potential additional customers to merchants that may not have been able to source those customers themselves. Factors Affecting our Performance Growth in Active Merchants and Transaction Volume. Growth trends in active merchants and transaction volume are highly significant variables directly affecting our revenue and financial results. Both factors influence the number of loans funded on our platform and, therefore, the fees that we earn and the per-unit cost of the services that we provide. Growth in active merchants and transaction volume depend on our ability to retain our existing platform participants, add new participants and expand to new industry verticals. To support our efforts to increase our network of merchants, we continue to expand our sales and marketing groups, which focus on merchant acquisition. Our sales and marketing team has collectively grown to 160 full-time-equivalents as of December 31, 2018 from 114 full-time-equivalents as of December 31, 2017 and 66 full-time-equivalents as of December 31, 2016. Increasing Bank Partner Commitments. Bank Partner funding commitments are integral to the success of our ecosystem, as they allow us to facilitate more financing, which enables us to serve more merchants and consumers. Our ability to increase transaction volume and expand our loan servicing portfolio is dependent on securing sufficient commitments from our Bank Partners and adding new Bank Partners. As of December 31, 2018, we had maximum commitments of approximately $11.8 billion in the aggregate from our Bank Partners, $4.8 billion of which were unused. Our efforts to grow existing commitments from our Bank Partners and to attract new Bank Partners are integral parts of our strategy. As we add new Bank Partners, the use of their full commitments are often phased in over time. Performance of the Loans our Bank Partners Originate. While our Bank Partners bear substantially all of the credit risk on their wholly-owned loan portfolios, Bank Partner credit losses and prepayments impact our profitability as follows: • Our contracts with our Bank Partners entitle us to incentive payments when the finance charges billed to borrowers exceed the sum of an agreed-upon portfolio yield, a fixed servicing fee and realized credit losses. This incentive payment varies from month to month, primarily due to the amount of realized credit losses. • With respect to deferred interest loans, we bill the consumer for interest throughout the deferred interest promotional period, but the consumer is not obligated to pay any interest if the loan is repaid in full before the end of the promotional period. We are obligated to remit this accumulated billed interest to our Bank Partners to the extent the loan principal balances are paid off within the promotional period (each event, a finance charge reversal or "FCR") even though the interest billed to the consumer is reversed. Our maximum FCR liability is limited to the gross amount of finance charges billed during the promotional period, offset by the collection of incentive payments from our Bank Partners during such period, proceeds received from transfers of previously charged-off loan receivables ("Charged-Off Receivables") and recoveries on unsold charged-off receivables. Our profitability is impacted by the difference between the cash collected from the incentive payments and Charged-Off Receivables, and the cash to be remitted on a future date to settle our FCR liability. Our FCR liability quantifies our expected future obligation to remit billed interest with respect to deferred interest loans. • If credit losses exceed an agreed-upon threshold, we make limited payments to our Bank Partners. Our maximum financial exposure is contractually limited to the escrow that we establish with each Bank Partner, which represented a weighted average target rate of 1.3% of the total outstanding loan balance as of December 31, 2018. Cash set aside to meet this requirement is classified as restricted cash in our Consolidated Balance Sheets. For further discussion of our sensitivity to the credit risk exposure of our Bank Partners, see

<s>[INST] Organization GreenSky, Inc. was formed as a Delaware corporation on July 12, 2017. The Company was formed for the purpose of completing an IPO of its Class A common stock and certain Reorganization Transactions (as detailed below) in order to carry on the business of GS Holdings and its consolidated subsidiaries. GS Holdings, a holding company with no operating assets or operations, was organized in August 2017. On August 24, 2017, GS Holdings acquired a controlling interest in GSLLC, a Georgia limited liability company, which is an operating entity. Common membership interests of GS Holdings are referred to as "Holdco Units." See Note 1 to the Consolidated Financial Statements in Item 8 for a detailed discussion of the Reorganization Transactions, as defined in that note, and the IPO. Executive Summary For a Company overview, see Part I, Item 1. "Business." We have achieved significant growth in active merchants, transaction volume and total revenue, which has resulted in strong net income and Adjusted EBITDA. Our lowcost gotomarket strategy, coupled with our recurring revenue model, has helped us generate strong margins. Transaction volume (as defined below) was $5.0 billion during the year ended December 31, 2018, representing an increase of 34% from $3.8 billion during the year ended December 31, 2017, which in turn increased by 31% from $2.9 billion during the year ended December 31, 2016. Active merchants totaled 14,907 as of December 31, 2018, representing an increase of 37% from 10,891 as of December 31, 2017, which in turn represented an increase of 48% from 7,361 as of December 31, 2016. Our total revenue of $414.7 million during the year ended December 31, 2018 represented an increase of 27% from $325.9 million during the year ended December 31, 2017, which in turn represented an increase of 24% from $263.9 million during the year ended December 31, 2016. Our net income of $128.0 million during the year ended December 31, 2018 decreased by 8% from $138.7 million during the year ended December 31, 2017, which in turn increased by 11% from $124.5 million during the year ended December 31, 2016. The decrease in 2018 was primarily attributable to the fair value change in FCR liability, higher interest expense and, to a lesser extent, income tax expense in the current year. Our Adjusted EBITDA (as defined below) increased by 8% to $171.5 million during the year ended December 31, 2018 from $159.4 million during the year ended December 31, 2017, which in turn increased by 22% from $130.7 million during the year ended December 31, 2016. Information regarding our use of Adjusted EBITDA, a nonGAAP measure, and a reconciliation of Adjusted EBITDA to net income, the most comparable GAAP (as defined below) measure, is included in "NonGAAP Financial Measures." NonGAAP Financial Measures In addition to financial measures presented in accordance with United States generally accepted accounting principles (“GAAP”), we monitor Adjusted EBITDA to manage our business, make planning decisions, evaluate our performance and allocate resources. We define “Adjusted EBITDA” as net income before interest expense, taxes, depreciation and amortization, adjusted to eliminate equitybased compensation and payments and certain noncash and nonrecurring expenses. We believe that Adjusted EBITDA is one of the key financial indicators of our business performance over the long term and provides useful information regarding whether cash provided by operating activities is sufficient to maintain and grow our business. We [/INST] Positive. </s>

GreenSky, Inc.

2020-03-02

2019-12-31

ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS (United States Dollars in thousands, except per share data and unless otherwise indicated) You should read the following discussion and analysis of our financial condition and results of operations together with our Consolidated Financial Statements and related notes included in Item 8 of this Form 10-K. This discussion and analysis contains forward-looking statements based upon current plans, expectations and beliefs involving risks and uncertainties. Our actual results may differ materially from those anticipated in these forward-looking statements as a result of various important factors, including those set forth under Part I, Item 1A“Risk Factors” in this Form 10-K. Unless the context requires otherwise, "we," "us," "our," "GreenSky" and "the Company" refer to GreenSky, Inc. and its subsidiaries. Organization GreenSky, Inc. was formed as a Delaware corporation on July 12, 2017. The Company was formed for the purpose of completing an IPO of its Class A common stock and certain Reorganization Transactions in order to carry on the business of GS Holdings and its consolidated subsidiaries. GS Holdings, a holding company with no operating assets or operations, was organized in August 2017. On August 24, 2017, GS Holdings acquired a 100% interest in GSLLC, a Georgia limited liability company, which is an operating entity. Common membership interests of GS Holdings are referred to as "Holdco Units." See Note 1 to the Notes to Consolidated Financial Statements in Item 8 for a detailed discussion of the Reorganization Transactions (as defined in that note) and the IPO. Executive Summary For a Company overview, see Part I, Item 1 "Business." 2019 Developments Specific key developments during the year ended December 31, 2019 include: •As announced in August 2019, the Company's Board of Directors (the "Board"), working together with its senior management team and legal and financial advisors, has commenced a process to explore, review and evaluate a range of potential strategic alternatives focused on maximizing stockholder value. ◦The Board has not made any decisions related to strategic alternatives at this time, and there is no assurance that the Board’s exploration of strategic alternatives will result in any change of strategy or transaction being entered into or consummated or, if a transaction is undertaken, as to its terms, structure or timing. ◦The Board's review is ongoing, and the Company does not intend to make further public comment regarding these matters unless and until the Board has approved a specific transaction or alternative or otherwise concludes its review. •In December 2019, we reached an agreement in principle for a three-year, $6 billion forward flow arrangement with a leading institutional asset manager, which would complement our current Bank Partner commitments. See "-Factors Affecting our Performance-Bank Partner Relationships; Other Funding" for additional discussion of this proposed forward flow arrangement. •We entered into a $350.0 million notional, four-year interest rate swap agreement to hedge changes in cash flows attributable to interest rate risk on $350.0 million of our variable-rate term loan. •We purchased 8.7 million shares of our Class A common stock at an incremental cost of $102.2 million under our share repurchase program and placed such shares in treasury. 2019 Results As of and for the year ended December 31, 2019, we achieved growth in many of our key business metrics and financial measures: •Transaction volume (as defined below) was $5.95 billion during the year ended December 31, 2019 compared to $5.03 billion during the year ended December 31, 2018 (increase of 18%) and $3.77 billion during the year ended December 31, 2017 (increase of 34%); •The outstanding balance of loans serviced by our platform totaled $9.15 billion as of December 31, 2019 compared to $7.34 billion as of December 31, 2018 (increase of 25%) and $5.39 billion as of December 31, 2017 (increase of 36%); •Active merchants totaled 17,216 as of December 31, 2019 compared to 14,907 as of December 31, 2018 (increase of 15%) and 10,891 as of December 31, 2017 (increase of 37%); •We maintained an attractive consumer profile. For all loans originated on our platform during 2019, the credit-line weighted average consumer credit score was 770. Furthermore, consumers with credit scores over 780 comprised 37% of the loan servicing portfolio as of December 31, 2019, and over 85% of the loan servicing portfolio as of December 31, 2019 consisted of consumers with credit scores over 700; and •Total revenue of $529.6 million during the year ended December 31, 2019 increased by 28% from $414.7 million during the year ended December 31, 2018, which in turn increased by 27% from $325.9 million during the year ended December 31, 2017. We recognized a fair value change in our servicing asset of $30.5 million primarily associated with increases to the contractual fixed servicing fees for certain Bank Partners, which positively impacted servicing and other revenue. Net income of $96.0 million during the year ended December 31, 2019 decreased from $128.0 million during the year ended December 31, 2018, which in turn decreased from $138.7 million during the year ended December 31, 2017. Adjusted EBITDA (as defined below) of $164.1 million during the year ended December 31, 2019 decreased from $170.0 million during the year ended December 31, 2018, which in turn increased from $157.1 million during the year ended December 31, 2017. The decreases in net income and Adjusted EBITDA in 2019 were primarily due to: •(i) the increase in the fair value change in finance charge reversal liability resulting from ◦(a) growth in our loan servicing portfolio, particularly deferred interest loans in the promotional period, ◦(b) an increase in credit losses, net of recoveries, and ◦(c) an increase in contracted Bank Partner portfolio yields; and •(ii) higher servicing, origination and operating expenses to support our growth and increased requirements as a public company. Net income for the year ended December 31, 2019 was also impacted by a non-cash contingent expense associated with our financial guarantee arrangement with a Bank Partner upon expiration of its loan origination agreement in the fourth quarter of 2019. See Note 14 to the Notes to Consolidated Financial Statements included in Item 8 for additional information regarding our financial guarantee. Information regarding our use of Adjusted EBITDA, a non-GAAP measure, and a reconciliation of Adjusted EBITDA to net income, the most comparable GAAP (as defined below) measure, is included in "Non-GAAP Financial Measures." Non-GAAP Financial Measures In addition to financial measures presented in accordance with United States generally accepted accounting principles (“GAAP”), we monitor Adjusted EBITDA to manage our business, make planning decisions, evaluate our performance and allocate resources. We define “Adjusted EBITDA” as net income before interest expense, taxes, depreciation and amortization, adjusted to eliminate equity-based compensation and payments and certain non-cash and non-recurring expenses. We believe that Adjusted EBITDA is one of the key financial indicators of our business performance over the long term and provides useful information regarding whether cash provided by operating activities is sufficient to maintain and grow our business. We believe that this methodology for determining Adjusted EBITDA can provide useful supplemental information to help investors better understand the economics of our business. During the year ended December 31, 2019, management removed the EBITDA adjustment for the non-cash impact of the initial recognition and subsequent fair value changes in our servicing liabilities, as the fair value measurements of our servicing rights are becoming a more significant component of our core business model. The Adjusted EBITDA measures for the years ended December 31, 2018 and 2017 were adjusted accordingly, which resulted in decreases of those measures by $945 and $2,071, respectively. During the year ended December 31, 2019, management removed the EBITDA adjustment for non-corporate tax expenses, which are recorded within general and administrative expenses in our Consolidated Statements of Operations, to align the adjustment with our corporate tax expense. The Adjusted EBITDA measures for the years ended December 31, 2018 and 2017 were adjusted accordingly, which resulted in decreases of those measures by $572 and $309, respectively. During the year ended December 31, 2019, management added an EBITDA adjustment for losses recorded in the fourth quarter of 2019 associated with the financial guarantee arrangement for a Bank Partner that did not renew its loan origination agreement when it expired in November 2019. The Adjusted EBITDA measures for the years ended December 31, 2018 and 2017 were not impacted by this item. Adjusted EBITDA has limitations as an analytical tool and should not be considered in isolation from, or as a substitute for, the analysis of other GAAP financial measures, such as net income. Some of the limitations of Adjusted EBITDA include: •It does not reflect our current contractual commitments that will have an impact on future cash flows; •It does not reflect the impact of working capital requirements or capital expenditures; and •It is not a universally consistent calculation, which limits its usefulness as a comparative measure. Management compensates for the inherent limitations associated with using the measure of Adjusted EBITDA through disclosure of such limitations, presentation of our financial statements in accordance with GAAP and reconciliation of Adjusted EBITDA to the most directly comparable GAAP measure, net income, as presented below. (1)Includes equity-based compensation to employees and directors, as well as equity-based payments to non-employees. (2)Includes losses recorded in the fourth quarter of 2019 associated with the financial guarantee arrangement for a Bank Partner that did not renew its loan origination agreement when it expired in November 2019. See Note 14 to the Notes to Consolidated Financial Statements included in Item 8 for additional discussion of our financial guarantee arrangements. (3)For the year ended December 31, 2019, includes loss on remeasurement of our tax receivable agreement liability of $9.8 million and professional fees associated with our strategic alternatives review process of $1.5 million. For the year ended December 31, 2018, includes certain costs associated with our IPO, which were not deferrable against the proceeds of the IPO. Further, includes certain costs, such as legal and debt arrangement costs, related to our March 2018 term loan upsizing. For the year ended December 31, 2017, includes one-time fees paid to an affiliate of one of the members of the board of managers in conjunction with the August 2017 term loan transaction. (4)For the year ended December 31, 2019, includes (i) legal fees associated with IPO related litigation of $2.0 million, (ii) one-time tax compliance fees related to filing the final tax return for the Former Corporate Investors associated with the Reorganization Transactions of $0.2 million, and (iii) lien filing expenses related to certain Bank Partner solar loans of $0.6 million. In light of the anticipated material non-cash charges to be recorded in connection with our financial guarantee arrangements as required subsequent to the adoption and implementation of ASU 2016-13 (as discussed in Note 1 to the Notes to Consolidated Financial Statements in Item 8 within "Accounting Standards Issued, But Not Yet Adopted - Measurement of credit losses on financial instruments"), management is evaluating both the disclosure of additional non-GAAP financial measures and the modification of its historical computation of adjusted EBITDA commencing in 2020 to enhance the disclosure of indicators of our business performance over the long term and to provide additional useful information to users of our financial statements. Further, we utilize Adjusted Pro Forma Net Income, which we define as consolidated net income, adjusted for (i) transaction and non-recurring expenses; (ii) for 2019, losses associated with the financial guarantee arrangement for a Bank Partner that did not renew its loan origination agreement; and (iii) incremental pro forma tax expense assuming all of our noncontrolling interests were subject to income taxation. Adjusted Pro Forma Net Income is a useful measure because it makes our results more directly comparable to public companies that have the vast majority of their earnings subject to corporate income taxation. Adjusted Pro Forma Net Income has limitations as an analytical tool and should not be considered in isolation from, or as a substitute for, the analysis of other GAAP financial measures, such as net income. Some of the limitations of Adjusted Pro Forma Net Income include: •It makes assumptions about tax expense, which may differ from actual results; and •It is not a universally consistent calculation, which limits its usefulness as a comparative measure. Management compensates for the inherent limitations associated with using the measure of Adjusted Pro Forma Net Income through disclosure of such limitations, presentation of our financial statements in accordance with GAAP and reconciliation of Adjusted Pro Forma Net Income to the most directly comparable GAAP measure, net income, as presented below. (1)Includes losses recorded in the fourth quarter of 2019 associated with the financial guarantee arrangement for a Bank Partner that did not renew its loan origination agreement when it expired in November 2019. See Note 14 to the Notes to Consolidated Financial Statements included in Item 8 for additional discussion of our financial guarantee arrangements. (2)For the year ended December 31, 2019, includes loss on remeasurement of our tax receivable agreement liability of $9.8 million and professional fees associated with our strategic alternatives review process of $1.5 million. For the year ended December 31, 2018, includes certain costs associated with our IPO, which were not deferrable against the proceeds of the IPO. Further, includes certain costs, such as legal and debt arrangement costs, related to our March 2018 term loan upsizing. For the year ended December 31, 2017, includes one-time fees paid to an affiliate of one of the members of the board of managers in conjunction with the August 2017 term loan transaction. (3)For the year ended December 31, 2019, includes (i) legal fees associated with IPO related litigation of $2.0 million, (ii) one-time tax compliance fees related to filing the final tax return for the Former Corporate Investors associated with the Reorganization Transactions of $0.2 million, and (iii) lien filing expenses related to certain Bank Partner solar loans of $0.6 million. (4)Represents the incremental tax effect on net income, adjusted for the items noted above, assuming that all consolidated net income was subject to corporate taxation for the periods presented. For the years ended December 31, 2019, 2018 and 2017, we assumed effective tax rates of 14.8%, 19.7% and 38.4%, respectively. Business Metrics We review a number of operating and financial metrics to evaluate our business, measure our performance, identify trends, formulate plans and make strategic decisions, including the following. Transaction Volume. We define transaction volume as the dollar value of loans facilitated on our platform during a given period. Transaction volume is an indicator of revenue and overall platform profitability and has grown substantially in the past several years. Loan Servicing Portfolio. We define our loan servicing portfolio as the aggregate outstanding consumer loan balance (principal plus accrued interest and fees) serviced by our platform at the date of measurement. Our loan servicing portfolio is an indicator of our servicing activities. The average loan servicing portfolio for the years ended December 31, 2019, 2018 and 2017 was $8,213 million, $6,303 million and $4,501 million, respectively. Active Merchants. We define active merchants as home improvement merchants and healthcare providers that have submitted at least one consumer application during the twelve months ended at the date of measurement. Because our transaction volume is a function of the size, engagement and growth of our merchant network, active merchants, in aggregate, are an indicator of future revenue and profitability, although they are not directly correlated. The comparative measures can also be impacted by disciplined corrective action taken by the Company to remove merchants from our program who do not meet our customer satisfaction standards. Cumulative Consumer Accounts. We define cumulative consumer accounts as the aggregate number of consumer accounts approved on our platform since our inception, including accounts with both outstanding and zero balances. Although not directly correlated to revenue, cumulative consumer accounts is a measure of our brand awareness among consumers, as well as the value of the data we have been collecting from such consumers since our inception. We may use this data to support future growth by cross-marketing products and delivering potential additional customers to merchants that may not have been able to source those customers themselves. Factors Affecting our Performance Network of Active Merchants and Transaction Volume. We have a robust network of active merchants, upon which our transaction volumes rely. Our revenues and financial results are heavily dependent on our transaction volume, which represents the dollar amount of loans funded on our platform and, therefore, influences the fees that we earn and the per-unit cost of the services that we provide. Our transaction volume depends on our ability to retain our existing platform participants, add new participants and expand to new industry verticals. We engage new merchants through both direct sales channels, as well as affiliate channel partners, such as manufacturers, software companies and other entities that have a network of merchants that would benefit from consumer financing. Once onboarded, merchant relationships are maintained and grown by direct account management, as well as regular product enhancements that facilitate merchant growth. Bank Partner Relationships; Other Funding. "Bank Partners" are defined as federally insured banks that originate loans under the consumer financing and payments program that we administer for use by merchants on behalf of such banks in connection with which we provide point-of-sale financing and payments technology and related marketing, servicing, collection and other services (the "GreenSky program" or "program"). Our ability to generate and increase transaction volume and expand our loan servicing portfolio is, in part, dependent on (a) retaining our existing Bank Partners and having them renew and expand their commitments, (b) adding new Bank Partners and/or (c) adding complementary funding arrangements to increase funding capacity. Our failure to do so could materially and adversely affect our business and our ability to grow. A Bank Partner’s funding commitment typically has an initial multi-year term, after which the commitment is either renewed (typically on an annual basis) or expires. No assurance is given that any of the current funding commitments of our Bank Partners will be renewed. In that regard, Regions Bank, one of our Bank Partners, made a strategic decision to reduce its use of indirect lending programs and elected not to renew its origination commitment when it expired on November 25, 2019. This prompted management to conclude at the end of 2019 that the likelihood of making escrow payments in future periods with respect to the Regions escrow account was probable of occurring, as a result of which we recorded a non-cash contingent expense of $16.2 million and a corresponding liability as of December 31, 2019. See Note 14 to the Notes to Consolidated Financial Statements included in Item 8 for further discussion of this item. As of December 31, 2019, we had aggregate funding commitments from our ongoing Bank Partners of approximately $9.0 billion, of which approximately $2.2 billion was unused. These funding commitments are "revolving" and replenish as outstanding loans are paid down. As a result of loan pay-downs, we anticipate approximately $2.7 billion of additional funding capacity will become available during 2020. As we add new Bank Partners, their full commitments are typically subject to a mutually agreed upon onboarding schedule. Two of our ongoing Bank Partners are in their initial three-year terms. The remaining six ongoing Bank Partners extended their commitment terms in the normal course during 2019, one of which adjusted its commitment from $4 billion to $3 billion in the fourth quarter of 2019. In addition to customary expansion of commitments from existing Bank Partners and the periodic addition of new Bank Partners to our funding group, over time we expect to diversify our funding to include a combination of commitments from Bank Partners and alternative structures with one or more institutional investors, financial institutions or other financing sources. As noted in Item 7 “Executive Summary-2019 Developments,” in December 2019, we reached an agreement in principle relating to a three-year, $6 billion forward flow arrangement with a leading institutional asset manager, which would complement our current Bank Partner commitments. Under this arrangement, the asset manager would have a commitment of up to $2 billion per year for a three-year period. Unlike our Bank Partner commitments, this forward flow arrangement would not be "revolving" and would not replenish as outstanding loans are paid down. We expect funding commitments to first be available under this arrangement during the second quarter of 2020. If we do not timely consummate the forward flow arrangement or alternative structures, or if the funding commitments from our Bank Partners and the forward flow arrangement or alternative structures (should they be consummated) are not sufficient to support expected originations, it would limit our ability to generate revenue at or above current levels. Performance of the Loans our Bank Partners Originate. While our Bank Partners bear substantially all of the credit risk on their wholly-owned loan portfolios, Bank Partner credit losses and prepayments impact our profitability as follows: •Our contracts with our Bank Partners entitle us to incentive payments when the finance charges billed to borrowers exceed the sum of an agreed-upon portfolio yield, a fixed servicing fee and realized credit losses. This incentive payment varies from month to month, primarily due to the amount of realized credit losses. •With respect to deferred interest loans, we bill the consumer for interest throughout the deferred interest promotional period, but the consumer is not obligated to pay any interest if the loan is repaid in full before the end of the promotional period. We are obligated to remit this accumulated billed interest to our Bank Partners to the extent the loan principal balances are paid off within the promotional period (each event, a finance charge reversal or "FCR") even though the interest billed to the consumer is reversed. Our maximum FCR liability is limited to the gross amount of finance charges billed during the promotional period, offset by the collection of incentive payments from our Bank Partners during such period, proceeds received from transfers of previously charged-off loan receivables ("Charged-Off Receivables") and recoveries on unsold charged-off receivables. Our profitability is impacted by the difference between the cash collected from these items and the cash to be remitted on a future date to settle our FCR liability. Our FCR liability quantifies our expected future obligation to remit previously billed interest with respect to deferred interest loans. •If credit losses exceed an agreed-upon threshold, we make limited payments to our Bank Partners. Our maximum financial exposure is contractually limited to the escrow that we establish with each Bank Partner, which represented a weighted average target rate of 2.1% of the total outstanding loan balance as of December 31, 2019. Cash set aside to meet this requirement is classified as restricted cash in our Consolidated Balance Sheets. For further discussion of our sensitivity to the credit risk exposure of our Bank Partners, see

<s>[INST] discussion and analysis contains forwardlooking statements based upon current plans, expectations and beliefs involving risks and uncertainties. Our actual results may differ materially from those anticipated in these forwardlooking statements as a result of various important factors, including those set forth under Part I, Item 1A“Risk Factors” in this Form 10K. Unless the context requires otherwise, "we," "us," "our," "GreenSky" and "the Company" refer to GreenSky, Inc. and its subsidiaries. Organization GreenSky, Inc. was formed as a Delaware corporation on July 12, 2017. The Company was formed for the purpose of completing an IPO of its Class A common stock and certain Reorganization Transactions in order to carry on the business of GS Holdings and its consolidated subsidiaries. GS Holdings, a holding company with no operating assets or operations, was organized in August 2017. On August 24, 2017, GS Holdings acquired a 100% interest in GSLLC, a Georgia limited liability company, which is an operating entity. Common membership interests of GS Holdings are referred to as "Holdco Units." See Note 1 to the Notes to Consolidated Financial Statements in Item 8 for a detailed discussion of the Reorganization Transactions (as defined in that note) and the IPO. Executive Summary For a Company overview, see Part I, Item 1 "Business." 2019 Developments Specific key developments during the year ended December 31, 2019 include: As announced in August 2019, the Company's Board of Directors (the "Board"), working together with its senior management team and legal and financial advisors, has commenced a process to explore, review and evaluate a range of potential strategic alternatives focused on maximizing stockholder value. ◦The Board has not made any decisions related to strategic alternatives at this time, and there is no assurance that the Board’s exploration of strategic alternatives will result in any change of strategy or transaction being entered into or consummated or, if a transaction is undertaken, as to its terms, structure or timing. ◦The Board's review is ongoing, and the Company does not intend to make further public comment regarding these matters unless and until the Board has approved a specific transaction or alternative or otherwise concludes its review. In December 2019, we reached an agreement in principle for a threeyear, $6 billion forward flow arrangement with a leading institutional asset manager, which would complement our current Bank Partner commitments. See "Factors Affecting our PerformanceBank Partner Relationships; Other Funding" for additional discussion of this proposed forward flow arrangement. We entered into a $350.0 million notional, fouryear interest rate swap agreement to hedge changes in cash flows attributable to interest rate risk on $350.0 million of our variablerate term loan. We purchased 8.7 million shares of our Class A common stock at an incremental cost of $102.2 million under our share repurchase program and placed such shares in treasury. 2019 Results As of and for the year ended December 31, 2019, we achieved growth in many of our key business metrics and financial measures: Transaction volume (as defined below) was $5.95 billion during the year ended December 31, 2019 compared to $5.03 billion during the year ended December 31, 2018 (increase of 18%) and $3.77 billion during the year ended December 31, 2017 (increase of 34%); The outstanding balance of loans serviced by our platform totaled $9.15 billion as of December 31, 2019 compared to $7.34 billion as of December 31, 2018 (increase of 25%) and $5.39 billion as of December 31, 2017 (increase of 36%); Active merchants totaled 17,216 as of December 31, 2019 compared to 14,907 as of December 31, 2018 (increase of 15%) and 10,891 [/INST] Negative. </s>

Eton Pharmaceuticals, Inc.

2019-03-25

2018-12-31

Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations You should read the following discussion and analysis together with our financial statements and the related notes thereto included in “Item 8. Financial Statements and Supplementary Data” in this Annual Report on Form 10-K. The following discussion contains forward-looking statements that involve risks and uncertainties. For a complete discussion of forward-looking statements, see the section above entitled “Forward Looking Statements.” Our actual results could differ materially from those expressed or implied in any forward-looking statements as a result of various factors, including those set forth under the caption “Item 1A. Risk Factors.” Overview We were formed in April 2017 as a specialty pharmaceutical company focused on developing and commercializing innovative pharmaceutical products utilizing the FDA’s 505(b)(2) regulatory pathway. Our business model is to develop proprietary innovative products that fulfill an unmet patient need. Since our formation, we have focused our efforts on the development of our initial product candidates, engaging in preliminary discussions with the FDA concerning the regulatory pathway for certain additional product candidates, registration filings of our initial product candidates and the licensing of late-stage product candidates. We have established a diversified pipeline of product candidates in various stages of development, four of which have been submitted to the FDA and are under review. We intend to focus on product candidates that are liquid in formulation, including injectables, oral liquids and ophthalmics, and qualify under the FDA’s 505(b)(2) regulatory pathway. Our corporate strategy is to pursue what we perceive to be low-risk product candidates where existing published literature, historical clinical trials, or physician usage has established safety and/or efficacy of the molecule, thereby reducing the incremental clinical burden required for us to bring the product to patients. We intend to pursue product candidates that require a single small Phase 3 trial, a bio-equivalence trial, or literature-based filings. Prior to initiating significant development activities on a product candidate, we typically meet with the FDA to establish a defined clinical and regulatory path to approval. We believe our product candidates can address situations where patient needs are not being met by current FDA-approved pharmaceutical products. This may include products that are being supplied on an unapproved basis, products that are currently being compounded, and products that are approved and widely used internationally but not approved in the United States. Results of Operations Since our inception, we have not generated any revenues and do not anticipate generating any revenues unless and until we successfully complete development and obtain regulatory approval for one of our product candidates. For the periods ended December 31, 2018 and 2017, we incurred $5.6 million and $3.9 million of research and development (“R&D”) expenses, respectively, and $4.7 million and $3.2 million of general and administrative (“G&A”) expenses, respectively. The comparative period detail of our R&D expense is listed in the table below. The $1.5 million increase in G&A expenses was primarily due to the partial year start-up in late April 2017 as compared to a full year of operations in 2018 combined with personnel additions in the second half of 2018. Our compensation-related costs increased by $1.1 million plus costs for our board of directors increased by $0.4 million. In addition, the fair value of our warrant liability reflected in other expense increased by $2.5 million as a result of the increase in our stock price up to the date of our IPO. We incurred a net loss of $12.7 million and $7.2 million for the periods ended December 31, 2018 and 2017, respectively. General and Administrative Expenses G&A expenses consist primarily of employee compensation expenses, stock-based consulting service fees, legal and professional fees and travel expenses. We anticipate that our G&A expenses will significantly increase to support our business growth and the additional costs associated with being a public company. Research and Development Expenses Set forth below is our R&D spending for our current product candidates. We currently have nine employees that support our overall product development and we also have facility and operating costs for a laboratory that will support product development. We do not track internal costs by product for our employees and laboratory expenses and they are listed as indirect expenses in the table below (amounts are in thousands). Liquidity and Capital Resources As of December 31, 2018, we had total assets of $28.3 million and working capital of $25.5 million. We had previously capitalized our operations primarily from the June 2017 private placement of approximately $20.1 million of Series A preferred stock, par value $0.001 (the “Series A Preferred”). Our Series A Preferred accumulated dividends at the rate of 6% per annum and those shares of stock plus all accrued but unpaid dividends automatically converted into shares of our common stock concurrent with our IPO in November 2018 at the conversion price of 50% of the IPO price. The IPO provided us with net proceeds of $22.0 million which we believe should be sufficient for at least the next twelve months of our operations including through securing regulatory approval and commencement of commercial sales for at least one product candidate. We do not anticipate requiring additional funding after that point, however our projected estimates for our product development spending, administrative expenses and our working capital requirements could be inaccurate, or we may experience growth more quickly or on a larger scale than we expect, any of which could result in the depletion of capital resources more rapidly than anticipated and could require us to seek additional financing earlier than we expect to support our operations. Cash Flows The following table sets forth a summary of our cash flows for the periods ended December 31, 2018 and 2017 (amounts are in thousands): The increase in cash used in operating activities is primarily a result of higher operating losses due to our business expansion including additional personnel and increased product candidate development activity. Investing activities consist primarily of capital expenditures for setting up our headquarters office and the initial set-up for our laboratory facility. The financing activity primarily consists of the Series A Preferred private placement funding in June 2017 and the November 2018 IPO. Critical Accounting Policies Our financial statements are prepared in accordance with GAAP. The preparation of our financial statements and related disclosures requires us to make estimates and judgments that affect the reported amounts of assets, liabilities, costs and expenses in our condensed financial statements. We base our estimates on historical experience, known trends and events and various other factors that we believe are reasonable under the circumstances, the results of which form the basis for making judgments about the carrying values of assets and liabilities that are not readily apparent from other sources. We evaluate our estimates and assumptions on an ongoing basis. Our actual results may differ from these estimates under different assumptions or conditions. While our significant accounting policies are described in more detail in Note 3 to our financial statements included herein, we believe that the following accounting policies are those most critical to the judgments and estimates used in the preparation of our financial statements. Stock-Based Compensation We account for stock-based compensation under the provisions of the Financial Accounting Standards Board (the “FASB”) Accounting Standards Codification (“ASC”) - 718 Compensation - Stock Compensation. The guidance under ASC 718 requires companies to estimate the fair value of the stock-based compensation awards on the date of grant for employees and directors and record expense over the related service periods, which are generally the vesting period of the equity awards. Awards for consultants are accounted for under ASC 505-50 - Equity Based Payments to Non-Employees. Compensation expense is recognized over the period during which services are rendered by such consultants and non-employees until completed. At the end of each financial reporting period prior to completion of the service, the fair value of these awards is remeasured using the then-current fair value of our common stock and updated assumption inputs in the Black-Scholes option-pricing model (“BSM”). We estimate the fair value of stock-based option awards to our employees and directors using the BSM. The BSM requires the input of subjective assumptions, including the expected stock price volatility, the calculation of expected term, forfeitures and the fair value of the underlying common stock on the date of grant, among other inputs. The risk-free interest rate was determined from the implied yields for zero-coupon U.S. government issues with a remaining term approximating the expected life of the options or warrants. Dividends on common stock are assumed to be zero for the BSM valuation of the stock options. The expected term of stock options granted is based on vesting periods and the contractual life of the options. Expected volatilities are based on comparable companies’ historical volatility, which management believes represents the most accurate basis for estimating expected future volatility under the current conditions. We account for forfeitures as they occur. Prior to the IPO, the fair value of the shares of common stock underlying our stock-based awards was determined by our board of directors, with input from management. Because there had been no public market for our common stock prior to the IPO, our board of directors had determined the fair value of the common stock on the grant-date of the stock-based award by considering a number of objective and subjective factors, including enterprise valuations of our common stock performed by an unrelated third-party specialist, valuations of comparable companies, sales of our convertible preferred stock to unrelated third parties, operating and financial performance, the lack of liquidity of our capital stock, and general and industry-specific economic outlook. Following our IPO in November 2018, we use the closing stock price on the date of grant for the fair value of the common stock. Research and Development Expenses R&D expenses include both internal R&D activities and external contracted services. Internal R&D activity expenses include salaries, benefits and stock-based compensation and other costs to support our R&D operations. External contracted services include product development efforts including certain product licensor milestone payments, clinical trial activities, manufacturing and control-related activities and regulatory costs. R&D expenses are charged to operations as incurred. We review and accrue R&D expenses based on services performed and rely upon estimates of those costs applicable to the stage of completion of each project. Significant judgments and estimates are made in determining the accrued balances at the end of any reporting period. Actual results could differ from our estimates. Upfront payments and milestone payments made for the licensing of technology for products that are not yet approved by the FDA are expensed as R&D in the period in which they are incurred. Nonrefundable advance payments for goods or services to be received in the future for use in R&D activities are recorded as prepaid expenses and are expensed as the related goods are delivered or the services are performed. Warrant Liability We estimated the fair value of certain warrants at each reporting period using Level 3 inputs. The estimates in valuation models were based, in part, on subjective assumptions, including but not limited to stock price volatility, the expected life of the warrants, the risk-free interest rate and the exercise price of the warrants, and could differ materially in the future. Changes in the fair value of the warrant liability during the periods prior to the IPO were recorded as a component of other income (expense). We continued to adjust the fair value of the warrant liability at the end of each reporting period for changes in fair value until the earlier of the exercise or expiration of the applicable warrants or when the number of shares issuable upon exercise of these warrants became fixed which occurred with our IPO in November 2018. Beneficial Conversion Feature Prior to the IPO in November 2018, we classified our Series A Preferred as temporary equity due to a possible cash redemption feature in the event that an IPO or alternate financing was not available by December 31, 2018. At the IPO date, the Series A Preferred automatically converted into shares of our common stock. The conversion share calculation was based on the $3.00 initial issue price for the Series A Preferred plus any accrued but unpaid dividends and converted to our common stock using a stated divisor conversion price equal to 50% of the IPO price to the public which was $6.00 per share. In accordance with relevant accounting literature, since the stated terms of the conversion option did not permit us to compute the additional number of shares that we would need to issue upon conversion of the Series A Preferred when the contingent event would occur, we recorded the beneficial conversion amount as a deemed dividend at the date of the IPO in November 2018. Off Balance Sheet Transactions We do not have any off-balance sheet transactions. JOBS Act Transition Period In April 2012, the Jumpstart Our Business Startups Act of 2012 (the “JOBS Act”), was enacted. Section 107 of the JOBS Act provides that an “emerging growth company” can take advantage of the extended transition period provided in Section 7(a)(2)(B) of the Securities Act for complying with new or revised accounting standards. Thus, an emerging growth company can delay the adoption of certain accounting standards until those standards would otherwise apply to private companies. We have irrevocably elected not to avail ourselves of this extended transition period and, as a result, we will adopt new or revised accounting standards on the relevant dates on which adoption of such standards is required for other public companies. We are in the process of evaluating the benefits of relying on other exemptions and reduced reporting requirements under the JOBS Act. Subject to certain conditions, as an emerging growth company, we may rely on certain of these exemptions, including without limitation, (i) providing an auditor’s attestation report on our system of internal controls over financial reporting pursuant to Section 404(b) of the Sarbanes-Oxley Act and (ii) complying with any requirement that may be adopted by the Public Company Accounting Oversight Board regarding mandatory audit firm rotation or a supplement to the auditor’s report providing additional information about the audit and the financial statements, known as the auditor discussion and analysis. We will remain an emerging growth company until the earlier to occur of (1) the last day of the fiscal year (a) December 31, 2023, which is the end of the fiscal year following the fifth anniversary of the completion of our IPO, (b) in which we have total annual gross revenues of at least $1.07 billion or (c) in which we are deemed to be a “large accelerated filer” under the rules of the SEC, which means the market value of our common stock that is held by non-affiliates exceeds $700 million as of the prior June 30th, and (2) the date on which we have issued more than $1.0 billion in non-convertible debt during the prior three-year period.

<s>[INST] Overview We were formed in April 2017 as a specialty pharmaceutical company focused on developing and commercializing innovative pharmaceutical products utilizing the FDA’s 505(b)(2) regulatory pathway. Our business model is to develop proprietary innovative products that fulfill an unmet patient need. Since our formation, we have focused our efforts on the development of our initial product candidates, engaging in preliminary discussions with the FDA concerning the regulatory pathway for certain additional product candidates, registration filings of our initial product candidates and the licensing of latestage product candidates. We have established a diversified pipeline of product candidates in various stages of development, four of which have been submitted to the FDA and are under review. We intend to focus on product candidates that are liquid in formulation, including injectables, oral liquids and ophthalmics, and qualify under the FDA’s 505(b)(2) regulatory pathway. Our corporate strategy is to pursue what we perceive to be lowrisk product candidates where existing published literature, historical clinical trials, or physician usage has established safety and/or efficacy of the molecule, thereby reducing the incremental clinical burden required for us to bring the product to patients. We intend to pursue product candidates that require a single small Phase 3 trial, a bioequivalence trial, or literaturebased filings. Prior to initiating significant development activities on a product candidate, we typically meet with the FDA to establish a defined clinical and regulatory path to approval. We believe our product candidates can address situations where patient needs are not being met by current FDAapproved pharmaceutical products. This may include products that are being supplied on an unapproved basis, products that are currently being compounded, and products that are approved and widely used internationally but not approved in the United States. Results of Operations Since our inception, we have not generated any revenues and do not anticipate generating any revenues unless and until we successfully complete development and obtain regulatory approval for one of our product candidates. For the periods ended December 31, 2018 and 2017, we incurred $5.6 million and $3.9 million of research and development (“R&D”) expenses, respectively, and $4.7 million and $3.2 million of general and administrative (“G&A”) expenses, respectively. The comparative period detail of our R&D expense is listed in the table below. The $1.5 million increase in G&A expenses was primarily due to the partial year startup in late April 2017 as compared to a full year of operations in 2018 combined with personnel additions in the second half of 2018. Our compensationrelated costs increased by $1.1 million plus costs for our board of directors increased by $0.4 million. In addition, the fair value of our warrant liability reflected in other expense increased by $2.5 million as a result of the increase in our stock price up to the date of our IPO. We incurred a net loss of $12.7 million and $7.2 million for the periods ended December 31, 2018 and 2017, respectively. General and Administrative Expenses G&A expenses consist primarily of employee compensation expenses, stockbased consulting service fees, legal and professional fees and travel expenses. We anticipate that our G&A expenses will significantly increase to support our business growth and the additional costs associated with being a public company. Research and Development Expenses Set forth below is our R&D spending for our current product candidates. We currently have nine employees that support our overall product development and we also have facility and operating costs for a laboratory that will support product development. We do not track internal costs by product for our employees and laboratory expenses and they are listed as indirect expenses in the table below (amounts are in thousands). Liquidity and Capital Resources As of December 31, 2018, we had total assets of $28.3 million and working capital of $25.5 million. We had previously capitalized our operations primarily from the June 2017 private placement of approximately $20.1 million of Series A preferred stock, par value $0.001 (the “Series A Preferred”). Our Series A Preferred accumulated dividends at the [/INST] Negative. </s>

Eton Pharmaceuticals, Inc.

2020-03-05

2019-12-31

Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations You should read the following discussion and analysis together with our financial statements and the related notes thereto included in “Item 8. Financial Statements and Supplementary Data” in this Annual Report on Form 10-K. The following discussion contains forward-looking statements that involve risks and uncertainties. For a complete discussion of forward-looking statements, see the section above entitled “Forward Looking Statements.” Our actual results could differ materially from those expressed or implied in any forward-looking statements as a result of various factors, including those set forth under the caption “Item 1A. Risk Factors.” Overview We were formed in April 2017 as a specialty pharmaceutical company focused on developing and commercializing innovative pharmaceutical products utilizing the FDA’s 505(b)(2) regulatory pathway. Our business model is to develop proprietary innovative products that fulfill an unmet patient need. Since our formation, we have focused our efforts on the development of our initial product candidates, engaging in preliminary discussions with the FDA concerning the regulatory pathway for certain additional product candidates, registration filings of our initial product candidates and the licensing of late-stage product candidates. In December 2019 we launched our Biorphen product and we have established a diversified pipeline of other product candidates in various stages of development, four of which have been submitted to the FDA and are under review. We intend to focus on product candidates that are liquid in formulation, including injectables, oral liquids and ophthalmics, and qualify under the FDA’s 505(b)(2) regulatory pathway. Our corporate strategy is to pursue what we perceive to be low-risk product candidates where existing published literature, historical clinical trials, or physician usage has established safety and/or efficacy of the molecule, thereby reducing the incremental clinical burden required for us to bring the product to patients. We intend to pursue product candidates that require a single small Phase 3 trial, a bioequivalence trial, or literature-based filings. Prior to initiating significant development activities on a product candidate, we typically meet with the FDA to establish a defined clinical and regulatory path to approval. We believe our product candidates can address situations where patient needs are not being met by current FDA-approved pharmaceutical products. This may include products that are being supplied on an unapproved basis, products that are currently being compounded, and products that are approved and widely used internationally but not approved in the United States. Results of Operations To date we have realized only limited revenues from a licensing arrangement on our EM-100 product and the launch of our Biorphen product. We anticipate successfully completing development of additional product candidates in 2020 and beyond and growing our business. Year Ended December 31, 2019 Compared to Year Ended December 31, 2018 For the years ended December 31, 2019 and 2018, we generated $1.0 and $0 in revenue, respectively. The revenue realized in 2019 was from a licensing arrangement for our EM-100 product which is pending additional FDA review and the launch of our Biorphen product in December 2019. For the years 2019 and 2018, we incurred $11.6 million and $5.6 million of research and development (“R&D”) expenses, respectively, and $7.6 million and $4.7 million of general and administrative (“G&A”) expenses, respectively. The comparative period detail of our R&D expense is listed in the table below. The $2.9 million increase in G&A expenses was primarily due to additional expenses related to becoming a public company, sales and marketing for the launch of our Biorphen product, and the impact of personnel additions in the second half of 2018 and first half of 2019. This was partially offset by lower stock-based consulting expenses. In addition, the change in the fair value of our warrant liability reflected in other expense decreased by $2.6 million as this mark-to-market accounting treatment was terminated in conjunction with our November 2018 IPO. We incurred a net loss of $18.3 million and $12.7 million for the years ended December 31, 2019 and 2018, respectively. General and Administrative Expenses G&A expenses consist primarily of employee compensation expenses, stock-based consulting service fees, sales and marketing expenses, business insurance, legal and professional fees and travel expenses. Research and Development Expenses Set forth below is our R&D spending for our current product candidates. We currently have ten employees that support our overall product development and we also have facility and operating costs for a laboratory that supports our product development. The laboratory personnel and related capital equipment additions were added in late 2018. We do not track internal costs by product for our employees and laboratory expenses and they are listed as indirect expenses in the table below (amounts are in thousands). Year Ended December 31, 2018 Compared to Period Ended December 31, 2017 For the periods ended December 31, 2018 and 2017, we incurred $5.6 million and $3.9 million of research and development (“R&D”) expenses, respectively, and $4.7 million and $3.2 million of general and administrative (“G&A”) expenses, respectively. The comparative period detail of our R&D expense is listed in the table below. The $1.5 million increase in G&A expenses was primarily due to the partial year start-up in late April 2017 as compared to a full year of operations in 2018 combined with personnel additions in the second half of 2018. Our compensation-related costs increased by $1.1 million plus costs for our board of directors increased by $0.4 million. In addition, the fair value of our warrant liability reflected in other expense increased by $2.5 million as a result of the increase in our stock price up to the date of our IPO. We incurred a net loss of $12.7 million and $7.2 million for the periods ended December 31, 2018 and 2017, respectively. General and Administrative Expenses G&A expenses consist primarily of employee compensation expenses, stock-based consulting service fees, legal and professional fees and travel expenses. We anticipate that our G&A expenses will significantly increase to support our business growth and the additional costs associated with being a public company. Research and Development Expenses Set forth below is our R&D spending for our current product candidates. We currently have nine employees that support our overall product development and we also have facility and operating costs for a laboratory that will support product development. We do not track internal costs by product for our employees and laboratory expenses and they are listed as indirect expenses in the table below (amounts are in thousands). Liquidity and Capital Resources As of December 31, 2019, we had total assets of $17.1 million and working capital of $13.0 million. We had previously capitalized our operations primarily from the June 2017 private placement of approximately $20.1 million of Series A preferred stock, par value $0.001 (the “Series A Preferred”). Our Series A Preferred accumulated dividends at the rate of 6% per annum and those shares of stock plus all accrued but unpaid dividends automatically converted into shares of our common stock concurrent with our IPO in November 2018 at the conversion price of 50% of the IPO price. The IPO provided us with net proceeds of $22.0 million and we also entered into a Credit Agreement with SWK Holdings in November 2019 which provides for up to $10 million in additional borrowing, $5.0 million of which was received at closing. We believe that our existing funding and the revenue from our Biorphen product and potential milestones and royalty payments from EM-100 will be sufficient for at least the next twelve months of our operations. However, our projected estimates for our product development spending, administrative expenses and our working capital requirements could be inaccurate, or we may experience growth more quickly or on a larger scale than we expect, any of which could result in the depletion of capital resources more rapidly than anticipated and could require us to seek additional financing earlier than we expect to support our operations. Cash Flows The following table sets forth a summary of our cash flows for the periods ended December 31, 2019, 2018 and 2017 (amounts are in thousands): The increase in cash used in operating activities is primarily a result of higher operating losses due to our business expansion including additional personnel and increased product candidate development activity. Investing activities consist primarily of licensing fees for Biorphen and capital expenditures for setting up our laboratory facility and our headquarters office. The financing activity primarily consists of the Series A Preferred private placement funding in June 2017, the November 2018 IPO and the November 2019 Credit Agreement with SWK Holdings. Critical Accounting Policies Our financial statements are prepared in accordance with GAAP. The preparation of our financial statements and related disclosures requires us to make estimates and judgments that affect the reported amounts of assets, liabilities, costs and expenses in our condensed financial statements. We base our estimates on historical experience, known trends and events and various other factors that we believe are reasonable under the circumstances, the results of which form the basis for making judgments about the carrying values of assets and liabilities that are not readily apparent from other sources. We evaluate our estimates and assumptions on an ongoing basis. Our actual results may differ from these estimates under different assumptions or conditions. While our significant accounting policies are described in more detail in Note 3 to our financial statements included herein, we believe that the following accounting policies are those most critical to the judgments and estimates used in the preparation of our financial statements. Revenue We account for contracts with its customers in accordance with Accounting Standards Codification (“ASC”) 606 - Revenue from Contracts with Customers. ASC 606 applies to all contracts with customers, except for contracts that are within the scope of other standards. Under ASC 606, an entity recognizes revenue when its customer obtains control of promised goods or services, in an amount that reflects the consideration which the entity expects to receive in exchange for those goods or services. To determine revenue recognition for arrangements that an entity determines are within the scope of ASC 606, the entity performs the following five steps: (i) identify the contract(s) with a customer; (ii) identify the performance obligations in the contract; (iii) determine the transaction price; (iv) allocate the transaction price to the performance obligations in the contract; and (v) recognize revenue when (or as) the entity satisfies a performance obligation. At contract inception, once the contract is determined to be within the scope of ASC 606, we assess the goods or services promised within each contract and determines those that are performance obligations and assesses whether each promised good or service is distinct. We then recognize as revenue the amount of the transaction price that is allocated to the respective performance obligation when (or as) the performance obligation is satisfied. Arrangements that include rights to additional goods or services that are exercisable at a customer’s discretion are generally considered options. We assess whether these options provide a material right to the customer and, if so, they are considered performance obligations. The exercise of a material right is accounted for as a contract modification for accounting purposes. We recognizes as revenue the amount of the transaction price that is allocated to the respective performance obligation when (or as) each performance obligation is satisfied at a point in time or over time, and if over time this is based on the use of an output or input method. Any amounts received prior to revenue recognition will be recorded as deferred revenue. Amounts expected to be recognized as revenue within the twelve months following the balance sheet date will be classified as current portion of deferred revenue in our balance sheets. Amounts not expected to be recognized as revenue within the twelve months following the balance sheet date are classified as long-term deferred revenue, net of current portion. Milestone Payments - If a commercial contract arrangement includes development and regulatory milestone payments, we will evaluate whether the milestone conditions have been achieved and if it is probable that a significant revenue reversal would not occur before recognizing the associated revenue. Milestone payments that are not within our control or the licensee’s control, such as regulatory approvals, are generally not considered probable of being achieved until those approvals are received. Royalties - For arrangements that include sales-based royalties, including milestone payments based on a level of sales, which are the result of a customer-vendor relationship and for which the license is deemed to be the predominant item to which the royalties relate, we will recognize revenue at the later of (i) when the related sales occur, or (ii) when the performance obligation to which some or all of the royalty has been allocated has been satisfied or partially satisfied. To date, we have not recognized any royalty revenue resulting from any of our licensing arrangements. Significant Financing Component - In determining the transaction price, we will adjust consideration for the effects of the time value of money if the expected period between payment by the licensees and the transfer of the promised goods or services to the licensees will be more than one year. We sell Biorphen in the U.S. to wholesale pharmaceutical distributors, who then sell the product to hospitals and other end-user customers. Sales to wholesalers are made pursuant to purchase orders subject to the terms of a master agreement, and delivery of individual shipments of Biorphen represent performance obligations under each purchase order. We use a third-party logistics (“3PL”) vendor to process and fulfill orders and have concluded it is the principal in the sales to wholesalers because it controls access to the 3PL vendor services rendered and directs the 3PL vendor activities. We have no significant obligations to wholesalers to generate pull-through sales. Selling prices initially billed to wholesalers are subject to discounts for prompt payment and subsequent chargebacks when the wholesalers sell Biorphen at negotiated discounted prices to members of certain group purchasing organizations (“GPOs”) and government programs. In addition, the we pay fees to wholesalers for their distribution services, inventory reporting and chargeback processing. We pay GPOs fees for administrative services and for access to GPO members and concluded the benefits received in exchange for these fees are not distinct from our sales of Biorphen, and accordingly we apply these amounts to reduce revenues. Wholesalers also have rights to return unsold product nearing or past the expiration date. Because of the shelf life of Biorphen and our lengthy return period, there may be a significant period of time between when the product is shipped and when we issue credits on returned product. We estimate the transaction price when we receive each purchase order, taking into account the expected reductions of the selling price initially billed to the wholesaler arising from all of the above factors. We have developed estimates for future returns and chargebacks of Biorphen and the impact of the other discounts and fees we pay. When estimating these adjustments to the transaction price, we reduce it sufficiently to be able to assert that it is probable that there will be no significant reversal of revenue when the ultimate adjustment amounts are known. We recognize revenue from Biorphen product sales and related cost of sales upon product delivery to the wholesaler location. At that time, the wholesalers take control of the product as they take title, bear the risk of loss of ownership, and have an enforceable obligation to pay us. They also have the ability to direct sales of product to their customers on terms and at prices they negotiate. Although wholesalers have product return rights, we do not believe they have a significant incentive to return the product to us. Upon recognition of revenue from product sales of Biorphen, the estimated amounts of credit for product returns, chargebacks, distribution fees, prompt payment discounts, and GPO fees are included in sales reserves, accrued liabilities and net of accounts receivable. We monitor actual product returns, chargebacks, discounts and fees subsequent to the sale. If these amounts end up differing from our estimates, we will make adjustments to these allowances, which are applied to increase or reduce product sales revenue and earnings in the period of adjustment. In addition, we anticipate we will receive revenues from product licensing agreements where we have contracted for milestone payments and royalties from products we have developed or for which we have acquired the rights to a product developed by a third party. Stock-Based Compensation We account for stock-based compensation under the provisions of the Financial Accounting Standards Board (the “FASB”) Accounting Standards Codification (“ASC”) - 718 Compensation - Stock Compensation. The guidance under ASC 718 requires companies to estimate the fair value of the stock-based compensation awards on the date of grant for employees and directors and record expense over the related service periods, which are generally the vesting period of the equity awards. Awards for consultants are accounted for under ASC 505-50 - Equity Based Payments to Non-Employees. Compensation expense is recognized over the period during which services are rendered by such consultants and non-employees until completed. At the end of each financial reporting period prior to completion of the service, the fair value of these awards is remeasured using the then-current fair value of our common stock and updated assumption inputs in the Black-Scholes option-pricing model (“BSM”). We estimate the fair value of stock-based option awards to our employees and directors using the BSM. The BSM requires the input of subjective assumptions, including the expected stock price volatility, the calculation of expected term, forfeitures and the fair value of the underlying common stock on the date of grant, among other inputs. The risk-free interest rate was determined from the implied yields for zero-coupon U.S. government issues with a remaining term approximating the expected life of the options or warrants. Dividends on common stock are assumed to be zero for the BSM valuation of the stock options. The expected term of stock options granted is based on vesting periods and the contractual life of the options. Expected volatilities are based on comparable companies’ historical volatility, which management believes represents the most accurate basis for estimating expected future volatility under the current conditions. We account for forfeitures as they occur. Prior to our initial public offering in November 2018 (the “IPO”), the fair value of the shares of common stock underlying our stock-based awards was determined by our board of directors, with input from management. Because there had been no public market for our common stock prior to the IPO, our board of directors had determined the fair value of the common stock on the grant-date of the stock-based award by considering a number of objective and subjective factors, including enterprise valuations of our common stock performed by an unrelated third-party specialist, valuations of comparable companies, sales of our convertible preferred stock to unrelated third parties, operating and financial performance, the lack of liquidity of our capital stock, and general and industry-specific economic outlook. Following our IPO, we use the closing stock price on the date of grant for the fair value of the common stock. Research and Development Expenses R&D expenses include both internal R&D activities and external contracted services. Internal R&D activity expenses include salaries, benefits and stock-based compensation and other costs to support our R&D operations. External contracted services include product development efforts including certain product licensor milestone payments, clinical trial activities, manufacturing and control-related activities and regulatory costs. R&D expenses are charged to operations as incurred. We review and accrue R&D expenses based on services performed and rely upon estimates of those costs applicable to the stage of completion of each project. Significant judgments and estimates are made in determining the accrued balances at the end of any reporting period. Actual results could differ from our estimates. Upfront payments and milestone payments made for the licensing of technology for products that are not yet approved by the FDA are expensed as R&D in the period in which they are incurred. Nonrefundable advance payments for goods or services to be received in the future for use in R&D activities are recorded as prepaid expenses and are expensed as the related goods are delivered or the services are performed. Off Balance Sheet Transactions We do not have any off-balance sheet transactions. JOBS Act Transition Period In April 2012, the Jumpstart Our Business Startups Act of 2012 (the “JOBS Act”), was enacted. Section 107 of the JOBS Act provides that an “emerging growth company” can take advantage of the extended transition period provided in Section 7(a)(2)(B) of the Securities Act for complying with new or revised accounting standards. Thus, an emerging growth company can delay the adoption of certain accounting standards until those standards would otherwise apply to private companies. We have irrevocably elected not to avail ourselves of this extended transition period and, as a result, we will adopt new or revised accounting standards on the relevant dates on which adoption of such standards is required for other public companies. We are in the process of evaluating the benefits of relying on other exemptions and reduced reporting requirements under the JOBS Act. Subject to certain conditions, as an emerging growth company, we may rely on certain of these exemptions, including without limitation, (i) providing an auditor’s attestation report on our system of internal controls over financial reporting pursuant to Section 404(b) of the Sarbanes-Oxley Act and (ii) complying with any requirement that may be adopted by the Public Company Accounting Oversight Board regarding mandatory audit firm rotation or a supplement to the auditor’s report providing additional information about the audit and the financial statements, known as the auditor discussion and analysis. We will remain an emerging growth company until the earlier to occur of (1) the last day of the fiscal year (a) December 31, 2023, which is the end of the fiscal year following the fifth anniversary of the completion of our IPO, (b) in which we have total annual gross revenues of at least $1.07 billion or (c) in which we are deemed to be a “large accelerated filer” under the rules of the SEC, which means the market value of our common stock that is held by non-affiliates exceeds $700 million as of the prior June 30th, and (2) the date on which we have issued more than $1.0 billion in non-convertible debt during the prior three-year period.

<s>[INST] Overview We were formed in April 2017 as a specialty pharmaceutical company focused on developing and commercializing innovative pharmaceutical products utilizing the FDA’s 505(b)(2) regulatory pathway. Our business model is to develop proprietary innovative products that fulfill an unmet patient need. Since our formation, we have focused our efforts on the development of our initial product candidates, engaging in preliminary discussions with the FDA concerning the regulatory pathway for certain additional product candidates, registration filings of our initial product candidates and the licensing of latestage product candidates. In December 2019 we launched our Biorphen product and we have established a diversified pipeline of other product candidates in various stages of development, four of which have been submitted to the FDA and are under review. We intend to focus on product candidates that are liquid in formulation, including injectables, oral liquids and ophthalmics, and qualify under the FDA’s 505(b)(2) regulatory pathway. Our corporate strategy is to pursue what we perceive to be lowrisk product candidates where existing published literature, historical clinical trials, or physician usage has established safety and/or efficacy of the molecule, thereby reducing the incremental clinical burden required for us to bring the product to patients. We intend to pursue product candidates that require a single small Phase 3 trial, a bioequivalence trial, or literaturebased filings. Prior to initiating significant development activities on a product candidate, we typically meet with the FDA to establish a defined clinical and regulatory path to approval. We believe our product candidates can address situations where patient needs are not being met by current FDAapproved pharmaceutical products. This may include products that are being supplied on an unapproved basis, products that are currently being compounded, and products that are approved and widely used internationally but not approved in the United States. Results of Operations To date we have realized only limited revenues from a licensing arrangement on our EM100 product and the launch of our Biorphen product. We anticipate successfully completing development of additional product candidates in 2020 and beyond and growing our business. Year Ended December 31, 2019 Compared to Year Ended December 31, 2018 For the years ended December 31, 2019 and 2018, we generated $1.0 and $0 in revenue, respectively. The revenue realized in 2019 was from a licensing arrangement for our EM100 product which is pending additional FDA review and the launch of our Biorphen product in December 2019. For the years 2019 and 2018, we incurred $11.6 million and $5.6 million of research and development (“R&D”) expenses, respectively, and $7.6 million and $4.7 million of general and administrative (“G&A”) expenses, respectively. The comparative period detail of our R&D expense is listed in the table below. The $2.9 million increase in G&A expenses was primarily due to additional expenses related to becoming a public company, sales and marketing for the launch of our Biorphen product, and the impact of personnel additions in the second half of 2018 and first half of 2019. This was partially offset by lower stockbased consulting expenses. In addition, the change in the fair value of our warrant liability reflected in other expense decreased by $2.6 million as this marktomarket accounting treatment was terminated in conjunction with our November 2018 IPO. We incurred a net loss of $18.3 million and $12.7 million for the years ended December 31, 2019 and 2018, respectively. General and Administrative Expenses G&A expenses consist primarily of employee compensation expenses, stockbased consulting service fees, sales and marketing expenses, business insurance, legal and professional fees and travel expenses. Research and Development Expenses Set forth below is our R&D spending for our current product candidates. We currently have ten employees that support our overall product development and we also have facility and operating costs for a laboratory that supports our product development. The laboratory personnel and related capital equipment additions were added in [/INST] Negative. </s>

SUTRO BIOPHARMA, INC.

2019-04-01

2018-12-31

Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations The following discussion should be read in conjunction with the attached financial statements and notes thereto. This Annual Report on Form 10-K, including the following sections, contains forward-looking statements within the meaning of the federal securities laws. These statements are subject to risks and uncertainties that could cause actual results and events to differ materially from those expressed or implied by such forward-looking statements. For a detailed discussion of these risks and uncertainties, see the “Risk Factors” section in Item 1A of this Annual Report on Form 10-K. We caution the reader not to place undue reliance on these forward-looking statements, which reflect management’s analysis only as of the date of this Form 10-K. We undertake no obligation to update forward-looking statements, which reflect events or circumstances occurring after the date of this Form 10-K. Overview We are a clinical stage drug discovery, development and manufacturing company focused on deploying our proprietary integrated cell-free protein synthesis and site-specific conjugation platform, XpressCF™, to create a broad variety of optimally designed, next-generation protein therapeutics initially for cancer and autoimmune disorders. We aim to design therapeutics using the most relevant and potent modalities, including cytokine-based targets, immuno-oncology, or I/O, agents, antibody-drug conjugates, or ADCs, and bispecific antibodies that are directed primarily against clinically validated targets where the current standard of care is suboptimal. We believe our platform allows us to accelerate the discovery and development of potential first-in-class and best-in-class molecules by enabling the rapid and systematic evaluation of protein structure-activity relationships to create optimized homogeneous product candidates. Our mission is to transform the lives of patients by using our XpressCF™ Platform to create medicines with improved therapeutic profiles for areas of unmet need. Once identified, production of protein drug candidates can be rapidly and predictably scaled in our current Good Manufacturing Practices compliant manufacturing facility. We have the ability to manufacture our cell-free extract that supports our production of proteins on a large scale using a semi-continuous fermentation process. Our two most advanced product candidates are wholly owned: STRO-001, an ADC directed against CD74, for patients with multiple myeloma and non-Hodgkin lymphoma, or NHL, and STRO-002, an ADC directed against folate receptor-alpha, or FolRα, for patients with ovarian and endometrial cancers. STRO-001 is currently enrolling patients in a Phase 1 trial, with initial safety data expected in mid-2019 and initial efficacy data expected by year end 2019. In October 2018, we were granted Orphan Drug Designation by the U.S. Food and Drug Administration (“FDA”), for STRO-001 for the treatment of multiple myeloma. We began enrolling patients in a STRO-002 Phase 1 trial focused on ovarian and endometrial cancers in March 2019, with initial safety data expected by year end 2019. We have also entered into multi-target, product-focused collaborations with leaders in the field of oncology, including a cytokine derivatives collaboration with Merck Sharp & Dohme Corp., a subsidiary of Merck & Co., Inc., Kenilworth, NJ, USA, or Merck, a B Cell Maturation Antigen, or BCMA, and an immuno-oncology directed alliance with Celgene Corporation, or Celgene, and an oncology-focused collaboration with Merck KGaA, Darmstadt, Germany (operating in the United States and Canada under the name “EMD Serono”). Since the commencement of our operations, we have devoted substantially all of our resources to performing research and development and manufacturing activities in support of our own product development efforts and those of our collaborators, raising capital to support and expand such activities and providing general and administrative support for these operations. We have funded our operations to date primarily from upfront, milestone and other payments under our collaboration agreements with Merck, Celgene and EMD Serono, the issuance and sale of redeemable convertible preferred stock, our initial public offering, or IPO, of common stock and debt proceeds. On September 26, 2018, our registration statements on Form S-1 (File Nos. 333-227103 and 333-227548) relating to our IPO, were declared effective by the Securities and Exchange Commission, or SEC, and shares of our common stock began trading on the Nasdaq Global Market on September 27, 2018. Upon the closing of the IPO on October 1, 2018, we issued and sold an aggregate of 5,667,000 shares of common stock at a price of $15.00 per share for gross proceeds of approximately $85.0 million. We received net proceeds from the IPO of approximately $74.4 million, after underwriting discounts, commissions and offering expenses. In addition to the shares of common stock sold in the IPO, we concurrently sold in a private placement to Merck, 666,666 shares of common stock at the IPO offering price of $15.00 per share, for proceeds of approximately $10.0 million. We have no products approved for commercial sale and have not generated any revenue from commercial product sales. We had a net loss of $35.3 million and $19.7 million for the years ended December 31, 2018 and 2017, respectively. Although we had net income for the year ended December 31, 2016 of $1.7 million, we cannot assure you that we will ever have net income again or that we will generate positive cash flow from operating activities. As of December 31, 2018, we had an accumulated deficit of $150.3 million. We do not expect to generate any revenue from commercial product sales unless and until we successfully complete development and obtain regulatory approval for one or more of our product candidates, which we expect will take a number of years. If we obtain regulatory approval for any of our product candidates, we expect to incur significant commercialization expenses related to product sales, marketing, manufacturing and distribution. We expect our operating expenses to significantly increase as we continue to develop, and seek regulatory approvals for, our product candidates, engage in other research and development activities, expand our pipeline of product candidates, continue to develop our manufacturing facility and capabilities, maintain and expand our intellectual property portfolio, seek regulatory and marketing approval for any product candidates that we may develop, acquire or in-license other assets or technologies, ultimately establish a sales, marketing and distribution infrastructure to commercialize any products for which we may obtain marketing approval and operate as a public company. Our net losses may fluctuate significantly from quarter-to-quarter and year-to-year, depending on the timing of our clinical trials, our expenditures on other research and development activities and the timing of achievement and receipt of upfront, milestones and other collaboration agreement payments. Recent Developments In October 2018, the FDA granted orphan drug designation for STRO-001, for the treatment of multiple myeloma. The FDA’s Orphan Drug Designation Program provides orphan status to drugs and biologics, which are defined as those intended for the safe and effective treatment, diagnosis or prevention of rare diseases/disorders that affect fewer than 200,000 people in the United States, or that affect more than 200,000 persons but are not expected to recover the costs of developing and marketing a treatment drug. We began enrolling patients in a STRO-002 Phase 1 trial focused on ovarian and endometrial cancers in March 2019. In December 2018, we earned a $10.0 million milestone payment from Celgene triggered by the successful development of a dry powder XtractCFTM formulation, using spray drying technology, which has been in general use for many years in the pharmaceutical industry. Financial Operations Overview Total Revenue We have no products approved for commercial sale and have not generated any revenue from commercial product sales. Our total revenue to date has been generated principally from our collaboration and license agreements with Celgene, Merck and EMD Serono, and to a lesser extent, from manufacturing, supply and services and products we provide to Celgene and SutroVax, Inc., or SutroVax. Collaboration Revenue Collaboration revenue consists of revenue received from upfront, milestone and contingent payments received from our collaborators. We recognize revenue from nonrefundable upfront license payments over the term of our estimated period of performance under the agreements. In addition to receiving upfront payments, we may also be entitled to milestone and other contingent payments upon achieving predefined objectives. Revenue from milestones, if they are nonrefundable and deemed substantive, are recognized upon successful accomplishment of the performance obligations. To the extent that non-substantive milestones are achieved, and we have remaining performance obligations, such payments are deferred and recognized as revenue over the estimated remaining period of performance. We expect that any collaboration revenue we generate principally from our current collaboration and license agreements with Celgene, Merck and EMD Serono, and from any future collaboration partners, will fluctuate in the future as a result of the timing and amount of upfront, milestones and other collaboration agreement payments. We began recognizing revenue under the 2018 Merck Agreement in the third quarter of 2018. Other Revenue Other revenue consists of revenue received from development, manufacturing and supply chain management services, including clinical product supply, that we provide to Celgene and from extracts and custom reagents that we provide to SutroVax. We recognize revenue when the services or products are provided. We expect other revenue will fluctuate from period to period as a result of the timing of ordering and providing such services and products. Operating Expenses Research and Development Research and development expenses represent costs incurred in performing research, development and manufacturing activities in support of our own product development efforts and those of our collaborators, and include salaries, employee benefits, stock-based compensation, laboratory supplies, outsourced research and development expenses, professional services and allocated facilities-related costs. We expense both internal and external research and development costs as they are incurred. Non-refundable advance payments for services that will be used or rendered for future research and development activities are recorded as prepaid expenses and recognized as expenses as the related services are performed. We expect our research and development expenses to increase in the future as we advance our product candidates into and through preclinical studies and clinical trials, pursue regulatory approval of our product candidates, expand our pipeline of product candidates and continue to develop our manufacturing facility and capabilities. The process of conducting the necessary preclinical and clinical research to obtain regulatory approval is costly and time consuming. The actual probability of success for our product candidates may be affected by a variety of factors including: the safety and efficacy of our product candidates, early clinical data, investment in our clinical programs, the ability of collaborators to successfully develop our licensed product candidates, competition, manufacturing capability and commercial viability. We may never succeed in achieving regulatory approval for any of our product candidates. As a result of the uncertainties discussed above, we are unable to determine the duration and completion costs of our research and development projects or when and to what extent we will generate revenue from the commercialization and sale of our product candidates. The following table summarizes our research and development expenses incurred during the periods indicated. The internal costs include personnel, facility costs and research and scientific related activities associated with our pipeline. The external program costs reflect external costs attributable to our clinical development candidates and preclinical candidates selected for further development. Such expenses include third-party costs for preclinical and clinical studies and research services, and other consulting costs. General and Administrative Our general and administrative expenses consist primarily of personnel costs, expenses for outside professional services, including legal, human resource, audit, accounting and tax services and allocated facilities-related costs. Personnel costs include salaries, employee benefits and stock-based compensation. We expect to incur additional expenses operating as a public company, including expenses related to compliance with the rules and regulations of the SEC and listing standards applicable to companies listed on the Nasdaq Global Market, additional insurance expenses, investor relations activities and other administrative and professional services. We also expect to increase the size of our administrative function to support the anticipated growth of our business. Interest Income Interest income consists primarily of interest received on our invested funds. Interest Expense Interest expense includes interest incurred on our debt and amortization of debt issuance costs. Other Income (Expense), Net Other income (expense), net primarily includes gains and losses from the remeasurement of our liabilities related to our redeemable convertible preferred stock warrants. We adjusted the liability for changes in estimated fair value until the earlier of the exercise of the warrants, expiration of the warrants, or conversion of the redeemable convertible preferred stock warrants upon the completion of our IPO, into common stock warrants. With the completion of our IPO on October 1, 2018, the redeemable convertible preferred stock warrant liability was reclassified to additional paid-in-capital and we will no longer record any related periodic fair value adjustments. Comparison of the Years Ended December 31, 2018 and 2017 * Percentage not meaningful Revenue We have recognized revenue as follows during the periods indicated: (1) Includes $5.0 million of collaboration revenue and $3.9 million of other revenue from Celgene as related party revenue. Celgene was a related party through September 30, 2018 as it held more than 10% of our common stock for the periods presented until the closing of our IPO. * Percentage not meaningful Total revenue decreased by $13.2 million, or 26%, during year ended December 31, 2018 compared to the year ended December 31, 2017, due to the decline in collaboration revenue of $19.4 million, offset partially by a $6.0 million increase in other revenue-related parties. The decline in collaboration revenue was due primarily to a net decrease of $27.9 million in revenues related to lower revenue from the 2017 Celgene Agreement as compared to revenue earned under the 2014 Celgene Agreement. The up-front payment under the 2017 Celgene Agreement, together with the remaining deferred revenue balance of the 2014 Celgene Agreement, are being recognized ratably, commencing in August 2017 and estimated to be completed in September 2020. The decline was partially offset by a $8.5 million increase in research and development services provided to Merck and the recognition of collaboration revenue from the up-front nonrefundable payment of $60.0 million received in 2018. Under the 2018 Merck Agreement, the upfront fee is being recognized as revenue on a proportion of performance basis, using full-time equivalents (FTEs) as the basis of measurement. Other revenue in 2018 was due primarily to development and clinical manufacturing services and supplies provided to Celgene for $4.5 million and supplies and other revenue related to SutroVax for $1.5 million. There were no such services during the year ended December 31, 2017. Research and Development Expense Research and development expense remained flat during the year ended December 31, 2018 compared to the year ended December 31, 2017. Lower overall spending on manufacturing materials of $3.4 million, a $2.7 million impairment cost taken in 2017, and the $0.7 million inclusion of personnel-related costs previously in research and development expense, were offset by a $2.9 million increase in compensation-related expenses due to higher headcount, a $2.2 million increase in external services attributable to clinical trial costs related to STRO-001 and STRO-002, and a $1.4 million increase in consulting services related to supply chain management. General and Administrative Expense General and administrative expense increased by $5.0 million, or 31%, during the year ended December 31, 2018 compared to the year ended December 31, 2017. The increase was due primarily to increases of $2.6 million in personnel-related expenses, $1.0 million in legal, insurance and audit fees, a $0.4 million fee related to the Merck transaction, $0.2 million of fees paid to a third party in relation to the Celgene milestone payment, and $0.7 million from the inclusion of personnel-related costs previously in research and development expense effective in January 2018. Interest Income Interest income increased by $1.3 million during the year ended December 31, 2018 compared to the year ended December 31, 2017, due primarily to a higher cash balance resulting from the proceeds from the May 2018 and July 2018 closings of the Series E financing, the up-front payment of $60.0 million received under the 2018 Merck Agreement, and the combined net proceeds of $84.4 million from the completion of our IPO and the concurrent private placement of common stock to Merck. Interest Expense Interest expense increased by $1.0 million during the year ended December 31, 2018 compared to the year ended December 31, 2017, due to interest incurred under a loan and security agreement that we entered into with Oxford and SVB in August 2017. Other Income (Expense), Net Other income (expense), net changed by $2.0 million during the year ended December 31, 2018 compared to the year ended December 31, 2017. The change was primarily due to a $1.0 million increase in the estimated fair value and conversion of our redeemable convertible preferred stock warrants during the year ended December 31, 2018 upon the completion of our initial public offering, and a $0.9 million increase in connection with the associated income attributable to the arrangement with the Leukemia & Lymphoma Society, Inc. Comparison of the Years Ended December 31, 2017 and 2016 * Percentage not meaningful Collaboration Revenue We have recognized revenue from our collaboration agreements as follows during the periods indicated: * Percentage not meaningful Revenue decreased by $8.0 million, or 13%, during the year ended December 31, 2017 compared to the year ended December 31, 2016. The decrease was due to the decline in collaboration revenue of $11.0 million recognized from the up-front nonrefundable payment of $83.1 million received in 2014 under the 2014 Celgene Agreement, as the remaining deferred revenue balance, as of the effective date of the 2017 Celgene Agreement, along with the payments under the 2017 Celgene Agreement, are being recognized ratably starting in August 2017 and ending in September 2020. The decrease was partially offset by a $1.0 million increase in revenue recognized from milestones and contingent payments from Celgene and an increase of an aggregate of $2.1 million in research and development services for Celgene and EMD Serono. Research and Development Expense Research and development expense increased by $11.1 million, or 25%, during the year ended December 31, 2017 compared to the year ended December 31, 2016. The increase was due to an increase of $3.4 million in personnel-related expenses due to headcount growth, an increase of $2.4 million in consulting and other external services, an increase of $1.7 million in facilities-related costs, as a result of increased research and development activities in support of our own product development efforts and those of our collaborators, and a net increase of $0.9 million in preclinical and pharmacology research spending as well as manufacturing supplies and production materials. The increase in research and development expense also reflects an impairment charge of $2.7 million pertaining to certain custom-built manufacturing equipment that failed to meet our acceptance criteria. General and Administrative Expense General and administrative expense increased by $1.6 million, or 11%, during the year ended December 31, 2017 compared to the year ended December 31, 2016. The increase was due to an increase of $0.5 million in equipment-related expenses and an increase of $0.7 million in personnel-related expenses due to higher headcount. In addition, we incurred an additional $0.4 million related to external investor relations services and professional services fees. Interest Expense Interest expense increased by $0.6 million during the year ended December 31, 2017 compared to the year ended December 31, 2016. The increase was due to the interest incurred under a loan and security agreement that we entered into in August 2017. We had no outstanding debt in 2016. Other Income (Expense), Net Other income (expense), net changed by $0.2 million during the year ended December 31, 2017 compared to the year ended December 31, 2016. The change was primarily due to the change in estimated fair value of our Series B and Series C redeemable convertible preferred stock warrants. Liquidity and Capital Resources Sources of Liquidity To date, we have incurred significant net losses, except for 2016, and negative cash flows from operations. Our operations have been funded primarily by payments received from our collaborators, and net proceeds from equity sales and debt. As of December 31, 2018, we had $204.5 million in cash, cash equivalents and marketable securities, and outstanding debt of $14.7 million, which is net of $0.3 million in unamortized debt discount, and an accumulated deficit of $150.3 million. Funding Requirements Based upon our current operating plan, we believe that our existing capital resources will enable us to fund our operating expenses and capital expenditure requirements through at least the next twelve months after the date of this filing. We have based this estimate on assumptions that may prove to be wrong, and we could utilize our available capital resources sooner than we currently expect. We will continue to require additional financing to advance our current product candidates into and through clinical development, to develop, acquire or in-license other potential product candidates, pay our obligations and to fund operations for the foreseeable future. We may seek to raise any necessary additional capital through a combination of public or private equity offerings, debt financings, collaborations, strategic alliances, licensing arrangements, marketing and distribution arrangements, or other sources of financing. Adequate additional funding may not be available to us on acceptable terms, or at all. Any failure to raise capital as and when needed could have a negative impact on our financial condition and on our ability to pursue our business plans and strategies, and may cause us to delay, reduce the scope of or suspend one or more of our pre-clinical and clinical studies, research and development programs or commercialization efforts, and may necessitate us to delay, reduce or terminate planned activities in order to reduce costs. Because of the numerous risks and uncertainties associated with the development and commercialization of our product candidates and the extent to which we may enter into additional collaborations with third parties to participate in their development and commercialization, we are unable to estimate the amounts of increased capital outlays and operating expenditures associated with our current and anticipated clinical studies. To the extent we raise additional capital through new collaborations, strategic alliances or licensing arrangements with third parties, we may have to relinquish valuable rights to our product candidates, future revenue streams, research programs or product candidates or to grant licenses on terms that may not be favorable to us. If we do raise additional capital through public or private equity or convertible debt offerings, the ownership interest of our existing stockholders will be diluted, and the terms of these securities may include liquidation or other preferences that adversely affect our stockholders’ rights. If we raise additional capital through debt financing, we may be subject to covenants limiting or restricting our ability to take specific actions, such as incurring additional debt, making capital expenditures or declaring dividends. Cash Flows The following table summarizes our cash flows during the periods indicated: Cash Flows from Operating Activities Cash provided by operating activities for the year ended December 31, 2018 was $12.7 million. Our net loss of $35.3 million was decreased by non-cash charges of $4.5 million for depreciation and amortization and $2.9 million for stock-based compensation, which were offset partially by the gain of $1.0 million for the change in fair value of our redeemable convertible preferred stock warrant liability and a $0.9 million reduction of the liability attributable to the arrangement with the Leukemia & Lymphoma Society, Inc. Cash provided in operating activities reflected a net increase in operating assets and liabilities of $42.6 million, primarily due to an increase in our deferred revenue balance of $60.0 million from the upfront payment related to the 2018 Merck Agreement, net of $17.7 million recognized in revenue under our collaboration agreements during prior periods, an increase in $0.6 million in other liabilities, of which $0.4 million was contributions received from participants of our employee stock purchase plan and $0.2 million was due to an increase in interest expense related to our loan with Oxford/SVB, an increase in accounts payable of $0.2 million due to timing of payments, and an increase of $2.6 million in accrued bonus compensation due to increased headcount and certain goal achievements. This was offset partially by an increase in accounts receivable of $0.9 million due to higher research and development services revenues from our collaborators, and an increase in $2.2 million in prepaid expenses and other current assets due to payments made to contract research organizations mainly related to STRO-001. Cash used in operating activities for the year ended December 31, 2017 was $37.1 million. Our net loss of $19.7 million was decreased by non-cash charges of $5.0 million for depreciation and amortization, $2.7 million for an impairment charge on certain equipment, $1.4 million for stock-based compensation and $0.4 million in other non-cash charges. Cash used in operating activities reflected a change in net operating assets of $26.9 million, primarily due to a decrease in our deferred revenue balance of $25.6 million from the recognition of revenue pertaining to payments received from our collaborators Celgene and EMD Serono during prior periods, and an increase in accounts receivable of $1.0 million due to higher research and development services revenues from our collaborators Celgene and EMD Serono. Cash used in operating activities for the year ended December 31, 2016 was $13.2 million. Our net income of $1.7 million was increased by non-cash charges of $5.7 million for depreciation and amortization, $1.0 million for stock-based compensation and $0.2 million for amortization of premium on marketable securities. Cash used in operating activities reflected a decrease in net operating assets of $21.7 million, primarily due to a decrease in our deferred revenue balance of $23.1 million from the recognition of revenue pertaining to payments received from our collaborators Celgene and EMD Serono during prior periods, an increase in accrued bonus compensation of $1.2 million driven primarily by higher headcount and an increase of $0.9 million in accounts payable due to a higher level of research and development activities. Cash Flows from Investing Activities Cash used in investing activities of $80.2 million for the year ended December 31, 2018 was related to purchases of marketable securities of $81.5 million and purchases of property and equipment of $1.6 million, principally for laboratory and manufacturing equipment, offset partially by maturities of marketable securities of $2.8 million. Cash provided by investing activities of $32.6 million for the year ended December 31, 2017 was related to proceeds from maturities of marketable securities of $34.9 million and sales of marketable securities of $15.2 million, partially offset by purchases of marketable securities of $14.2 million and purchases of property and equipment of $3.3 million, principally for laboratory and manufacturing equipment and leasehold improvements. Cash provided by investing activities of $9.6 million for the year ended December 31, 2016 was related to proceeds from maturities of marketable securities of $57.8 million and sales of marketable securities of $8.5 million, partially offset by purchases of marketable securities of $52.3 million and purchases of property and equipment of $4.4 million, principally for laboratory and manufacturing equipment and leasehold improvements. Cash Flows from Financing Activities Cash provided by financing activities of $170.8 million for the year ended December 31, 2018 was primarily related to the proceeds from our sale of Series E redeemable convertible preferred stock, net of issuance costs, of $84.7 million, proceeds of $84.4 million from the issuance of common stock upon our IPO, net of issuance costs, and the concurrent private placement of common stock to Merck, proceeds of $0.4 million related to the exercise of common stock options and preferred stock warrants, proceeds of $1.0 million in connection with a research, development and commercialization agreement, and proceeds of $0.2 million from the payment of a note receivable from a stockholder. Cash provided by financing activities of $14.6 million for the year ended December 31, 2017 was primarily related to the proceeds from our debt with Oxford and SVB, net of issuance costs, of $14.8 million, partially offset by the payment of $0.3 million in financing costs related to the IPO. Cash provided by financing activities of $0.2 million for the year ended December 31, 2016 was related to proceeds from the issuances of common stock from the exercise of stock options. Contractual Obligations and Other Commitments The following table summarizes our contractual obligations as of December 31, 2018: (1) Represents principal payments only. We will pay interest on outstanding indebtedness based on the rates and terms summarized in Note 7 to our audited financial statements included elsewhere in this filing. (2) Represents interest expense expected to be incurred on our debt based on obligations outstanding and rates effective at December 31, 2018, including a final one-time payment of $0.6 million. In addition, we enter into agreements in the normal course of business with contract research organizations for clinical trials and with vendors for preclinical studies and other services and products for operating purposes, which are generally cancelable upon written notice. These payments are not included in this table of contractual obligations. Off-Balance Sheet Arrangements We have not entered into any off-balance sheet arrangements, as defined under SEC rules. While we have an investment classified as variable interest entity, its purpose is not to provide off-balance sheet financing. Critical Accounting Policies and Estimates Our management’s discussion and analysis of our financial condition and results of operations is based on our financial statements, which have been prepared in accordance with United States generally accepted accounting principles. The preparation of these financial statements requires us to make estimates and assumptions that affect the reported amounts of assets and liabilities and the disclosure of contingent assets and liabilities at the date of the financial statements, as well as the reported revenue generated and expenses incurred during the reporting periods. Our estimates are based on our historical experience and on various other factors that we believe are reasonable under the circumstances, the results of which form the basis for making judgments about the carrying value of assets and liabilities that are not readily apparent from other sources. Actual results may differ from these estimates under different assumptions or conditions. While our significant accounting policies are described in the notes to our financial statements included elsewhere in this filing, we believe that the following critical accounting policies are most important to understanding and evaluating our reported financial results. Revenue Recognition We generate revenue from collaboration and license agreements for the development and commercialization of our product candidates. Under our collaboration agreements, we may receive non-refundable upfront payments, funding for research and development services, milestones, other contingent payments and royalties. In assessing the appropriate revenue recognition related to a collaboration agreement, we first determine whether an arrangement includes multiple elements, such as the delivery of intellectual property rights and research and development services. For revenue agreements with multiple-elements, we identify the deliverables included within the agreement and evaluate which deliverables may represent separate units of accounting, based on the achievement of certain criteria, including whether the deliverable has stand-alone value to the collaborator. Upfront payments received in connection with licenses to our technology rights are deferred if facts and circumstances dictate that the license does not have stand-alone value, and are recognized as license revenue over the estimated period of performance that is generally consistent with the terms of the research and development obligations contained in the specific collaboration and license agreement. We periodically review our estimated periods of performance based on the progress under each arrangement and account for the impact of any changes in estimated periods of performance on a prospective basis. Typically, access to the intellectual property rights under our collaboration agreements do not have stand-alone value from the other elements within the arrangement. As such, upfront payments are recorded as deferred revenue in the balance sheet and are recognized as collaboration revenue over the estimated period of performance that is consistent with the terms of the research and development obligations contained in the collaboration, or on a proportion of performance basis. Revenue is recognized when persuasive evidence of an arrangement exists, delivery has occurred or services have been rendered, the price is fixed or determinable and collectability is reasonably assured. For multiple-element arrangements, each deliverable within a multiple-deliverable revenue arrangement is accounted for as a separate unit of accounting if both of the following criteria are met: (i) the delivered item or items has value to the customer on a stand-alone basis and (ii) for an arrangement that includes a general right of return relative to the delivered item, delivery or performance of the undelivered item is considered probable and substantially in management’s control. We recognize revenue from milestone payments when: (i) the milestone event is substantive and its achievability has substantive uncertainty at the inception of the agreement and (ii) we have completed our performance obligations related to the achievement of the milestone. Milestone payments are considered substantive if all of the following conditions are met: the milestone payment (a) is commensurate with either our performance subsequent to the inception of the arrangement to achieve the milestone or the enhancement of the value of the delivered item or items as a result of a specific outcome resulting from our performance subsequent to the inception of the arrangement to achieve the milestone, (b) relates solely to past performance and (c) is reasonable relative to all of the deliverables and payment terms (including other potential milestone consideration) within the arrangement. Determining whether and when these revenue recognition criteria have been satisfied often involves assumptions and judgments that can have a significant impact on the timing and amount of reported revenue. Changes in assumptions or judgments or changes to the elements in an arrangement could cause a material increase or decrease in the amount of revenue that is reported in a particular period. Under certain collaborative arrangements, we are entitled to payments for certain research and development activities, including providing product and other related materials. Our policy is to account for such payments by our collaboration partners as collaboration revenue. In May 2014, the FASB issued ASU No. 2014-09 (Topic 606), Revenue from Contracts with Customers. In August 2015, the FASB issued ASU No. 2015-14 (Topic 606), Revenue from Contracts with Customers: Deferral of the Effective Date, which delayed the effective date of ASU 2014-09 by one year. The core principle of ASU 2014-09 is that an entity should recognize revenue when it transfers promised goods or services to customers in an amount that reflects the consideration to which the entity expects to be entitled in exchange for those goods or services. ASU 2014-09 defines a five-step process to achieve this core principle and, in doing so, it is possible more judgment and estimates may be required within the revenue recognition process than required under existing U.S. generally accepted accounting pronouncements. We continue to assess the impact of the new revenue standard on our financial statements. We will adopt the new standard and its related amendments effective January 1, 2019 using the modified retrospective method. Research and Development We record accrued expenses for estimated costs of our research and development activities conducted by third party service providers, which include outsourced research and development expenses, professional services and contract manufacturing activities. We record the estimated costs of research and development activities based upon the estimated amount of services provided but not yet invoiced, and include these costs in current liabilities in the balance sheets and within research and development expense in the statements of operations. Nonrefundable advance payments for goods or services that will be used or rendered for future research and development activities are deferred and capitalized and recognized as an expense as the goods are delivered or the related services are performed. For outsourced research and development expenses, such as professional fees payable to third parties for preclinical studies, clinical trials and research services and other consulting costs, we estimate the expenses based on the services performed, pursuant to contracts with research institutions that conduct and manage preclinical studies, clinical trials and research services on our behalf. We estimate these expenses based on discussions with internal management personnel and external service providers as to the progress or stage of completion of services and the contracted fees to be paid for such services. If the actual timing of the performance of services or the level of effort varies from the original estimates, we will adjust the accrual accordingly. Payments made to third parties under these arrangements in advance of the performance of the related services by the third parties are recorded as prepaid expenses until the services are rendered. Stock-Based Compensation We recognize compensation costs related to stock options granted to employees based on the estimated fair value of the awards on the date of grant, net of estimated forfeitures. We estimate the grant date fair value, and the resulting stock-based compensation expense, using the Black-Scholes option-pricing model. The grant date fair value of the stock-based awards is generally recognized on a straight-line basis over the requisite service period, which is generally the vesting period of the respective awards. The Black-Scholes option-pricing model requires the use of highly subjective assumptions to determine the fair value of stock-based awards, including the expected term and the price volatility of the underlying stock. These assumptions include: ▪ Expected term-The expected term represents the period that the stock-based awards are expected to be outstanding. We use the “simplified” method to determine the expected life of options granted, which calculates the expected term as the average of the weighted-average vesting term and the contractual term of the option. ▪ Expected volatility-Since we have limited information available on the volatility of our common stock due to its short trading history, the expected volatility is estimated based on the average historical volatilities of common stock of comparable publicly traded entities over a period equal to the expected term of the stock option grants. We will continue to apply this process until a sufficient amount of historical information regarding the volatility of our own stock price becomes available. ▪ Risk-free interest rate-The risk-free interest rate is based on the U.S. Treasury yield in effect at the time of grant for zero coupon U.S. Treasury notes with maturities approximately equal to the expected term of the options. ▪ Expected dividend-We have never paid dividends on our common stock and have no plans to pay dividends on our common stock. Therefore, we use an expected dividend yield of zero. In addition to the assumptions used in the Black-Scholes option-pricing model, we must also estimate a forfeiture rate to calculate the stock-based compensation for our awards. We will continue to use judgment in evaluating the expected volatility, expected terms and forfeiture rates utilized for our stock-based compensation calculations on a prospective basis. Historically, for all periods prior to our IPO, the fair value of the shares of common stock underlying our share-based awards was estimated on each grant date by our board of directors. In order to determine the fair value of our common stock underlying option grants, given the absence of a public trading market for our common stock, our board of directors exercised reasonable judgment and considered a number of objective and subjective factors to determine the best estimate of the fair value of our common stock, including timely valuations of our common stock prepared by an independent third-party valuation firm in accordance with the guidance provided by the American Institute of Certified Public Accountants Practice Guide, Valuation of Privately-Held-Company Equity Securities Issued as Compensation, important developments in our operations, our stage of development, sales of our redeemable convertible preferred stock, actual operating results and financial performance, the conditions in the biotechnology industry and the economy in general, the stock price performance and volatility of comparable public companies, the lack of liquidity of our common stock, and the likelihood of achieving a liquidity event, such as an initial public offering or sale. For each of the valuation dates during the years ended December 31, 2017 and 2016, we applied the Guideline Publicly Traded Company Analysis (Life Science Expected Compound Method) for the valuation of our equity. We were at an early stage of development and future liquidity events were difficult to forecast. We therefore used the option-pricing method, or OPM, to determine the estimated fair value of our common stock. In an OPM framework, shares are valued by creating a series of call options with exercise prices based on the liquidation preferences and conversion terms of each equity class. The estimated fair values of the preferred and common stock are inferred by analyzing these options. For the valuation dates during the nine months ended September 30, 2018, the equity value was allocated using the OPM and the Probability Weighted Expected Return Method, or PWERM, or the hybrid method. The hybrid method applied the PWERM utilizing the probability of going public and the OPM was utilized in the remaining private scenario. The hybrid method was used commencing May 31, 2018 because of a near-term potential IPO scenario, which also factored in the inherent uncertainty associated with being able to complete an IPO. For stock options granted after the completion of the IPO, the closing sale price per share of our common stock as reported on the Nasdaq Global Market on the date of grant is used to determine the exercise price per share of our share-based awards to purchase common stock. Redeemable Convertible Preferred Stock Warrants In the past, we have issued freestanding warrants to purchase shares of redeemable convertible preferred stock. We accounted for these warrants as a liability in our financial statements and they were recorded at their estimated fair value, because the warrants may have conditionally obligated us to transfer assets at some point in the future due to redemption provisions that were outside our control. The fair value of the warrants at the issuance date, at September 30, 2018 (immediately prior to our IPO) and December 31, 2017 was determined using the OPM. The warrants were re-measured at each financial reporting period with any changes in fair value being recognized in other income (expense), net in the statement of operations. We continued to adjust the liability for changes in fair value until the earlier of the expiration of the warrants, exercise of the warrants, or conversion of the redeemable convertible preferred stock warrants into common stock warrants upon the completion of a liquidation event, including the completion of an IPO, which occurred on October 1, 2018. Beginning in the fourth quarter of 2018, there was no longer any warrant-related liability. Income Taxes As of December 31, 2018, we had federal net operating loss, or NOL, carryforwards of $114.0 million and federal general business credits from research and development expenses totaling $10.9 million, as well as state NOL carryforwards of $73.4 million and state research and development credits of $9.5 million. If not utilized, the federal NOL carryforwards will expire at various dates beginning in 2032, and the federal credits will expire at various dates beginning in 2023. The state NOL carryforwards will expire at various dates beginning in 2030, if not utilized. The state research and development tax credits can be carried forward indefinitely. Utilization of the net operating loss carryforwards may be subject to a substantial annual limitation due to the ownership change limitations provided by the Tax Reform Act of 1986, or the Tax Reform Act, as amended, and similar state provisions. The annual limitation may result in the expiration of NOLs and credits before utilization. We have performed a Section 382 study for the period of June 16, 2003 through December 31, 2018 and concluded that it is more likely than not that we experienced an ownership change on April 9, 2007. This change does not limit our ability to use our existing NOLs within the carryforward period provided by the Internal Revenue Code, subject to availability of taxable income. We may experience ownership changes in the future as a result of equity offerings or other shifts in our stock ownership, some of which are outside our control. If there is a subsequent event or further change in ownership, these losses may be subject to limitations, resulting in their expiration before they can be utilized. We assess all material positions taken in any income tax return, including all significant uncertain positions, in all tax years that are still subject to assessment or challenge by relevant taxing authorities. Assessing an uncertain tax position begins with the initial determination of the position’s sustainability and is measured at the largest amount of benefit that is greater than fifty percent likely of being realized upon ultimate settlement. As of each balance sheet date, unresolved uncertain tax positions must be reassessed, and we will determine whether (i) the factors underlying the sustainability assertion have changed and (ii) the amount of the recognized tax benefit is still appropriate. The recognition and measurement of tax benefits requires significant judgment. Judgments concerning the recognition and measurement of a tax benefit might change as new information becomes available. JOBS Act Accounting Election We are an “emerging growth company,” as defined in the Jumpstart Our Business Startups Act of 2012, or the JOBS Act. Under the JOBS Act, emerging growth companies can delay adopting new or revised accounting standards issued subsequent to the enactment of the JOBS Act until such time as those standards apply to private companies. We have elected to use this extended transition period for complying with new or revised accounting standards that have different effective dates for public and private companies until the earlier of the date we (i) are no longer an emerging growth company or (ii) affirmatively and irrevocably opt out of the extended transition period provided in the JOBS Act. As a result, our financial statements may not be comparable to companies that comply with new or revised accounting pronouncements as of public company effective dates. We will remain an emerging growth company until the earliest of (1) the last day of our first fiscal year (a) following the fifth anniversary of the completion of our IPO, (b) in which we have total annual gross revenues of at least $1.07 billion, or (ii) in which we are deemed to be a large accelerated filer, which means the market value of our common stock that is held by non-affiliates exceeds $700.0 million as of the prior June 30th and (2) the date on which we have issued more than $1.0 billion in non-convertible debt securities during the prior three-year period. Recent Accounting Pronouncements See Note 2 to our financial statements included elsewhere in this report for more information.

<s>[INST] The following discussion should be read in conjunction with the attached financial statements and notes thereto. This Annual Report on Form 10K, including the following sections, contains forwardlooking statements within the meaning of the federal securities laws. These statements are subject to risks and uncertainties that could cause actual results and events to differ materially from those expressed or implied by such forwardlooking statements. For a detailed discussion of these risks and uncertainties, see the “Risk Factors” section in Item 1A of this Annual Report on Form 10K. We caution the reader not to place undue reliance on these forwardlooking statements, which reflect management’s analysis only as of the date of this Form 10K. We undertake no obligation to update forwardlooking statements, which reflect events or circumstances occurring after the date of this Form 10K. Overview We are a clinical stage drug discovery, development and manufacturing company focused on deploying our proprietary integrated cellfree protein synthesis and sitespecific conjugation platform, XpressCF™, to create a broad variety of optimally designed, nextgeneration protein therapeutics initially for cancer and autoimmune disorders. We aim to design therapeutics using the most relevant and potent modalities, including cytokinebased targets, immunooncology, or I/O, agents, antibodydrug conjugates, or ADCs, and bispecific antibodies that are directed primarily against clinically validated targets where the current standard of care is suboptimal. We believe our platform allows us to accelerate the discovery and development of potential firstinclass and bestinclass molecules by enabling the rapid and systematic evaluation of protein structureactivity relationships to create optimized homogeneous product candidates. Our mission is to transform the lives of patients by using our XpressCF™ Platform to create medicines with improved therapeutic profiles for areas of unmet need. Once identified, production of protein drug candidates can be rapidly and predictably scaled in our current Good Manufacturing Practices compliant manufacturing facility. We have the ability to manufacture our cellfree extract that supports our production of proteins on a large scale using a semicontinuous fermentation process. Our two most advanced product candidates are wholly owned: STRO001, an ADC directed against CD74, for patients with multiple myeloma and nonHodgkin lymphoma, or NHL, and STRO002, an ADC directed against folate receptoralpha, or FolRα, for patients with ovarian and endometrial cancers. STRO001 is currently enrolling patients in a Phase 1 trial, with initial safety data expected in mid2019 and initial efficacy data expected by year end 2019. In October 2018, we were granted Orphan Drug Designation by the U.S. Food and Drug Administration (“FDA”), for STRO001 for the treatment of multiple myeloma. We began enrolling patients in a STRO002 Phase 1 trial focused on ovarian and endometrial cancers in March 2019, with initial safety data expected by year end 2019. We have also entered into multitarget, productfocused collaborations with leaders in the field of oncology, including a cytokine derivatives collaboration with Merck Sharp & Dohme Corp., a subsidiary of Merck & Co., Inc., Kenilworth, NJ, USA, or Merck, a B Cell Maturation Antigen, or BCMA, and an immunooncology directed alliance with Celgene Corporation, or Celgene, and an oncologyfocused collaboration with Merck KGaA, Darmstadt, Germany (operating in the United States and Canada under the name “EMD Serono”). Since the commencement of our operations, we have devoted substantially all of our resources to performing research and development and manufacturing activities in support of our own product development efforts and those of our collaborators, raising capital to support and expand such activities and providing general and administrative support for these operations. We have funded our operations to date primarily from upfront, milestone and other payments under our collaboration agreements with Merck, Celgene and EMD Serono, the issuance and sale of redeemable convertible preferred stock, our initial public offering, or IPO, of common stock and debt proceeds. On September 26, 2018 [/INST] Positive. </s>

SUTRO BIOPHARMA, INC.

2020-03-16

2019-12-31

Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations The following discussion should be read in conjunction with the attached financial statements and notes thereto. This Annual Report on Form 10-K, including the following sections, contains forward-looking statements within the meaning of the federal securities laws. These statements are subject to risks and uncertainties that could cause actual results and events to differ materially from those expressed or implied by such forward-looking statements. For a detailed discussion of these risks and uncertainties, see the “Risk Factors” section in Item 1A of this Annual Report on Form 10-K. We caution the reader not to place undue reliance on these forward-looking statements, which reflect management’s analysis only as of the date of this Form 10-K. We undertake no obligation to update forward-looking statements, which reflect events or circumstances occurring after the date of this Form 10-K. Overview We are a clinical stage drug discovery, development and manufacturing company focused on deploying our proprietary integrated cell-free protein synthesis and site-specific conjugation platform, XpressCF®, to create a broad variety of optimally designed, next-generation protein therapeutics initially for cancer and autoimmune disorders. We aim to design therapeutics using the most relevant and potent modalities, including cytokine-based targets, immuno-oncology, or I/O, agents, antibody-drug conjugates, or ADCs, and bispecific antibodies that are directed primarily against clinically validated targets where the current standard of care is suboptimal. We believe our platform allows us to accelerate the discovery and development of potential first-in-class and best-in-class molecules by enabling the rapid and systematic evaluation of protein structure-activity relationships to create optimized homogeneous product candidates. Our mission is to transform the lives of patients by using our XpressCF® Platform to create medicines with improved therapeutic profiles for areas of unmet need. Once identified, production of protein drug candidates can be rapidly and predictably scaled in our current Good Manufacturing Practices compliant manufacturing facility. We have the ability to manufacture our cell-free extract that supports our production of proteins on a large scale using a semi-continuous fermentation process. Our two most advanced product candidates are wholly owned: STRO-001, an ADC directed against CD74, for patients with multiple myeloma and non-Hodgkin lymphoma, or NHL, and STRO-002, an ADC directed against folate receptor-alpha, or FolRα, for patients with ovarian and endometrial cancers. STRO-001 is currently enrolling patients in a Phase 1 trial, with initial safety and efficacy data reported in 2019. Based on such reported data, STRO-001 has been generally well-tolerated and no ocular toxicity signals have been observed, with no patients receiving prophylactic corticosteroid eye drops. Dose escalation in the STRO-001 Phase 1 trial is continuing, and the maximum tolerated dose has not yet been reached. In October 2018, we were granted Orphan Drug Designation by the U.S. Food and Drug Administration, or FDA, for STRO-001 for the treatment of multiple myeloma. We began enrolling patients in a STRO-002 Phase 1 trial focused on ovarian and endometrial cancers in March 2019, with initial safety and efficacy data reported in late 2019. Based on such reported data, STRO-002 has been well-tolerated and no ocular toxicity signals have been observed, with no patients receiving prophylactic corticosteroid eye drops. Dose escalation in the STRO-002 Phase 1 trial is continuing, and the maximum tolerated dose has not yet been reached. We have also entered into multi-target, product-focused collaborations with leaders in the field of oncology, including a cytokine derivatives collaboration with Merck Sharp & Dohme Corp., a subsidiary of Merck & Co., Inc., Kenilworth, NJ, or Merck, a B Cell Maturation Antigen, or BCMA, and an immuno-oncology directed alliance with Celgene Corporation, or Celgene, a wholly owned subsidiary of Bristol-Myers Squibb Company, New York, NY, or BMS, and an oncology-focused collaboration with Merck KGaA, Darmstadt Germany (operating in the United States and Canada under the name “EMD Serono”). In November 2019, BMS acquired Celgene, and Celgene became a wholly owned subsidiary of BMS. However, we continue to refer to our agreements with Celgene throughout this Form 10-K as being with Celgene. Since the commencement of our operations, we have devoted substantially all of our resources to performing research and development and manufacturing activities in support of our own product development efforts and those of our collaborators, raising capital to support and expand such activities and providing general and administrative support for these operations. We have funded our operations to date primarily from upfront, milestone and other payments under our collaboration agreements with Celgene (now BMS), Merck and EMD Serono, the issuance and sale of redeemable convertible preferred stock, our initial public offering, or IPO, of common stock and debt proceeds. We have no products approved for commercial sale and have not generated any revenue from commercial product sales. We had a net loss of $55.7 million, $35.3 million and $19.7 million for the years ended December 31, 2019, 2018 and 2017, respectively. We cannot assure you that we will have net income or that we will generate positive cash flow from operating activities in the future. As of December 31, 2019, we had an accumulated deficit of $195.7 million. We do not expect to generate any revenue from commercial product sales unless and until we successfully complete development and obtain regulatory approval for one or more of our product candidates, which we expect will take a number of years. If we obtain regulatory approval for any of our product candidates, we expect to incur significant commercialization expenses related to product sales, marketing, manufacturing and distribution. We expect our operating expenses to significantly increase as we continue to develop, and seek regulatory approvals for, our product candidates, engage in other research and development activities, expand our pipeline of product candidates, continue to develop our manufacturing facility and capabilities, maintain and expand our intellectual property portfolio, seek regulatory and marketing approval for any product candidates that we may develop, acquire or in-license other assets or technologies, ultimately establish a sales, marketing and distribution infrastructure to commercialize any products for which we may obtain marketing approval and operate as a public company. Our net losses may fluctuate significantly from quarter-to-quarter and year-to-year, depending on the timing of our clinical trials, our expenditures on other research and development activities and the timing of achievement and receipt of upfront, milestones and other collaboration agreement payments. A discussion and analysis of our financial condition, results of operations, and cash flows for the year ended December 31, 2017 is included in Item 7 of Part II, “Management’s Discussion and Analysis of Financial Condition and Results of Operations” in our Annual Report on Form 10-K for the year ended December 31, 2018 filed with the SEC on April 1, 2019. Financial Operations Overview Revenue We have no products approved for commercial sale and have not generated any revenue from commercial product sales. Our total revenue to date has been generated principally from our collaboration and license agreements with Celgene (now BMS), Merck and EMD Serono, and to a lesser extent, from manufacturing, supply and services and products we provide to Celgene, SutroVax, Inc., or SutroVax, and EMD Serono. As described in Note 2 to our Financial Statements, on January 1, 2019, we adopted ASC 606, Revenue from Contracts with Customers (ASC 606). ASC 606 supersedes the guidance in ASC 605, Revenue Recognition (ASC 605). We adopted ASC 606 on a modified retrospective basis under which we recognized the $10.3 million cumulative effect of adoption as a reduction to the accumulated deficit balance as of January 1, 2019. Revenue for the years ended December 31, 2018 and 2017 were recorded under ASC 605, while revenue for the year ended December 31, 2019 was recorded under ASC 606. If we had continued to use ASC 605 during 2019, revenue would have been $43.5 million for the year ended December 31, 2019, as compared to the $42.7 million reported. We derive revenue from collaboration arrangements, under which we may grant licenses to our collaboration partners to further develop and commercialize our proprietary product candidates. We may also perform research and development activities under the collaboration agreements. Consideration under these contracts generally includes a nonrefundable upfront payment, development, regulatory and commercial milestones and other contingent payments, and royalties based on net sales of approved products. Additionally, the collaborations may provide options for the customer to acquire from our materials and reagents, clinical product supply or additional research and development services under separate agreements.We assess which activities in the collaboration agreements are considered distinct performance obligations that should be accounted for separately. We develop assumptions that require judgement to determine whether the license to our intellectual property is distinct from the research and development services or participation in activities under the collaboration agreements. At the inception of each agreement, we determine the arrangement transaction price, which includes variable consideration, based on the assessment of the probability of achievement of future milestones and contingent payments and other potential consideration. For arrangements that include multiple performance obligations, we allocate the transaction price to the identified performance obligations based on the standalone selling price, or SSP, of each distinct performance obligation. In instances where SSP is not directly observable, we develop assumptions that require judgment to determine the SSP for each performance obligation identified in the contract. These key assumptions may include full-time equivalent, or FTE, personnel effort, estimated costs, discount rates and probabilities of clinical development and regulatory success. Please see an expanded discussion on the revenue recognition treatment of performance obligations under Critical Accounting Policies and Estimates. Operating Expenses Research and Development Research and development expenses represent costs incurred in performing research, development and manufacturing activities in support of our own product development efforts and those of our collaborators, and include salaries, employee benefits, stock-based compensation, laboratory supplies, outsourced research and development expenses, professional services and allocated facilities-related costs. We expense both internal and external research and development costs as they are incurred. Non-refundable advance payments for services that will be used or rendered for future research and development activities are recorded as prepaid expenses and recognized as expenses as the related services are performed. We expect our research and development expenses to increase in the future as we advance our product candidates into and through preclinical studies and clinical trials, pursue regulatory approval of our product candidates, expand our pipeline of product candidates and continue to develop our manufacturing facility and capabilities. The process of conducting the necessary preclinical and clinical research to obtain regulatory approval is costly and time consuming. The actual probability of success for our product candidates may be affected by a variety of factors including: the safety and efficacy of our product candidates, early clinical data, investment in our clinical programs, the ability of collaborators to successfully develop our licensed product candidates, competition, manufacturing capability and commercial viability. We may never succeed in achieving regulatory approval for any of our product candidates. As a result of the uncertainties discussed above, we are unable to determine the duration and completion costs of our research and development projects or when and to what extent we will generate revenue from the commercialization and sale of our product candidates. The following table summarizes our research and development expenses incurred during the periods indicated. The internal costs include personnel, facility costs and research and scientific related activities associated with our pipeline. The external program costs reflect external costs attributable to our clinical development candidates and preclinical candidates selected for further development. Such expenses include third-party costs for preclinical and clinical studies and research services, and other consulting costs. General and Administrative Our general and administrative expenses consist primarily of personnel costs, expenses for outside professional services, including legal, human resources, audit, accounting and tax services and allocated facilities-related costs. Personnel costs include salaries, employee benefits and stock-based compensation. We expect to incur additional expenses operating as a public company, including expenses related to compliance with the rules and regulations of the SEC and listing standards applicable to companies listed on the Nasdaq Global Market, additional insurance expenses, investor relations activities and other administrative and professional services. We also expect to increase the size of our administrative function to support the anticipated growth of our business. Interest Income Interest income consists primarily of interest earned on our invested funds. Interest Expense and Other Income (Expense), Net Interest expense includes interest incurred on our debt and amortization of debt issuance costs. Additionally, under ASC 606, the Company identified a financing component under the Merck 2018 Agreement and recorded interest expense associated with the upfront payment. Other expense in each of 2019 and 2018 includes changes in values attributable to the arrangement with the Leukemia & Lymphoma Society, Inc. Additionally, in 2018 this expense category includes gains and losses from the remeasurement of our liabilities related to our redeemable convertible preferred stock warrants. We adjusted the liability for changes in estimated fair value until the earlier of the exercise of the warrants, expiration of the warrants, or conversion of the redeemable convertible preferred stock warrants upon the completion of our IPO, into common stock warrants. With the completion of our IPO on October 1, 2018, the redeemable convertible preferred stock warrant liability was reclassified to additional paid-in-capital and we no longer record any related periodic fair value adjustments. Comparison of the Years Ended December 31, 2019 and 2018 * Percentage not meaningful Revenue We have recognized revenue as follows during the periods indicated: (1) In January 2019, BMS announced the entry into a definitive agreement to acquire Celgene and the transaction was completed in the fourth quarter of 2019. (2) During the year ended December 31, 2018, $8.9 million of revenue from BMS (formerly Celgene) was related party revenue. Celgene was a related party through September 30, 2018 as it held more than 10% of our common stock for the periods presented until the closing of our IPO. Total revenue increased by $4.3 million, or 11%, during the year ended December 31, 2019 compared to the year ended December 31, 2018, due primarily to the 2018 Merck Agreement which added revenue of $12.9 million. Further, we received and recognized revenue of $1.5 million under the License Agreement, or MDA Agreement, with EMD Serono, upon designation by EMD Serono of a specific bispecific antibody drug conjugate as a clinical development candidate with their approval to advance it to IND-enabling studies and another $2.2 million in clinical materials supplies less a decrease of $1.9 million related to the MDA Agreement which ended in May 2019. The increases were partially offset by a $0.5 million decrease from SutroVax, and a $9.9 million decrease from Celgene. In 2018, revenue from Celgene included a $10.0 million milestone that was recognized during the year and did not recur in 2019. Research and Development Expense Research and development expense increased by $11.4 million, or 21%, during the year ended December 31, 2019 compared to the year ended December 31, 2018. The increase was due primarily to increases of $4.9 million in personnel-related expenses due to higher headcount, $2.3 million in laboratory supplies and production materials-related expenses, $2.1 million in external clinical trial services for STRO-001 and STRO-002, and $1.7 million in facilities-related expenses. General and Administrative Expense General and administrative expense increased by $11.2 million, or 52%, during the year ended December 31, 2019 compared to the year ended December 31, 2018. The increase was due primarily to increases of $7.5 million in personnel-related expenses, $1.5 million in IT-related expenses, $1.4 million in insurance and other fees associated with being a public company, $0.3 million in legal, audit and external services, and $0.3 million in facilities-related expenses. Interest Income Interest income increased by $2.5 million during the year ended December 31, 2019 compared to the year ended December 31, 2018, due primarily to higher average investment balances in 2019, including proceeds received primarily in the second half of 2018 from the issuance of our Series E redeemable convertible preferred stock, the upfront payment received under the 2018 Merck Agreement, and combined net proceeds from the completion of our IPO and the private placement of common stock to Merck. Interest and Other Income (Expense), Net Interest and other income (expense) changed by $4.6 million during the year ended December 31, 2019 compared to the year ended December 31, 2018, due primarily to $3.1 million of interest expense associated with a financing component under ASC 606 related to the 2018 Merck Agreement, and $1.0 million related to the remeasurement of the fair value of our redeemable convertible preferred stock warrant liability during the year ended December 31, 2018. Liquidity and Capital Resources Sources of Liquidity To date, we have incurred significant net losses, and negative cash flows from operations. Our operations have been funded primarily by payments received from our collaborators, and net proceeds from equity sales and debt. As of December 31, 2019, we had $133.5 million in cash, cash equivalents and marketable securities, and outstanding debt of $9.9 million and an accumulated deficit of $195.7 million. Term Loan On February 28, 2020, (the “Effective Date”), we entered into a loan and security agreement (the “Loan and Security Agreement”) with Oxford Finance LLC (“Oxford”), as the collateral agent and a lender, and Silicon Valley Bank, as a lender (together with Oxford, the “Lenders”), pursuant to which the Lenders have agreed to lend us up to an aggregate of $25.0 million in a series of term loans (the “Term A Loan”). Upon entering into the Loan and Security Agreement, we borrowed $25.0 million from the Lenders, with approximately $9.6 million of such amount applied to the repayment of the outstanding principal, interest and final payment fees owed pursuant to the prior loan and security agreement dated August 4, 2017. Under the terms of the Loan and Security Agreement, we may, at our sole discretion, borrow from the Lenders up to an additional $5.0 million (the “Term B Loan” and together with the Term A Loan, the “Term Loans”) upon the closing of a new collaboration agreement that includes an upfront payment of at least $50.0 million to us, as determined by Oxford in its sole and absolute discretion (the “Term B Milestone Event”). We may draw the Term B Loan during the period commencing on the date of the occurrence of the Term B Milestone Event and ending on the earliest of (i) December 31, 2020, (ii) the thirtieth (30th) day following the occurrence of the Term B Milestone Event, and (iii) the occurrence of an event of default. The proceeds from the Term Loans under the Loan and Security Agreement may be used to satisfy our future working capital needs and to fund our general business requirements. Our obligations under the Loan and Security Agreement are secured by all our assets, other than our intellectual property. We have also agreed not to encumber our intellectual property assets, except as permitted by the Loan and Security Agreement. The Term Loans mature on March 1, 2024 (the “Maturity Date”) and will be interest-only through March 1, 2022, followed by 24 equal monthly payments of principal and interest. The Term Loans will bear interest at a floating per annum rate equal to the greater of (i) 8.07% or (ii) the sum of (a) the greater of (1) the thirty (30) day U.S. LIBOR rate reported in the Wall Street Journal on the last business day of the month that immediately precedes the month in which the interest will accrue or (2) 1.67%, plus (b) 6.40%. We will be required to make a final payment of 3.83% of the original principal amount of the Term Loans drawn, payable on the earlier of (i) the Maturity Date, (ii) the acceleration of any Term Loans, or (iii) the prepayment of the Term Loans (the “Final Payment”). We may prepay all, but not less than all, of the Term Loans upon 30 days’ advance written notice to Oxford, provided that we will be obligated to pay a prepayment fee equal to (i) 3.00% of the principal amount of the applicable Term Loan prepaid on or before the first anniversary of the applicable funding date, or (ii) 2.00% of the principal amount of the applicable Term Loan prepaid between the first and second anniversary of the applicable funding date, or (iii) 1.00% of the principal amount of the applicable Term Loan prepaid thereafter, and prior to the Maturity Date (each, a “Prepayment Fee”). The Loan and Security Agreement contains customary affirmative and restrictive covenants, including covenants regarding incurrence of additional indebtedness or liens, investments, transactions with affiliates, delivery of financial statements, maintenance of inventory, payment of taxes, maintenance of insurance, protection of intellectual property rights, dispositions of property, business combinations or acquisitions, among other customary covenants. We are also restricted from paying dividends or making other distributions or payments on its capital stock, subject to limited exceptions. The Loan and Security Agreement provides that an event of default will occur if, among other triggers, there occurs any circumstances that could reasonably be expected to result in a material adverse change in our business, or operations or condition (financial or otherwise) or a material impairment of the prospect of us to repay any portion of our obligations under the Loan and Security Agreement. The Loan and Security Agreement also includes customary representations and warranties, other events of default and termination provisions. In connection with entering into the Loan and Security Agreement, we issued to the Lenders warrants exercisable for 81,257 shares of our common stock (the “Debt Warrants”). The Debt Warrants are exercisable in whole or in part, immediately, and have a per share exercise price of $9.23, which is the closing price of our common stock reported on the Nasdaq Global Market on the day prior to the Effective Date. The Debt Warrants will terminate on the earlier of February 28, 2030 or the closing of certain merger or consolidation transactions. Funding Requirements Based upon our current operating plan, we believe that our existing capital resources will enable us to fund our operating expenses and capital expenditure requirements through at least the next twelve months after the date of this filing. We have based this estimate on assumptions that may prove to be wrong, and we could utilize our available capital resources sooner than we currently expect. We will continue to require additional financing to advance our current product candidates into and through clinical development, to develop, acquire or in-license other potential product candidates, pay our obligations and to fund operations for the foreseeable future. We may seek to raise any necessary additional capital through a combination of public or private equity offerings, debt financings, collaborations, strategic alliances, licensing arrangements, marketing and distribution arrangements, or other sources of financing. Adequate additional funding may not be available to us on acceptable terms, or at all. Any failure to raise capital as and when needed could have a negative impact on our financial condition and on our ability to pursue our business plans and strategies, and may cause us to delay, reduce the scope of or suspend one or more of our pre-clinical and clinical studies, research and development programs or commercialization efforts, and may necessitate us to delay, reduce or terminate planned activities in order to reduce costs. Because of the numerous risks and uncertainties associated with the development and commercialization of our product candidates and the extent to which we may enter into additional collaborations with third parties to participate in their development and commercialization, we are unable to estimate the amounts of increased capital outlays and operating expenditures associated with our current and anticipated clinical studies. To the extent we raise additional capital through new collaborations, strategic alliances or licensing arrangements with third parties, we may have to relinquish valuable rights to our product candidates, future revenue streams, research programs or product candidates or to grant licenses on terms that may not be favorable to us. If we do raise additional capital through public or private equity or convertible debt offerings, the ownership interest of our existing stockholders will be diluted, and the terms of these securities may include liquidation or other preferences that adversely affect our stockholders’ rights. If we raise additional capital through debt financing, we may be subject to covenants limiting or restricting our ability to take specific actions, such as incurring additional debt, making capital expenditures or declaring dividends. Cash Flows The following table summarizes our cash flows during the periods indicated: Cash Flows from Operating Activities Cash used in operating activities for the year ended December 31, 2019 was $65.0 million. Our net loss of $55.7 million was reduced by non-cash charges of $10.3 million for stock-based compensation, $4.8 million for depreciation and amortization, and a $0.3 million loss on disposal of property and equipment, which were offset partially by a $1.5 million increase in the accretion of discount on our marketable securities and a $0.1 million reduction of the liability attributable to the agreement with the Leukemia & Lymphoma Society, Inc. Cash used in operating activities also reflected a net decrease in operating assets and liabilities of $23.3 million, due to a decrease in our deferred revenue balance of $20.2 million from revenue recognized under our collaboration agreements, a decrease of $0.2 million in accrued compensation expense primarily due to bonuses paid in connection with certain goal achievements and increases of $1.4 million in prepaid expenses and other assets and $3.8 million in accounts receivable from higher research and development services revenues from our collaborators. This was offset partially by a $2.3 million increase in accounts payable due to timing of payments. Cash provided by operating activities for the year ended December 31, 2018 was $12.7 million. Our net loss of $35.3 million was decreased by non-cash charges of $4.5 million for depreciation and amortization and $2.9 million for stock-based compensation, which were offset partially by the gain of $1.0 million for the change in fair value of our redeemable convertible preferred stock warrant liability and a $0.9 million reduction of the liability attributable to the arrangement with the Leukemia & Lymphoma Society, Inc. Cash provided in operating activities reflected a net increase in operating assets and liabilities of $42.6 million, primarily due to an increase in our deferred revenue balance of $60.0 million from the upfront payment related to the 2018 Merck Agreement, net of $17.7 million recognized in revenue under our collaboration agreements during prior periods, an increase in $0.6 million in other liabilities, of which $0.4 million was contributions received from participants of our employee stock purchase plan and $0.2 million was due to an increase in interest expense related to our loan with Oxford/SVB, an increase in accounts payable of $0.2 million due to timing of payments, and an increase of $2.6 million in accrued bonus compensation due to increased headcount and certain goal achievements. This was offset partially by an increase in accounts receivable of $0.9 million due to higher research and development services revenues from our collaborators, and an increase in $2.2 million in prepaid expenses and other current assets due to payments made to contract research organizations mainly related to STRO-001. Cash Flows from Investing Activities Cash used in investing activities of $51.1 million for the year ended December 31, 2019 was primarily related to purchases of marketable securities of $196.2 million and purchases of property and equipment of $3.5 million, principally for laboratory and manufacturing equipment, offset partially by maturities and sales of marketable securities of $148.6 million. Cash used in investing activities of $80.2 million for the year ended December 31, 2018 was related to purchases of marketable securities of $81.5 million and purchases of property and equipment of $1.6 million, principally for laboratory and manufacturing equipment, offset partially by maturities of marketable securities of $2.8 million. Cash Flows from Financing Activities Cash used in financing activities of $4.2 million for the year ended December 31, 2019 was primarily related to principal repayment on the August 2017 Loan of $5.0 million and payment of $0.3 million related to the entry into a sales agreement for an at-the-market offering of our common stock, partially offset by $1.3 million of proceeds received from participants in our employee stock purchase plan. Cash provided by financing activities of $170.8 million for the year ended December 31, 2018 was primarily related to the proceeds from our sale of Series E redeemable convertible preferred stock, net of issuance costs, of $84.7 million, proceeds of $84.4 million from the issuance of common stock upon our IPO, net of issuance costs, and the concurrent private placement of common stock to Merck, proceeds of $0.4 million related to the exercise of common stock options and preferred stock warrants, proceeds of $1.0 million in connection with a research, development and commercialization agreement, and proceeds of $0.2 million from the payment of a note receivable from a stockholder. Contractual Obligations and Other Commitments As described in Notes 1 and 15 of our financial statements, we entered into the Loan and Security Agreement on February 28, 2020, for gross proceeds of $25 million. Pursuant to the Loan and Security Agreement, $9.6 million of the gross proceeds were used to fully repay the August 2017 Loan. As a result, of the $9.9 million that was outstanding as of December 31, 2019, $8.9 million has been classified on our balance sheet as Debt - non-current. The remaining $1.0 million that was outstanding as of December 31, 2019 has been classified as Debt - current, and payment of such amount was made prior to the execution of the February 28, 2020 Loan Agreement. The following table summarizes our contractual obligations as of December 31, 2019: (1)This debt and related interest were repaid on February 28, 2020 with proceeds from the Loan and Security Agreement. In addition, we enter into agreements in the normal course of business with contract research organizations for clinical trials and with vendors for preclinical studies and other services and products for operating purposes, which are generally cancelable upon written notice. These payments are not included in this table of contractual obligations. Off-Balance Sheet Arrangements We have not entered into any off-balance sheet arrangements, as defined under SEC rules. While we have an investment classified as variable interest entity, its purpose is not to provide off-balance sheet financing. Critical Accounting Policies and Estimates Our management’s discussion and analysis of our financial condition and results of operations is based on our financial statements, which have been prepared in accordance with United States generally accepted accounting principles. The preparation of these financial statements requires us to make estimates and assumptions that affect the reported amounts of assets and liabilities and the disclosure of contingent assets and liabilities at the date of the financial statements, as well as the reported revenue generated and expenses incurred during the reporting periods. Our estimates are based on our historical experience and on various other factors that we believe are reasonable under the circumstances, the results of which form the basis for making judgments about the carrying value of assets and liabilities that are not readily apparent from other sources. Actual results may differ from these estimates under different assumptions or conditions. While our significant accounting policies are described in the notes to our financial statements included elsewhere in this filing, we believe that the following critical accounting policies are most important to understanding and evaluating our reported financial results. Revenue Recognition We have no products approved for commercial sale and have not generated any revenue from commercial product sales. Our total revenue to date has been generated principally from our collaboration and license agreements with Celgene (now BMS), Merck and EMD Serono, and to a lesser extent, from manufacturing, supply and services and products we provide to Celgene, SutroVax, Inc., or SutroVax, and EMD Serono. When we enter into collaboration agreements, we assess whether the arrangements fall within the scope of ASC 808, Collaborative Arrangements (ASC 808) based on whether the arrangements involve joint operating activities and whether both parties have active participation in the arrangement and are exposed to significant risks and rewards. To the extent that the arrangement falls within the scope of ASC 808, we assess whether the payments between us and our collaboration partner fall within the scope of other accounting literature. If we conclude that payments from the collaboration partner to us represent consideration from a customer, such as license fees and contract research and development activities, we account for those payments within the scope of ASC 606, Revenue from Contracts with Customers. However, if we conclude that our collaboration partner is not a customer for certain activities and associated payments, such as for certain collaborative research, development, manufacturing and commercial activities, we present such payments as a reduction of research and development expense or general and administrative expense, based on where we present the underlying expense. As described in Note 2 to our Financial Statements, on January 1, 2019, we adopted ASC 606, Revenue from Contracts with Customers. ASC 606 supersedes the guidance in ASC 605, Revenue Recognition. We adopted ASC 606 on a modified retrospective basis under which we recognized the $10.3 million cumulative effect of adoption as a reduction to the accumulated deficit balance as of January 1, 2019. Revenue for the years ended December 31, 2018 and 2017 were recorded under ASC 605, while revenue for the year ended December 31, 2019 was recorded under ASC 606. If we had continued to use ASC 605 during 2019, revenue would have been $43.5 million for the year ended December 31, 2019, as compared to the $42.7 million reported. Collaboration revenue We derive revenue from collaboration arrangements, under which we may grant licenses to our collaboration partners to further develop and commercialize our proprietary product candidates. We may also perform research and development activities under the collaboration agreements. Consideration under these contracts generally includes a nonrefundable upfront payment, development, regulatory and commercial milestones and other contingent payments, and royalties based on net sales of approved products. Additionally, the collaborations may provide options for the customer to acquire from our materials and reagents, clinical product supply or additional research and development services under separate agreements. We assess which activities in the collaboration agreements are considered distinct performance obligations that should be accounted for separately. We develop assumptions that require judgement to determine whether the license to our intellectual property is distinct from the research and development services or participation in activities under the collaboration agreements. At the inception of each agreement, we determine the arrangement transaction price, which includes variable consideration, based on the assessment of the probability of achievement of future milestones and contingent payments and other potential consideration. For arrangements that include multiple performance obligations, we allocate the transaction price to the identified performance obligations based on the standalone selling price, or SSP, of each distinct performance obligation. In instances where SSP is not directly observable, we develop assumptions that require judgment to determine the SSP for each performance obligation identified in the contract. These key assumptions may include full-time equivalent, or FTE, personnel effort, estimated costs, discount rates and probabilities of clinical development and regulatory success. Upfront Payments: For collaboration arrangements that include a nonrefundable upfront payment, if the license fee and research and development services cannot be accounted for as separate performance obligations, the transaction price is deferred and recognized as revenue over the expected period of performance using a cost-based input methodology. We use judgement to assess the pattern of delivery of the performance obligation. In addition, amounts paid in advance of services being rendered may result in an associated financing component to the upfront payment. Accordingly, the interest on such borrowing cost component will be recorded as interest expense and revenue, based on an appropriate borrowing rate applied to the value of services to be performed by us over the estimated service performance period. License Grants: For collaboration arrangements that include a grant of a license to our intellectual property, we consider whether the license grant is distinct from the other performance obligations included in the arrangement. For licenses that are distinct, we recognize revenues from nonrefundable, upfront payments and other consideration allocated to the license when the license term has begun and we have provided all necessary information regarding the underlying intellectual property to the customer, which generally occurs at or near the inception of the arrangement. Milestone and Contingent Payments: At the inception of the arrangement and at each reporting date thereafter, we assess whether it should include any milestone and contingent payments or other forms of variable consideration in the transaction price using the most likely amount method. If it is probable that a significant reversal of cumulative revenue would not occur upon resolution of the uncertainty, the associated milestone value is included in the transaction price. At the end of each subsequent reporting period, we re-evaluate the probability of achievement of each such milestone and any related constraint and, if necessary, adjust our estimate of the overall transaction price. Since milestone and contingent payments may become payable to us upon the initiation of a clinical study or filing for or receipt of regulatory approval, we review the relevant facts and circumstances to determine when we should update the transaction price, which may occur before the triggering event. When we update the transaction price for milestone and contingent payments, we allocate the changes in the total transaction price to each performance obligation in the agreement on the same basis as the initial allocation. Any such adjustments are recorded on a cumulative catch-up basis in the period of adjustment, which may result in recognizing revenue for previously satisfied performance obligations in such period. Our collaborators generally pay milestones and contingent payments subsequent to achievement of the triggering event. Research and Development Services: For amounts allocated to our research and development obligations in a collaboration arrangement, we recognize revenue over time using a cost-based input methodology, representing the transfer of goods or services as activities are performed over the term of the agreement. Materials Supply: We provide materials and reagents, clinical materials and services to certain of our collaborators under separate agreements. The consideration for such services is generally based on FTE personnel effort used to manufacture those materials reimbursed at an agreed upon rate in addition to agreed-upon pricing for the provided materials. The amounts billed are recognized as revenue as the performance obligations are met by us. Our revenue recognition policies under ASC 605 are described in our Annual Report on Form 10-K for the year ended December 31, 2018. Research and Development We record accrued expenses for estimated costs of our research and development activities conducted by third party service providers, which include outsourced research and development expenses, professional services and contract manufacturing activities. We record the estimated costs of research and development activities based upon the estimated amount of services provided but not yet invoiced, and include these costs in current liabilities in the balance sheets and within research and development expense in the statements of operations. Nonrefundable advance payments for goods or services that will be used or rendered for future research and development activities are deferred and capitalized and recognized as an expense as the goods are delivered or the related services are performed. For outsourced research and development expenses, such as professional fees payable to third parties for preclinical studies, clinical trials and research services and other consulting costs, we estimate the expenses based on the services performed, pursuant to contracts with research institutions that conduct and manage preclinical studies, clinical trials and research services on our behalf. We estimate these expenses based on discussions with internal management personnel and external service providers as to the progress or stage of completion of services and the contracted fees to be paid for such services. If the actual timing of the performance of services or the level of effort varies from the original estimates, we will adjust the accrual accordingly. Payments made to third parties under these arrangements in advance of the performance of the related services by the third parties are recorded as prepaid expenses until the services are rendered. Stock-Based Compensation We recognize compensation costs related to stock options granted to employees based on the estimated fair value of the awards on the date of grant. We account for forfeitures of stock-based awards as they occur. We estimate the grant date fair value, and the resulting stock-based compensation expense, using the Black-Scholes option-pricing model. The grant date fair value of the stock-based awards is generally recognized on a straight-line basis over the requisite service period, which is generally the vesting period of the respective awards. The Black-Scholes option-pricing model requires the use of highly subjective assumptions to determine the fair value of stock-based awards, including the expected term and the price volatility of the underlying stock. These assumptions include: ▪ Expected term-The expected term represents the period that the stock-based awards are expected to be outstanding. We use the “simplified” method to determine the expected life of options granted, which calculates the expected term as the average of the weighted-average vesting term and the contractual term of the option. ▪ Expected volatility-Since we have limited information available on the volatility of our common stock due to its short trading history, the expected volatility is estimated based on the average historical volatilities of common stock of comparable publicly traded entities over a period equal to the expected term of the stock option grants. We will continue to apply this process until a sufficient amount of historical information regarding the volatility of our own stock price becomes available. ▪ Risk-free interest rate-The risk-free interest rate is based on the U.S. Treasury yield in effect at the time of grant for zero coupon U.S. Treasury notes with maturities approximately equal to the expected term of the options. ▪ Expected dividend-We have never paid dividends on our common stock and have no plans to pay dividends on our common stock. Therefore, we use an expected dividend yield of zero. We will continue to use judgment in evaluating the expected volatility and expected terms utilized for our stock-based compensation calculations on a prospective basis. Historically, for all periods prior to our IPO, the fair value of the shares of common stock underlying our share-based awards was estimated on each grant date by our board of directors. In order to determine the fair value of our common stock underlying option grants, given the absence of a public trading market for our common stock, our board of directors exercised reasonable judgment and considered a number of objective and subjective factors to determine the best estimate of the fair value of our common stock, including timely valuations of our common stock prepared by an independent third-party valuation firm in accordance with the guidance provided by the American Institute of Certified Public Accountants Practice Guide, Valuation of Privately-Held-Company Equity Securities Issued as Compensation, important developments in our operations, our stage of development, sales of our redeemable convertible preferred stock, actual operating results and financial performance, the conditions in the biotechnology industry and the economy in general, the stock price performance and volatility of comparable public companies, the lack of liquidity of our common stock, and the likelihood of achieving a liquidity event, such as an initial public offering or sale. For stock options granted after the completion of the IPO, the closing sale price per share of our common stock as reported on the Nasdaq Global Market on the date of grant is used to determine the exercise price per share of our share-based awards to purchase common stock. Redeemable Convertible Preferred Stock Warrants In the past, we have issued freestanding warrants to purchase shares of redeemable convertible preferred stock. We accounted for these warrants as a liability in our financial statements and they were recorded at their estimated fair value, because the warrants may have conditionally obligated us to transfer assets at some point in the future due to redemption provisions that were outside our control. The fair value of the warrants at the issuance date, at September 30, 2018 (immediately prior to our IPO) and December 31, 2017 was determined using the OPM. The warrants were re-measured at each financial reporting period with any changes in fair value being recognized in other income (expense), net in the statements of operations. We continued to adjust the liability for changes in fair value until the earlier of the expiration of the warrants, exercise of the warrants, or conversion of the redeemable convertible preferred stock warrants into common stock warrants upon the completion of a liquidation event, including the completion of an IPO, which occurred on October 1, 2018. Beginning in the fourth quarter of 2018, there was no longer any warrant-related liability. Income Taxes As of December 31, 2019, we had federal net operating loss, or NOL, carryforwards of $120.7 million and federal general business credits from research and development expenses totaling $14.8 million, as well as state NOL carryforwards of $75.1 million and state research and development credits of $11.5 million. If not utilized, the federal NOL carryforwards will expire at various dates beginning in 2032, and the federal credits will expire at various dates beginning in 2023. The state NOL carryforwards will expire at various dates beginning in 2030, if not utilized. The state research and development tax credits can be carried forward indefinitely. Utilization of the net operating loss carryforwards may be subject to a substantial annual limitation due to the ownership change limitations provided by the Tax Reform Act of 1986, or the Tax Reform Act, as amended, and similar state provisions. The annual limitation may result in the expiration of NOLs and credits before utilization. We have performed a Section 382 study for the period of June 16, 2003 through December 31, 2019 and concluded that it is more likely than not that we experienced an ownership change on April 9, 2007. This change does not limit our ability to use our existing NOLs within the carryforward period provided by the Internal Revenue Code, subject to availability of taxable income. We may experience ownership changes in the future as a result of equity offerings or other shifts in our stock ownership, some of which are outside our control. If there is a subsequent event or further change in ownership, these losses may be subject to limitations, resulting in their expiration before they can be utilized. We assess all material positions taken in any income tax return, including all significant uncertain positions, in all tax years that are still subject to assessment or challenge by relevant taxing authorities. Assessing an uncertain tax position begins with the initial determination of the position’s sustainability and is measured at the largest amount of benefit that is greater than fifty percent likely of being realized upon ultimate settlement. As of each balance sheet date, unresolved uncertain tax positions must be reassessed, and we will determine whether (i) the factors underlying the sustainability assertion have changed and (ii) the amount of the recognized tax benefit is still appropriate. The recognition and measurement of tax benefits requires significant judgment. Judgments concerning the recognition and measurement of a tax benefit might change as new information becomes available. JOBS Act Accounting Election We are an “emerging growth company,” as defined in the Jumpstart Our Business Startups Act of 2012, or the JOBS Act. Under the JOBS Act, emerging growth companies can delay adopting new or revised accounting standards issued subsequent to the enactment of the JOBS Act until such time as those standards apply to private companies. We have elected to use this extended transition period for complying with new or revised accounting standards that have different effective dates for public and private companies until the earlier of the date we (i) are no longer an emerging growth company or (ii) affirmatively and irrevocably opt out of the extended transition period provided in the JOBS Act. As a result, our financial statements may not be comparable to companies that comply with new or revised accounting pronouncements as of public company effective dates. We will remain an emerging growth company until the earliest of (1) the last day of our first fiscal year (a) following the fifth anniversary of the completion of our IPO, (b) in which we have total annual gross revenues of at least $1.07 billion, or (ii) in which we are deemed to be a large accelerated filer, which means the market value of our common stock that is held by non-affiliates exceeds $700.0 million as of the prior June 30th and (2) the date on which we have issued more than $1.0 billion in non-convertible debt securities during the prior three-year period. Recent Accounting Pronouncements See Note 2 to our financial statements included elsewhere in this report for more information.

<s>[INST] The following discussion should be read in conjunction with the attached financial statements and notes thereto. This Annual Report on Form 10K, including the following sections, contains forwardlooking statements within the meaning of the federal securities laws. These statements are subject to risks and uncertainties that could cause actual results and events to differ materially from those expressed or implied by such forwardlooking statements. For a detailed discussion of these risks and uncertainties, see the “Risk Factors” section in Item 1A of this Annual Report on Form 10K. We caution the reader not to place undue reliance on these forwardlooking statements, which reflect management’s analysis only as of the date of this Form 10K. We undertake no obligation to update forwardlooking statements, which reflect events or circumstances occurring after the date of this Form 10K. Overview We are a clinical stage drug discovery, development and manufacturing company focused on deploying our proprietary integrated cellfree protein synthesis and sitespecific conjugation platform, XpressCF®, to create a broad variety of optimally designed, nextgeneration protein therapeutics initially for cancer and autoimmune disorders. We aim to design therapeutics using the most relevant and potent modalities, including cytokinebased targets, immunooncology, or I/O, agents, antibodydrug conjugates, or ADCs, and bispecific antibodies that are directed primarily against clinically validated targets where the current standard of care is suboptimal. We believe our platform allows us to accelerate the discovery and development of potential firstinclass and bestinclass molecules by enabling the rapid and systematic evaluation of protein structureactivity relationships to create optimized homogeneous product candidates. Our mission is to transform the lives of patients by using our XpressCF® Platform to create medicines with improved therapeutic profiles for areas of unmet need. Once identified, production of protein drug candidates can be rapidly and predictably scaled in our current Good Manufacturing Practices compliant manufacturing facility. We have the ability to manufacture our cellfree extract that supports our production of proteins on a large scale using a semicontinuous fermentation process. Our two most advanced product candidates are wholly owned: STRO001, an ADC directed against CD74, for patients with multiple myeloma and nonHodgkin lymphoma, or NHL, and STRO002, an ADC directed against folate receptoralpha, or FolRα, for patients with ovarian and endometrial cancers. STRO001 is currently enrolling patients in a Phase 1 trial, with initial safety and efficacy data reported in 2019. Based on such reported data, STRO001 has been generally welltolerated and no ocular toxicity signals have been observed, with no patients receiving prophylactic corticosteroid eye drops. Dose escalation in the STRO001 Phase 1 trial is continuing, and the maximum tolerated dose has not yet been reached. In October 2018, we were granted Orphan Drug Designation by the U.S. Food and Drug Administration, or FDA, for STRO001 for the treatment of multiple myeloma. We began enrolling patients in a STRO002 Phase 1 trial focused on ovarian and endometrial cancers in March 2019, with initial safety and efficacy data reported in late 2019. Based on such reported data, STRO002 has been welltolerated and no ocular toxicity signals have been observed, with no patients receiving prophylactic corticosteroid eye drops. Dose escalation in the STRO002 Phase 1 trial is continuing, and the maximum tolerated dose has not yet been reached. We have also entered into multitarget, productfocused collaborations with leaders in the field of oncology, including a cytokine derivatives collaboration with Merck Sharp & Dohme Corp., a subsidiary of Merck & Co., Inc., Kenilworth, NJ, or Merck, a B Cell Maturation Antigen, or BCMA, and an immunooncology directed alliance with Celgene Corporation, or Celgene, a wholly owned subsidiary of BristolMyers Squibb Company, New York, NY, or BMS, and an oncologyfocused [/INST] Negative. </s>

PhaseBio Pharmaceuticals Inc

2019-03-26

2018-12-31

Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations. The following discussion and analysis of our financial condition and results of operations should be read in conjunction with our financial statements and related notes and the related Management’s Discussion and Analysis of Financial Condition and Results of Operations included in this Annual Report on Form 10-K. Overview We are a clinical-stage biopharmaceutical company focused on the development and commercialization of novel therapies to treat orphan diseases, with an initial focus on cardiopulmonary indications. Our lead product candidate, PB2452, is a novel reversal agent for the antiplatelet drug ticagrelor, which we are developing for the treatment of patients experiencing major bleeding or those who require urgent surgery. We recently completed a Phase 1 clinical trial of PB2452 in healthy subjects and intend to initiate a Phase 2b clinical trial in healthy older subjects in the first half of 2019. Our second product candidate, PB1046, is a once-weekly fusion protein currently in a Phase 2b clinical trial for the treatment of pulmonary arterial hypertension, or PAH. PB1046 utilizes our proprietary half-life extending elastin-like polypeptide, or ELP, technology, which also serves as the engine for our preclinical pipeline. We have a limited operating history. Since our inception in 2002, our operations have focused on developing our clinical and preclinical product candidates and our proprietary ELP technology, organizing and staffing our company, business planning, raising capital, establishing our intellectual property portfolio and conducting clinical trials and preclinical studies. We do not have any product candidates approved for sale and have not generated any revenue from product sales. Since inception, we have funded our operations through the sale of equity and debt securities and our term loans with Silicon Valley Bank, or SVB, and WestRiver Innovation Lending Fund VIII, L.P., or WestRiver. In 2018, we received $60.7 million in aggregate net proceeds from our initial public offering and the sale of our Series D convertible preferred stock and $4.0 million in net proceeds from borrowings under our term loan with SVB. As of December 31, 2018, we had cash and cash equivalents of $61.0 million. We believe that our existing cash and cash equivalents are sufficient to fund our operating expenses and capital requirements into the second quarter of 2020. See “-Liquidity and Capital Resources.” Since our inception, we have incurred significant operating losses. Our net loss was $23.8 million for the year ended December 31, 2018. As of December 31, 2018, we had an accumulated deficit of $122.9 million. We expect to continue to incur significant expenses and operating losses for the foreseeable future. We anticipate that our expenses will increase significantly in connection with our ongoing activities, as we: • continue our ongoing clinical trials of PB2452 and PB1046, as well as initiate and complete additional clinical trials, as needed; • pursue regulatory approvals for PB2452 as a reversal agent for the antiplatelet drug ticagrelor and PB1046 for the treatment of PAH; • seek to discover and develop additional clinical and preclinical product candidates; • scale up our clinical and regulatory capabilities; • establish a commercialization infrastructure and scale up external manufacturing and distribution capabilities to commercialize any product candidates for which we may obtain regulatory approval, including PB2452 and PB1046; • adapt our regulatory compliance efforts to incorporate requirements applicable to marketed products, if any; • maintain, expand and protect our intellectual property portfolio; • hire additional clinical, manufacturing and scientific personnel; • add operational, financial and management information systems and personnel, including personnel to support our product development and planned future commercialization efforts; and • incur additional legal, accounting and other expenses in operating as a public company. FINANCIAL OVERVIEW Components of Operating Results Grant Revenues Grant revenues are derived from government grants that support our efforts on specific research projects. We recognize grant revenue when there is reasonable assurance of compliance with the conditions of the grant and reasonable assurance that the grant revenue will be received. Research and Development Expense Research and development expense consists of expenses incurred in connection with the discovery and development of our product candidates. We expense research and development costs as incurred. These expenses include: • expenses incurred under agreements with contract research organizations, or CROs, as well as investigative sites and consultants that conduct our clinical trials and preclinical studies; • manufacturing and supply scale-up expenses and the cost of acquiring and manufacturing preclinical and clinical trial supply and potential commercial supply, including manufacturing validation batches; • outsourced professional scientific development services; • employee-related expenses, which include salaries, benefits and stock-based compensation; • expenses relating to regulatory activities; and • laboratory materials and supplies used to support our research activities. Research and development activities are central to our business model. Product candidates in later stages of clinical development generally have higher development costs than those in earlier stages of clinical development, primarily due to the increased size and duration of later-stage clinical trials. We expect our research and development expense to increase significantly over the next several years as we increase personnel costs, including stock-based compensation, conduct our later-stage clinical trials for PB2452 and PB1046 and conduct other preclinical studies and clinical trials and prepare regulatory filings for our product candidates. The successful development of our product candidates is highly uncertain. At this time, we cannot reasonably estimate or know the nature, timing and costs of the efforts that will be necessary to complete the remainder of the development of, or when, if ever, material net cash inflows may commence from our product candidates. This uncertainty is due to the numerous risks and uncertainties associated with the duration and cost of clinical trials, which vary significantly over the life of a project as a result of many factors, including: • delays in regulators or institutional review boards authorizing us or our investigators to commence our clinical trials or in our ability to negotiate agreements with clinical trial sites or contract research organizations; • our ability to secure adequate supply of product candidates for our trials; • the number of clinical sites included in the trials; • the length of time required to enroll suitable patients; • the number of patients that ultimately participate in the trials; • the number of doses patients receive; • any side effects associated with our product candidates; • the duration of patient follow-up; and • the results of our clinical trials. Our expenditures are subject to additional uncertainties, including the terms and timing of regulatory approvals, and the expense of filing, prosecuting, defending and enforcing any patent claims or other intellectual property rights. We may never succeed in achieving regulatory approval for our product candidates. We may obtain unexpected results from our clinical trials. We may elect to discontinue, delay or modify clinical trials of our product candidates. A change in the outcome of any of these variables with respect to the development of a product candidate could mean a significant change in the costs and timing associated with the development of that product candidate. For example, if the Food and Drug Administration, or the FDA, or other regulatory authorities were to require us to conduct clinical trials beyond those that we currently anticipate, or if we experience significant delays in enrollment in any of our clinical trials, we could be required to expend significant additional financial resources and time on the completion of clinical development. Product commercialization will take several years and millions of dollars in development costs. General and Administrative Expense General and administrative expense consists principally of salaries and related costs for personnel in executive and administrative functions, including stock-based compensation, travel expenses and recruiting expenses. Other general and administrative expense includes professional fees for legal, accounting and tax-related services and insurance costs. We anticipate that our general and administrative expense will increase as a result of increased payroll, expanded infrastructure and higher consulting, legal and tax-related services associated with maintaining compliance with stock exchange listing and SEC requirements, accounting and investor relations costs, and director and officer insurance premiums associated with being a public company. We anticipate the additional costs for these services will increase our general and administrative expense. Interest Expense Interest expense consists of interest expense on our convertible promissory notes and term loan. Change in Fair Value of Warrant and Derivative Liabilities Change in fair value of warrant and derivative liabilities reflects the revaluation at each reporting date of our redeemable convertible preferred stock warrants and the conversion option on our convertible promissory notes, respectively. Subsequent to the conversion of all outstanding shares of our preferred stock into common stock in connection with the closing of our initial public offering in October 2018, we are no longer required to remeasure the warrant liability for periods following the closing of the initial public offering. Additionally, in August 2018 all of our previously outstanding convertible promissory notes converted with the sale and issuance of the Series D redeemable preferred stock. As such, we will no longer be required to remeasure the conversion option for the periods following the closing of that financing. License Agreements MedImmune Limited In November 2017, we entered into an exclusive license agreement, or the MedImmune License, with MedImmune Limited, or Medimmune, a wholly owned subsidiary of AstraZeneca plc. Pursuant to the MedImmune License, MedImmune granted us an exclusive, worldwide license under certain patent rights owned or controlled by MedImmune to develop and commercialize any products covered by the MedImmune License, or the MedImmune licensed products, for the treatment, palliation, diagnosis or prevention of any human disorder or condition. Under the MedImmune License, we paid MedImmune an upfront fee of $0.1 million. We are also required to pay MedImmune: quarterly fees relating to technical services provided by MedImmune; up to $18.0 million in clinical and regulatory milestone fees; up to $50.0 million in commercial milestone fees; and mid-single digit to low-teen royalty percentages on net sales of MedImmune licensed products, subject to reduction in specified circumstances. In addition, the MedImmune License offers an option for third-party product storage costs. As of December 31, 2018, we have paid $0.5 million under the MedImmune License. Duke University In October 2006, we entered into an exclusive license agreement, or the Duke License, with Duke University, or Duke, which we most recently amended in May 2017. Pursuant to the Duke License, Duke granted us an exclusive, worldwide license under certain patent rights owned or controlled by Duke, and a non-exclusive, worldwide license under certain know-how of Duke, to develop and commercialize any products covered by the Duke License, or Duke licensed products, relating to ELPs. Under the Duke License, we paid Duke an upfront fee of $37,000, additional fees in connection with amendments to the Duke License of $0.2 million and other additional licensing fees of $0.2 million. In consideration for license rights granted to us, we initially issued Duke 24,493 shares of our common stock. Until we reached a certain stipulated equity milestone, which we reached in October 2007, we were obligated to issue additional shares of common stock to Duke from time to time so that its aggregate ownership represented 7.5% of our issued and outstanding capital stock. We are also required to pay Duke: up to $2.2 million in regulatory and clinical milestone fees; up to $0.4 million in commercial milestone fees; low single-digit royalty percentages on net sales of Duke licensed products, with minimum aggregate royalty payments of $0.2 million payable following our achievement of certain commercial milestones; and up to the greater of $0.3 million or a low double-digit percentage of the fees we receive from a third party in consideration of forming a strategic alliance with respect to certain patent rights covered under the Duke License. We also must pay Duke the first $1.0 million of non-royalty payments we receive from a sublicensee, and thereafter a low double-digit percentage of any additional nonroyalty payments we receive. As of December 31, 2018, we have not paid any amounts under the Duke License. We are also required to apply for, prosecute and maintain all U.S. and foreign patent rights under the Duke License. Results of Operations Comparison of the Years Ended December 31, 2018 and 2017 The following table summarizes our results of operations for the years ended December 31, 2018 and 2017 (in thousands): Grant Revenues Grant revenues were $0.7 million for the year ended December 31, 2018, as we incurred allowable costs qualifying for reimbursement under our government grants. We did not receive any grant revenues for the year ended December 31, 2017. Research and Development Expense Research and development expense was $15.5 million for the year ended December 31, 2018, compared to $6.2 million for the year ended December 31, 2017. The increase of $9.2 million was primarily attributable to increased costs associated with preclinical and clinical development activities largely related to PB2452 and PB1046. The following table summarizes our research and development expense by functional area for the years ended December 31, 2018 and 2017 (in thousands): The following table summarizes our research and development expense by product candidate for the years ended December 31, 2018 and 2017 (in thousands): General and Administrative Expense General and administrative expense was $4.9 million for the year ended December 31, 2018, compared to $2.3 million for the year ended December 31, 2017. The increase of $2.5 million was primarily attributable to an increase in professional services including legal, marketing and other consulting services of $1.4 million, an increase in employee compensation expense of $0.7 million, an increase in insurance expenses of $0.3 million and an increase in business travel-related expenses of $0.2 million. Interest Expense Interest expense was $3.9 million for the year ended December 31, 2018, compared to $2.7 million for the year ended December 31, 2017. The increase of $1.2 million was partially attributable to an additional $8.1 million in borrowings pursuant to our convertible promissory notes entered into in October 2017. Additionally, we entered into our term loan in October 2017, pursuant to which we borrowed $3.5 million in November 2017, $2.0 million in April 2018 and $2.0 million in August 2018, which also contributed to the increase in interest expense year over year. Change in Fair Value of Warrant Liability Change in fair value of warrant liability resulted in other income of $11,000 for the year ended December 31, 2018, compared to other income of $1.0 million for the year ended December 31, 2017. The preferred stock warrants were subject to remeasurement at each reporting period, with changes in fair value recorded in the statement of operations. The outstanding preferred stock warrants converted into common stock warrants upon the completion of our initial public offering. Change in Fair Value of Derivative Liability Change in fair value of derivative liability was $0.7 million of expense for the year ended December 31, 2018, compared to $0.1 million of expense for the year ended December 31, 2017. The conversion option related to our convertible promissory notes was subject to remeasurement at each reporting period, with changes in fair value recorded in the statement of operations. The convertible promissory notes converted into redeemable convertible preferred stock in August 2018 upon the sale of the Series D redeemable convertible preferred stock. Liquidity and Capital Resources Since our inception, we have not generated any revenue from product sales and have incurred net losses and negative cash flows from our operations. We have financed our operations since our inception primarily through the sales of equity and debt securities and borrowings under our term loans with SVB and WestRiver. As of December 31, 2018, we had cash and cash equivalents of $61.0 million. October 2017 Loan Agreement with SVB In October 2017, we entered into a loan and security agreement, or the SVB Loan, with SVB, which provided that we could borrow up to $7.5 million, issuable in three separate tranches, or Growth Capital Advances, of $3.5 million, $2.0 million and $2.0 million, each available upon achievement of certain clinical and regulatory milestones. We drew each of the tranches in November 2017, April 2018 and August 2018, respectively. The maturity date of the SVB Loan was June 1, 2020, which was extended to December 31, 2020 when we drew on the third tranche. The SVB Loan was interest-only through July 31, 2018, which was extended to December 31, 2018 when we drew on the third tranche. In addition to interest and principal payments, we were required to make a final payment equal to 7% of the original aggregate principal amount of the Growth Capital Advances. We had the option to prepay all, but not less than all, of the borrowed amounts, provided that we would be obligated to pay a prepayment fee equal to (a) 3.0% of the outstanding principal balance of the applicable Growth Capital Advances if prepayment was made prior to the first anniversary of the effective date of the SVB Loan, (b) 2.0% of the outstanding principal balance of the applicable Growth Capital Advances if prepayment was made by the second anniversary of the effective date of the SVB Loan or (c) 1.0% of the outstanding principal balance of the applicable Growth Capital Advances if prepayment was made after the second anniversary of the effective date of the SVB Loan. On March 25, 2019, we repaid the outstanding principal balance and accrued portion of the final payment under the SVB Loan in full using Tranche A from the 2019 Loan described below. March 2019 Loan Agreement with SVB and WestRiver On March 25, 2019, we entered into a term loan agreement, or the 2019 Loan, with SVB and WestRiver, pursuant to which we may borrow up to $15.0 million, issuable in three separate tranches, or Advances, of $7.5 million, or Tranche A, which was issued upon execution of the 2019 Loan, $2.5 million, or Tranche B, available to be issued until May 31, 2019 and $5.0 million, or Tranche C, which we will draw upon the achievement of certain regulatory milestones, or the Tranche C milestones. The maturity date of the 2019 Loan is March 1, 2023. Under the terms of the 2019 Loan, we are to make interest-only payments through December 31, 2019 on Tranche A and Tranche B at a rate equal to the greater of the Prime Rate plus 1.00%, as defined in the 2019 Loan, or 6.5%, followed by an amortization period of 39 months of equal monthly payments of principal plus interest amounts until paid in full. The interest-only period will automatically be extended to June 30, 2020 if we achieve the Tranche C milestones, followed by an amortization period of 33 months of equal monthly payments of principal plus interest amounts until paid in full. In addition to and not in substitution for our regular monthly payments of principal plus accrued interest, we are required to make a final payment equal to 6% of the aggregate principal amount of the Advances on the maturity date. We have agreed to issue to SVB and WestRiver warrants to purchase an aggregate of 37,606 shares of our common stock when we draw on Tranche A, an aggregate of 12,131 shares of our common stock on when we draw on Tranche B and an aggregate of 24,462 shares of our common stock when we draw on Tranche C, each with an exercise price of the lower of the average closing price of our common stock for the previous ten days of trading or the closing price on the day prior to funding. The warrants are immediately exercisable upon issuance and expire ten years from the date of issuance. Upon execution of the 2019 Loan, we drew $7.5 million from Tranche A and repaid the outstanding principal balance and accrued portion of the final payment for the SVB Loan in full. We also issued warrants to purchase 18,803 shares of our common stock to each of SVB and WestRiver, with exercise prices of $4.73 per share. Our obligations under the 2019 Loan are secured by a first priority security interest in substantially all of our current and future assets, excluding intellectual property. We are also obligated to comply with various other customary covenants, including restrictions on our ability to encumber our intellectual property assets. Convertible Promissory Notes In January 2017 and October 2017, we issued $14.7 million of convertible promissory notes, or the 2017 Notes, to holders of Series C-1 redeemable convertible preferred stock. The 2017 Notes bore interest at the rate of 8%. The 2017 Notes had a stated maturity date of March 31, 2018. In October 2017, the noteholders entered into a subordination agreement with SVB, pursuant to which the noteholders agreed that they would not demand or receive any payment on the 2017 Notes until all amounts owed under the SVB Loan were repaid in full on June 1, 2020. In August 2018, all of the 2017 Notes were converted concurrent with the sale of our Series D redeemable convertible preferred stock. As of December 31, 2018, we had cash and cash equivalents of $61.0 million. The following table summarizes our cash flows for each of the periods set forth below (in thousands): Operating Activities Net cash used in operating activities was $17.1 million during the year ended December 31, 2018. The use of cash primarily related to our net loss of $23.8 million, adjusted for non-cash charges primarily related to $3.7 million for non-cash interest expense, $0.7 million for the change in the fair value of the derivative liability and a $2.0 million change in our operating assets and liabilities. The change in our operating assets and liabilities was principally due to a $3.3 million increase in accounts payable and accrued expenses, partially offset by a $1.0 million increase in prepaid expenses, all as a result of increased clinical activities for our ongoing clinical trials of PB2452 and PB1046. Net cash used in operating activities was $8.3 million during the year ended December 31, 2017. The use of cash primarily related to our net loss of $10.2 million, adjusted for non-cash charges principally related to $2.7 million for non-cash interest expense and $1.0 million for the change in the fair value of the warrant liability. Investing Activities Net cash used in investing activities was $0.1 million for the purchase of property and equipment during the year ended December 31, 2018. Net cash used in investing activities was $0.2 million for the purchase of property and equipment during the year ended December 31, 2017. Financing Activities Net cash provided by financing activities was $64.8 million during the year ended December 31, 2018, consisting primarily of $43.0 million in net proceeds from our initial public offering, $17.7 million from the issuance of the Series D redeemable convertible preferred stock and $4.0 million from the issuance of our term loan with SVB. Net cash provided by financing activities was $18.2 million during the year ended December 31, 2017 consisting of net proceeds from the issuance of convertible promissory notes and our term loan with SVB. Funding Requirements To date, we have not generated any revenues from the commercial sale of approved drug products, and we do not expect to generate substantial revenue for at least the next several years. If we fail to complete the development of our product candidates in a timely manner or fail to obtain their regulatory approval, our ability to generate future revenue will be compromised. We do not know when, or if, we will generate any revenue from our product candidates, and we do not expect to generate significant revenue unless and until we obtain regulatory approval of, and commercialize, our product candidates. We expect our expenses to increase in connection with our ongoing activities, particularly as we continue the research and development of, continue or initiate clinical trials of and seek marketing approval for our product candidates. In addition, if we obtain approval for any of our product candidates, we expect to incur significant commercialization expenses related to sales, marketing, manufacturing and distribution. We anticipate that we will need substantial additional funding in connection with our continuing operations. If we are unable to raise capital when needed or on attractive terms, we could be forced to delay, reduce or eliminate our research and development programs or future commercialization efforts. We believe that our existing cash and cash equivalents are sufficient to fund our operating expenses and capital requirements into the second quarter of 2020. We intend to devote our existing cash and cash equivalents to advance our clinical and preclinical development programs. We have based our estimates on assumptions that may prove to be wrong, and we may use our available capital resources sooner than we currently expect. Because of the numerous risks and uncertainties associated with the development and commercialization of product candidates, we are unable to estimate the amounts of increased capital outlays and operating expenditures necessary to complete the development of product candidates. Our future capital requirements will depend on many factors, including: • the progress and results of our ongoing and planned future clinical trials of PB2452 and PB1046 and our preclinical programs; • the scope, progress, results and costs of preclinical development, laboratory testing and clinical trials for any future product candidates we may decide to pursue; • the extent to which we develop, in-license or acquire other product candidates and technologies; • the number and development requirements of other product candidates that we may pursue; • the costs, timing and outcome of regulatory review of our product candidates; • the costs and timing of future commercialization activities, including product manufacturing, marketing, sales and distribution, for any of our product candidates for which we receive marketing approval; • the revenue, if any, received from commercial sales of our product candidates for which we receive marketing approval; • our ability to establish collaborations to commercialize PB1046 in the United States; • our ability to establish collaborations to commercialize PB2452, PB1046 or any of our other product candidates outside the United States; and • the costs and timing of preparing, filing and prosecuting patent applications, maintaining and enforcing our intellectual property rights and defending any intellectual property-related claims. Identifying potential product candidates and conducting preclinical studies and clinical trials is a time-consuming, expensive and uncertain process that takes many years to complete, and we may never generate the necessary data or results required to obtain marketing approval and achieve product sales. In addition, our product candidates, if approved, may not achieve commercial success. Our commercial revenues, if any, will be derived from sales of product candidates that we do not expect to be commercially available in the near term, if at all. Our future commercial revenue, if any, will be derived from sales of products that we do not expect to be commercially available for several years, if at all. Accordingly, we will need to continue to rely on additional financing to achieve our business objectives. Adequate additional financing may not be available to us on acceptable terms, or at all. To the extent that we raise additional capital through the sale of equity or convertible debt securities, the terms of these equity securities or this debt may restrict our ability to operate. Any future debt financing and equity financing, if available, may involve agreements that include, covenants limiting and restricting our ability to take specific actions, such as incurring additional debt, making capital expenditures, entering into profit-sharing or other arrangements or declaring dividends. If we raise additional funds through government or private grants, collaborations, strategic alliances or marketing, distribution or licensing arrangements with third parties, we may be required to relinquish valuable rights to our technologies, future revenue streams, research programs or product candidates or to grant licenses on terms that may not be favorable to us. Off-Balance Sheet Arrangements We did not have during the periods presented, and we do not currently have, any off-balance sheet arrangements, as defined in the SEC rules and regulations. Critical Accounting Policies and Significant Judgments and Estimates Our management’s discussion and analysis of our financial condition and results of operations is based on our financial statements, which have been prepared in accordance with U.S. generally accepted accounting policies, or GAAP. The preparation of these financial statements requires us to make estimates, judgments and assumptions that affect the reported amounts of assets and liabilities, disclosure of contingent assets and liabilities as of the dates of the balance sheets and the reported amounts of expenses during the reporting periods. In accordance with GAAP, we evaluate our estimates and judgments on an ongoing basis. We believe the following accounting policies are the most critical to the judgments and estimates used in the preparation of our financial statements. See Note 2 to the financial statements appearing elsewhere in this Annual Report for a discussion of our significant accounting policies. Accrued Research and Development Expense The majority of our operating expenses to date have been incurred in research and development activities. As part of the process of preparing our financial statements, we are required to estimate expenses resulting from obligations under contracts with vendors, consultants and research organizations, in connection with conducting clinical and preclinical activities. The financial terms of these contracts are subject to negotiations which vary from contract to contract and may result in payment flows that do not match the periods over which materials or services are provided under such contracts. We reflect preclinical study and clinical trial expenses in our financial statements by matching those expenses with the period in which services and efforts are expended. We account for these expenses according to the progress of the preclinical study or clinical trial as measured by the timing of various aspects of the preclinical study or clinical trial, or related activities. Our accrual estimates are determined through review of the underlying contracts along with preparation of financial models taking into account discussions with research and other key personnel as to the progress of preclinical studies or clinical trials, or other services being conducted. During the course of a preclinical study or clinical trial, we will adjust the rate of expense recognition if actual results differ from our original estimates. Recent Accounting Pronouncements See Note 2 to the financial statements appearing elsewhere in this Annual Report for information concerning recent accounting pronouncements. JOBS Act Transition Period In April 2012, the JOBS Act was enacted. Section 107 of the JOBS Act provides that an “emerging growth company” can take advantage of the extended transition period provided in Section 7(a)(2)(B) of the Securities Act for complying with new or revised accounting standards. Thus, an emerging growth company can delay the adoption of certain accounting standards until those standards would otherwise apply to private companies. We have irrevocably elected not to avail ourselves of this extended transition period and, as a result, we will adopt new or revised accounting standards on the relevant dates on which adoption of such standards is required for other public companies. We are in the process of evaluating the benefits of relying on other exemptions and reduced reporting requirements under the JOBS Act. Subject to certain conditions, as an emerging growth company, we may rely on certain of these exemptions, including without limitation, (i) not providing an auditor’s attestation report on our system of internal controls over financial reporting pursuant to Section 404(b) of the Sarbanes-Oxley Act and (ii) not complying with any requirement that may be adopted by the Public Company Accounting Oversight Board. We will remain an emerging growth company until the earliest to occur of (1) the last day of the fiscal year (a) ending December 31, 2023, which is the end of the fiscal year following the fifth anniversary of the completion our initial public offering, (b) in which we have total annual gross revenues of at least $1.07 billion or (c) in which we are deemed to be a “large accelerated filer” under the rules of the SEC, which means the market value of our common stock that is held by non-affiliates exceeds $700 million as of the prior June 30th, and (2) the date on which we have issued more than $1.0 billion in non-convertible debt during the prior three-year period. Effect of Inflation Inflation did not have a significant impact on our net sales, revenues or income from continuing operations in 2018 or 2017.

<s>[INST] Overview We are a clinicalstage biopharmaceutical company focused on the development and commercialization of novel therapies to treat orphan diseases, with an initial focus on cardiopulmonary indications. Our lead product candidate, PB2452, is a novel reversal agent for the antiplatelet drug ticagrelor, which we are developing for the treatment of patients experiencing major bleeding or those who require urgent surgery. We recently completed a Phase 1 clinical trial of PB2452 in healthy subjects and intend to initiate a Phase 2b clinical trial in healthy older subjects in the first half of 2019. Our second product candidate, PB1046, is a onceweekly fusion protein currently in a Phase 2b clinical trial for the treatment of pulmonary arterial hypertension, or PAH. PB1046 utilizes our proprietary halflife extending elastinlike polypeptide, or ELP, technology, which also serves as the engine for our preclinical pipeline. We have a limited operating history. Since our inception in 2002, our operations have focused on developing our clinical and preclinical product candidates and our proprietary ELP technology, organizing and staffing our company, business planning, raising capital, establishing our intellectual property portfolio and conducting clinical trials and preclinical studies. We do not have any product candidates approved for sale and have not generated any revenue from product sales. Since inception, we have funded our operations through the sale of equity and debt securities and our term loans with Silicon Valley Bank, or SVB, and WestRiver Innovation Lending Fund VIII, L.P., or WestRiver. In 2018, we received $60.7 million in aggregate net proceeds from our initial public offering and the sale of our Series D convertible preferred stock and $4.0 million in net proceeds from borrowings under our term loan with SVB. As of December 31, 2018, we had cash and cash equivalents of $61.0 million. We believe that our existing cash and cash equivalents are sufficient to fund our operating expenses and capital requirements into the second quarter of 2020. See “Liquidity and Capital Resources.” Since our inception, we have incurred significant operating losses. Our net loss was $23.8 million for the year ended December 31, 2018. As of December 31, 2018, we had an accumulated deficit of $122.9 million. We expect to continue to incur significant expenses and operating losses for the foreseeable future. We anticipate that our expenses will increase significantly in connection with our ongoing activities, as we: continue our ongoing clinical trials of PB2452 and PB1046, as well as initiate and complete additional clinical trials, as needed; pursue regulatory approvals for PB2452 as a reversal agent for the antiplatelet drug ticagrelor and PB1046 for the treatment of PAH; seek to discover and develop additional clinical and preclinical product candidates; scale up our clinical and regulatory capabilities; establish a commercialization infrastructure and scale up external manufacturing and distribution capabilities to commercialize any product candidates for which we may obtain regulatory approval, including PB2452 and PB1046; adapt our regulatory compliance efforts to incorporate requirements applicable to marketed products, if any; maintain, expand and protect our intellectual property portfolio; hire additional clinical, manufacturing and scientific personnel; add operational, financial and management information systems and personnel, including personnel to support our product development and planned future commercialization efforts; and incur additional legal, accounting and other expenses in operating as a public company. FINANCIAL OVERVIEW Components of Operating Results Grant Revenues Grant revenues are derived from government grants that support our efforts on specific research projects. We recognize grant revenue when there is reasonable assurance of compliance with the conditions of the grant and reasonable assurance that the grant revenue will be received. Research and Development Expense Research and development expense consists of expenses incurred in connection with the discovery and development [/INST] Positive. </s>

PhaseBio Pharmaceuticals Inc

2020-03-30

2019-12-31

Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations. The following discussion and analysis of our financial condition and results of operations should be read in conjunction with our financial statements and related notes and the related Management’s Discussion and Analysis of Financial Condition and Results of Operations included in this Annual Report on Form 10-K. Overview We are a clinical-stage biopharmaceutical company focused on the development and commercialization of novel therapies for cardiopulmonary diseases, with an initial focus on cardiopulmonary indications. Our lead product candidate, PB2452, is a novel reversal agent for the antiplatelet drug ticagrelor, which we are developing for the reversal of the antiplatelet effects of ticagrelor in patients with uncontrolled major or life-threatening bleeding or requiring urgent surgery or an invasive procedure. Based on feedback from the FDA we intend to seek approval of PB2452 in the United States through an accelerated approval process. In our completed Phase 2a clinical trial of PB2452, we observed immediate and complete reversal of ticagrelor’s antiplatelet activity within five minutes following initiation of infusion and sustained reversal for over 20 hours. We are developing PB2452 with SFJ pursuant to the SFJ Agreement. Under the SFJ Agreement, SFJ has agreed to pay us up to $120.0 million to support the clinical development of PB2452. During the term of the SFJ Agreement, we will have primary responsibility for clinical development and regulatory activities for PB2452 in the United States and the European Union, while SFJ will have primary responsibility for clinical development and regulatory activities for PB2452 in China and Japan and will provide clinical trials operations support in the European Union. The FDA granted Breakthrough Therapy designation for PB2452 in April 2019. The EMA granted PB2452 PRIME designation in February 2020. Based on feedback from the FDA, we intend to submit a BLA for potential accelerated approval based on an interim analysis of the first approximately 100 patients treated in our Phase 3 trial, with approximately 50 patients with uncontrolled major or life-threatening bleeding and approximately 50 patients requiring urgent surgery or an invasive procedure. We recently commenced our pivotal Phase 3 clinical trial. Based on an 18-month estimated enrollment timeline for the first 100 patients in the Phase 3 trial, we are targeting to submit our BLA for PB2452 in the second half of 2022. To support full approval for patients with uncontrolled major or life-threatening bleeding or requiring urgent surgery or an invasive procedure, the FDA recommended enrollment of 200 total patients in the Phase 3 trial. After we submit our BLA with data from the first 100 patients, we intend to complete the Phase 3 trial and establish a post-approval registry in accordance with FDA requirements. The CHMP of the EMA has also generally agreed with our proposed development plan for PB2452. Our second product candidate, PB1046, is a once-weekly fusion protein currently in a Phase 2b clinical trial for the treatment of PAH. PB1046 utilizes our ELP technology, which also serves as an engine for our preclinical pipeline. We have temporarily paused enrollment of new patients in this trial as a precaution to minimize potential exposure of this patient population at high risk of serious illness from COVID-19. However, we have also informed investigators that they may continue dosing PB1046 and performing assessments for current trial participants if they deem it appropriate and such activities are permitted by their respective institutions. Additionally, we continue to identify new trial sites for future initiation. Although we have been targeting to report results from this trial in the fourth quarter of 2020, we believe that the COVID-19 outbreak will temporarily prevent us from being able to initiate new trial sites and enroll new patients, likely delaying our ability to report the results of this trial into 2021. We are also developing our preclinical product candidate, PB6440, for treatment-resistant hypertension. We retain worldwide commercial rights to all of our product candidates. We have a limited operating history. Since our inception in 2002, our operations have focused on developing our clinical and preclinical product candidates and our proprietary ELP technology, organizing and staffing our company, business planning, raising capital, establishing our intellectual property portfolio and conducting clinical trials and preclinical studies. We do not have any product candidates approved for sale and have not generated any revenue from product sales. Since inception, we have financed our operations primarily through the sale of equity and debt securities and our term loans with SVB and WestRiver. In 2018, we received $60.7 million in aggregate net proceeds from our IPO and the sale of Series D convertible preferred stock and $4.0 million in borrowings under our term loan with SVB. In April 2019, we received $46.3 million in net proceeds from an underwritten public offering of our common stock. In May 2019, we received an additional $2.5 million under our term loan with SVB and WestRiver, or our 2019 Loan, and in October 2019, we received an additional $5.0 million under our 2019 Loan. In January 2020, we entered into the SFJ Agreement pursuant to which SFJ has agreed to provide us up to $120.0 million of funding to support the clinical development of PB2452. In March 2020, SFJ paid us an initial $10.0 million. SFJ will pay us an additional $80.0 million through cost reimbursements followed by six equal quarterly payments beginning with the quarter ending September 30, 2020 through the quarter ending December 31, 2021, and up to an additional $30.0 million upon the achievement of specified clinical development milestones with respect to our ongoing Phase 3 clinical trial of PB2452. Since our inception, we have incurred significant operating losses. Our net loss was $39.2 million for the year ended December 31, 2019. As of December 31, 2019, we had an accumulated deficit of $162.2 million. We expect to continue to incur significant expenses and operating losses for the foreseeable future. We anticipate that our expenses will increase substantially in connection with our ongoing activities, as we: • continue our ongoing clinical trials of PB2452 and PB1046, as well as initiate and complete additional clinical trials, as needed; • seek to expand our geographical reach through the SFJ Agreement and the corresponding clinical development support fees that we will incur; • pursue regulatory approvals for PB2452 as a reversal agent for the antiplatelet drug ticagrelor and PB1046 for the treatment of PAH; • develop PB6440 for treatment-resistant hypertension; • seek to discover and develop additional clinical and preclinical product candidates; • scale up our clinical and regulatory capabilities; • establish a commercialization infrastructure and scale up external manufacturing and distribution capabilities to commercialize any product candidates for which we may obtain regulatory approval, including PB2452 and PB1046; • adapt our regulatory compliance efforts to incorporate requirements applicable to marketed products; • maintain, expand and protect our intellectual property portfolio; • hire additional clinical, manufacturing and scientific personnel; • add operational, financial and management information systems and personnel, including personnel to support our product development and planned future commercialization efforts; and • incur additional legal, accounting and other expenses in operating as a public company. Recent Developments Co-Development Agreement with SFJ In January 2020, we entered into the SFJ Agreement with SFJ, pursuant to which SFJ has agreed to pay us up to $120.0 million to support the clinical development of PB2452. In March 2020, SFJ paid us an initial $10.0 million. SFJ will fund $80.0 million of development expenses through the end of 2021 and up to an additional $30.0 million based on us meeting specific, pre-defined clinical milestones for PB2452. During the term of the SFJ Agreement, we will have primary responsibility for clinical development and regulatory activities for PB2452 in the United States and the European Union, while SFJ will have primary responsibility for clinical development and regulatory activities for PB2452 in China and Japan and will provide clinical trials operations support in the European Union. Refer to "Item 1. Business" under the subheading Business - License, Co-Development and Other Agreements - Co-Development Agreement for PB2452 with SFJ Pharmaceuticals in this annual report. PB6440 Asset Purchase Agreement In January 2020, we entered into an asset purchase agreement with Viamet and Selenity to acquire all of the assets and intellectual property rights related to PB6440, a novel oral aldosterone synthase inhibitor, which we plan to develop for treatment-resistant hypertension. Refer to "Item 1. Business" under the subheading Business - License, Co-Development and Other Agreements - Viamet Asset Purchase Agreement in this annual report. Commencement of Pivotal Phase 3 Clinical Trial for PB2452 We recently commenced our pivotal Phase 3 clinical trial. Based on feedback from the FDA, we intend to submit a BLA for potential accelerated approval based on an interim analysis of the first approximately 100 patients treated in our Phase 3 trial, with approximately 50 patients with uncontrolled major or life-threatening bleeding and approximately 50 patients requiring urgent surgery or an invasive procedure. After we submit our BLA with data from the first 100 patients, we intend to complete the Phase 3 trial and establish a post-approval registry in accordance with FDA requirements. FINANCIAL OVERVIEW Components of Operating Results Revenue Grant Revenue Grant revenue is derived from government grants that support our efforts on specific research projects. We recognize grant revenue when there is reasonable assurance of compliance with the conditions of the grant and reasonable assurance that the grant revenue will be received. Revenue Under Collaborative Agreement Revenue under collaborative agreement is derived from an agreement with our collaboration partner, ImmunoForge Co., Ltd., or ImmunoForge. We have granted ImmunoForge a license to develop certain compound indications in exchange for an upfront license payment and event-based payments subject to ImmunoForge’s achievement of specified development, regulatory and sales-based milestones. In addition, we are entitled to royalties if products under the collaboration are commercialized. We recognize revenue for upfront amounts when the license is transferred to ImmunoForge. Development milestones and other fees are recognized as revenue when it is probable that the amount will not result in a significant reversal of revenue in the future. Sales-based milestones and royalties cannot be recognized until the underlying sales occur. Research and Development Expense Research and development expense consists of expenses incurred in connection with the discovery and development of our product candidates. We expense research and development costs as incurred. These expenses include: • expenses incurred under agreements with contract research organizations, or CROs, as well as investigative sites and consultants that conduct our clinical trials and preclinical studies; • manufacturing and supply scale-up expenses and the cost of acquiring and manufacturing preclinical and clinical trial supply and potential commercial supply, including manufacturing validation batches; • clinical development support fees that we incur related to the SFJ Agreement; • outsourced professional scientific development services; • employee-related expenses, which include salaries, benefits and stock-based compensation; • expenses relating to regulatory activities; and • laboratory materials and supplies used to support our research activities. Research and development activities are central to our business model. Product candidates in later stages of clinical development generally have higher development costs than those in earlier stages of clinical development, primarily due to the increased size and duration of later-stage clinical trials. We expect our research and development expense to increase significantly over the next several years as we increase personnel costs, including stock-based compensation, conduct our later-stage clinical trials for PB2452 and PB1046, develop PB6440, conduct other preclinical studies and clinical trials and prepare regulatory filings and, if we receive regulatory approval for one or more product candidates, prepare for commercialization efforts. The successful development of our product candidates is highly uncertain. At this time, we cannot reasonably estimate or know the nature, timing and costs of the efforts that will be necessary to complete the remainder of the development of our product candidates, or when, if ever, material net cash inflows may commence from those candidates. This uncertainty is due to the numerous risks and uncertainties associated with the duration and cost of clinical trials, which vary significantly over the life of a project as a result of many factors, including: • delays in regulators or institutional review boards authorizing us or our investigators to commence our clinical trials or in our ability to negotiate agreements with clinical trial sites or contract research organizations; • our ability to secure adequate supply of product candidates for our trials; • the number of clinical sites included in the trials; • the length of time required to enroll suitable patients; • the number of patients that ultimately participate in the trials; • the number of doses patients receive; • any side effects associated with our product candidates; • the duration of patient follow-up; and • the results of our clinical trials. Our expenditures are subject to additional uncertainties, including the terms and timing of regulatory approvals, and the expense of filing, prosecuting, defending and enforcing any patent claims or other intellectual property rights. We may never succeed in achieving regulatory approval for our product candidates. We may obtain unexpected results from our clinical trials. We may elect to discontinue, delay or modify clinical trials of our product candidates. A change in the outcome of any of these variables with respect to the development of a product candidate could mean a significant change in the costs and timing associated with the development of that product candidate. For example, if the FDA or other regulatory authorities were to require us to conduct clinical trials beyond those that we currently anticipate, or if we experience significant delays in enrollment in any of our clinical trials, we could be required to expend significant additional financial resources and time on the completion of clinical development. Product commercialization will take several years and millions of dollars in development costs. General and Administrative Expense General and administrative expense consists principally of salaries and related costs for personnel in executive and administrative functions, including stock-based compensation, travel expenses and recruiting expenses. Other general and administrative expense includes professional fees for legal, accounting and tax-related services and insurance costs. We anticipate that our general and administrative expense will increase as we continue to operate as a public reporting company and continue to develop PB2452, PB1046, PB6440 and our future product candidates. We believe that these increases likely will include increased costs for director and officer liability insurance, costs related to the hiring of additional personnel and increased fees for outside consultants, lawyers and accountants. We also expect to incur increased costs to comply with corporate governance, internal controls, investor relations, disclosure and similar requirements applicable to public reporting companies. Interest Expense Interest expense consists of interest expense on our convertible promissory notes and term loan. Following the conversion of the convertible promissory notes into shares of redeemable convertible Series D preferred stock in August 2018, we no longer recognize interest on the convertible promissory notes. We recognize interest on our term loan with SVB and WestRiver. Change in Fair Value of Warrant and Derivative Liabilities Change in fair value of warrant and derivative liabilities reflects the revaluation at each reporting date of our redeemable convertible preferred stock warrants and the conversion option on our convertible promissory notes, respectively. Following the conversion of our convertible promissory notes to preferred stock in August 2018, the conversion of all outstanding shares of our preferred stock into common stock, and the corresponding conversion of all outstanding preferred stock warrants into common stock warrants, in connection with the closing of our IPO in October 2018, we no longer remeasure the warrant liability or derivative liability for periods following the closing of the IPO. License, Co-Development and Other Agreements MedImmune Limited License Agreement In November 2017, we entered into the MedImmune License with MedImmune. Pursuant to the MedImmune License, MedImmune granted us an exclusive, worldwide license under certain patent rights owned or controlled by MedImmune to develop and commercialize the MedImmune Licensed Products, for the treatment, palliation, diagnosis or prevention of any human disorder or condition. Under the MedImmune License, we paid MedImmune an upfront fee of $0.1 million. We are also required to pay MedImmune: quarterly fees relating to technical services provided by MedImmune; up to $18.0 million in clinical and regulatory milestone fees, $1.0 million of which was incurred in the second quarter of 2019; up to $50.0 million in commercial milestone fees; and mid-single digit to low-teen royalty percentages on net sales of MedImmune Licensed Products, subject to reduction in specified circumstances. In addition, the MedImmune License offers an option for third-party product storage costs. From the inception of the MedImmune License through December 31, 2019, we have incurred costs of $1.6 million under the MedImmune License. Co-Development Agreement with SFJ Pharmaceuticals In January 2020, we entered into the SFJ Agreement, pursuant to which SFJ will provide us funding to support the global development of PB2452 as a reversal agent for the antiplatelet drug ticagrelor in patients with uncontrolled major or life-threatening bleeding or requiring urgent surgery or an invasive procedure. Under the SFJ Agreement, SFJ has agreed to pay us up to $120.0 million to support the clinical development of PB2452. SFJ paid us an initial $10.0 million in March 2020 after we obtained the consent of Silicon Valley Bank, or SVB, to grant SFJ a security interest in all of the assets owned or controlled by us that are necessary for the manufacture, use or sale of PB2452. SFJ will pay us an additional $80.0 million through cost reimbursements followed by six equal quarterly payments beginning with the quarter ending September 30, 2020 through the quarter ending December 31, 2021 and up to an additional $30.0 million upon the achievement of specified milestones with respect to our clinical development of PB2452. During the term of the SFJ Agreement, we will have primary responsibility for clinical development and regulatory activities for PB2452 in the United States and the European Union, while SFJ will have primary responsibility for clinical development and regulatory activities for PB2452 in China and Japan and will provide clinical trials operational support in the European Union. Under the terms of the SFJ Agreement, following the FDA approval of a BLA for PB2452, we will pay SFJ an initial payment of $5.0 million and an additional $325.0 million in the aggregate in seven additional annual payments. If the EMA or the national regulatory authority in certain European countries approve a BLA for PB2452, we will pay SFJ an initial payment of $5.0 million and an additional $205.0 million in the aggregate in seven additional annual payments. If either the PMDA of Japan or the NMPA of China approves a marketing application for PB2452, we will pay SFJ an initial payment of $1.0 million and then an additional $59.0 million in the aggregate in eight additional annual payments. Within 120 days following approval of a BLA for PB2452 in one of the jurisdictions described above, we have the right, at our option, to make a one-time cash payment to SFJ to buy out all or a portion of the future unpaid approval payments for such jurisdiction (i.e., the U.S. Approval Payments, EU Approval Payments or Japan/China Approval Payments, as applicable) for a price reflecting a mid-single-digit discount rate. Within 120 days following a change of control of our company, we or our successor have the right, at its option, to make a one-time cash payment to SFJ to buy out all or a portion of the future unpaid approval payments in any of the jurisdictions in which a BLA for PB2452 was approved prior to the change of control for a price reflecting a mid-single-digit discount rate, provided that SFJ has not previously assigned the right to receive such payments to a third party (in which event we or our successor shall not have such right). If following termination of the SFJ Agreement we continue to develop PB2452 and obtain BLA approval in the United States, the European Union, Japan or China, we will make the applicable approval payments for such jurisdiction to SFJ as if the SFJ Agreement had not been terminated, less any payments made upon termination, except that if we terminate the SFJ Agreement for SFJ’s failure to make any payment to us when due, or SFJ terminates the SFJ Agreement due to a material adverse event, as defined in the SFJ Agreement, then our obligation to make such approval payments would be reduced by 50%. Duke License Agreement In October 2006, we entered into the Duke License with Duke, which we most recently amended in April 2019. Pursuant to the Duke License, Duke granted us an exclusive, worldwide license under certain patent rights owned or controlled by Duke, and a non-exclusive, worldwide license under certain know-how of Duke, to develop and commercialize the Duke licensed products relating to ELPs. Under the Duke License, we paid Duke an upfront fee of $37,000, additional fees in connection with amendments to the Duke License of $0.2 million and other additional licensing fees of $0.2 million. In consideration for license rights granted to us, we initially issued Duke 24,493 shares of our common stock. Until we reached a certain stipulated equity milestone, which we reached in October 2007, we were obligated to issue additional shares of common stock to Duke from time to time so that its aggregate ownership represented 7.5% of our issued and outstanding capital stock. We are also required to pay Duke: up to $2.2 million in regulatory and clinical milestone fees; up to $0.4 million in commercial milestone fees; low single-digit royalty percentages on net sales of Duke licensed products, with minimum aggregate royalty payments of $0.2 million payable following our achievement of certain commercial milestones; and up to the greater of $0.3 million or a low double-digit percentage of the fees we receive from a third party in consideration of forming a strategic alliance with respect to certain patent rights covered under the Duke License. We also must pay Duke the first $1.0 million of non-royalty payments we receive from a sublicensee, and thereafter a low double-digit percentage of any additional nonroyalty payments we receive, subject to certain conditions. From the inception of the Duke License through December 31, 2019, we have incurred royalty costs of $0.3 million under the Duke License. We are also required to apply for, prosecute and maintain all United States and foreign patent rights under the Duke License. Wacker License Agreement In April 2019, we entered into a license agreement, or the Wacker License Agreement, with Wacker Biotech GmbH, or Wacker, pursuant to which Wacker granted us an exclusive license under certain of Wacker’s intellectual property rights to use Wacker’s proprietary E. coli strain for the manufacture of PB2452 worldwide outside of specified Asian countries and to commercialize PB2452, if approved, manufactured by us or on our behalf using Wacker’s proprietary E. coli strain throughout the world. We have the right to grant sublicenses under the license, subject to certain conditions as specified in the Wacker License Agreement. Under the terms of the agreement, we are required to pay a fixed, nominal per-unit royalty, which is subject to adjustment, and an annual license fee in a fixed Euro amount in the low to mid six digits. The agreement will be in force for an indefinite period of time, and upon the expiration of our royalty obligations, the license will be considered fully paid and will convert to a non-exclusive license. Either party may terminate the Wacker License Agreement for breach if such breach is not cured within a specified number of days. We incurred $0.2 million in costs under the Wacker License Agreement for the year ended December 31, 2019. Viamet Asset Purchase Agreement In January 2020, we entered into the PB6440 Agreement with Viamet Pharmaceuticals Holdings, LLC and its wholly-owned subsidiary, Selenity Therapeutics (Bermuda), Ltd., or the Sellers, pursuant to which we acquired all of the assets and intellectual property rights related to the Sellers’ proprietary CYP11B2 inhibitor compound, formerly known as SE-6440 or VT-6440, and certain other CYP11B2 inhibitor compounds that are covered by the patent rights acquired by us under the PB6440 Agreement, or together, Compounds. Under the terms of the PB6440 Agreement, we paid the Sellers an upfront fee of $0.1 million upon the closing of the transaction, and we are required to pay the Sellers up to $5.1 million upon the achievement of certain development and intellectual property milestones with respect to certain product candidates that contain a Compound, up to $142.5 million upon the achievement of certain commercial milestones with respect to any approved product that contains a Compound and low- to mid-single digit royalty percentages on the net sales of approved products that contain a Compound, subject to customary reductions and offsets in specified circumstances. We incurred $0.1 million in costs under the PB6440 Agreement for the year ended December 31, 2019. Results of Operations Comparison of the Years Ended December 31, 2019 and 2018 The following table summarizes our results of operations for the years ended December 31, 2019 and 2018 (in thousands): Revenue Grant revenue was $1.8 million for the year ended December 31, 2019, compared to $0.7 million for the year ended December 31, 2018. The increase was due to higher costs that qualified for grant reimbursement under our SBIR grants for the development of PB1046 during the year ended December 31, 2019. We began incurring costs that qualified for grant reimbursement in August 2018 and continued to incur costs throughout 2019. Revenue under collaborative agreement was $0.6 million for the year ended December 31, 2019, compared to zero for the year ended December 31, 2018. The increase of $0.6 million was related to revenue from our agreement with ImmunoForge, which was entered into in 2019. Research and Development Expense Research and development expense was $30.9 million for the year ended December 31, 2019, compared to $15.5 million for the year ended December 31, 2018. The increase of $15.5 million was primarily attributable to increased clinical and drug production activities related to PB2452, increased personnel costs due to additional headcount, increased costs associated with our general research efforts and increased clinical activity related to PB1046. The following table summarizes our research and development expense by functional area for the years ended December 31, 2019 and 2018 (in thousands): The following table summarizes our research and development expense by product candidate for the years ended December 31, 2019 and 2018 (in thousands): General and Administrative Expense General and administrative expense was $11.2 million for the year ended December 31, 2019, compared to $4.9 million for the year ended December 31, 2018. The increase of $6.3 million was primarily attributable to an increase in professional services related to consulting services and legal services, an increase in personnel expense due to additional headcount and additional expenses associated with being a public company. Interest Income Interest income was $1.6 million for the year ended December 31, 2019, compared to $0.4 million for the year ended December 31, 2018. The increase of $1.2 million was attributable to higher balances of cash and cash equivalents during 2019. Interest Expense Interest expense was $1.1 million for the year ended December 31, 2019, compared to $3.9 million for the year ended December 31, 2018. Interest expense for the year ended December 31, 2019 was attributable to interest on the 2019 Loan. Interest expense for the year ended December 31, 2018 was primarily attributable to interest from borrowings pursuant to our convertible promissory notes, which were outstanding during 2018. These notes were converted into shares of redeemable convertible Series D stock in August 2018. Change in Fair Value of Derivative Liability Change in fair value of derivative liability resulted in no expense for the year ended December 31, 2019, compared to $0.7 million of expense for the year ended December 31, 2018. The conversion option related to our convertible promissory notes was subject to remeasurement at each reporting period, with changes in fair value recorded in the statement of operations. The convertible promissory notes converted into redeemable convertible preferred stock in August 2018 upon the sale of the Series D redeemable convertible preferred stock and, accordingly, we no longer remeasure the fair value of the derivative liability. Liquidity and Capital Resources Since our inception, we have not generated any revenue from product sales and have incurred net losses and negative cash flows from our operations. We have financed our operations since our inception primarily through public offerings of our common stock, private placements of convertible debt and convertible preferred stock and borrowings under our term loans. In future periods, we expect to receive up to $120.0 million from the SFJ Agreement. In October 2017, we entered into a loan and security agreement, or the SVB Loan, with SVB, which provided that we could borrow up to $7.5 million. In August 2018, we received $17.7 million in net proceeds from the sale of our Series D redeemable convertible preferred stock. Concurrent with this financing, all of our outstanding convertible promissory notes, and accrued interest thereon, were converted into 2.1 million shares of Series D redeemable convertible preferred stock. In October 2018, we completed our IPO of our common stock, which resulted in the issuance and sale of 9.9 million shares of common stock at a public offering price of $5.00 per share, generating net proceeds of approximately $43.0 million after deducting underwriting discounts and commissions and other offering costs. Upon closing of the IPO, all outstanding shares of our redeemable convertible preferred stock were converted into an aggregate of 13.2 million shares of common stock. In March 2019, we entered into the 2019 Loan with SVB and WestRiver, pursuant to which we could borrow up to $15.0 million, issuable in three separate tranches. As of December 31, 2019, we had drawn on all three tranches under the 2019 Loan in the amounts of $7.5 million, $2.5 million and $5.0 million. In April 2019, we completed an underwritten public offering of our common stock, which resulted in the issuance and sale of an aggregate of 4,124,475 shares of common stock at a public offering price of $12.00 per share, generating net proceeds of $46.3 million after deducting underwriting discounts and commissions and other offering costs. In December 2019, we filed a shelf registration statement on Form S-3, or the 2019 Shelf Registration Statement, which became effective in January 2020. The 2019 Shelf Registration Statement permits: (i) the offering, issuance and sale by us of up to a maximum aggregate offering price of $200.0 million of common stock, preferred stock, debt securities and warrants in one or more offerings and in any combination; and (ii) the offering, issuance and sale by us of up to a maximum aggregate offering price of $60.0 million of our common stock that may be issued and sold under an “at-the-market” sales agreement, or ATM, with Citigroup Global Markets Inc. and William Blair & Company, L.L.C. No securities have been sold under the 2019 Shelf Registration Statement. In January 2020, we entered into the SFJ Agreement, pursuant to which SFJ agreed to provide funding to support the development of PB2452 as a reversal agent for the antiplatelet drug ticagrelor. Pursuant to the SFJ Agreement, SFJ has agreed to pay us up to $120.0 million, including an initial payment of $10.0 million paid in March 2020, an additional $80.0 million through cost reimbursements followed by six equal quarterly payments beginning with the quarter ending September 30, 2020 through the quarter ending December 31, 2021 and up to an additional $30.0 million upon the achievement of specific clinical development milestones with respect to our ongoing Phase 3 clinical trial of PB2452. As of December 31, 2019, we had cash and cash equivalents of $74.0 million. The following table summarizes our cash flows for each of the periods set forth below (in thousands): Operating Activities Net cash used in operating activities was $39.6 million during the year ended December 31, 2019. The use of cash primarily related to our net loss of $39.2 million, adjusted for non-cash charges primarily related to $1.4 million in stock-based compensation expense, $0.5 million for non-cash interest expense and a $2.4 million change in our operating assets and liabilities. The change in our operating assets and liabilities was principally due to a $2.0 million increase in prepaid expense and other assets and an increase in other receivables of $1.0 million, partially offset by a $0.8 million increase in accounts payable, all as a result of increased clinical activities for our ongoing clinical trials of PB2452 and PB1046. Net cash used in operating activities was $17.1 million during the year ended December 31, 2018. The use of cash primarily related to our net loss of $23.8 million, adjusted for non-cash charges primarily related to $3.7 million for non-cash interest expense, $0.7 million for the change in the fair value of the derivative liability and a $2.0 million change in our operating assets and liabilities. The change in our operating assets and liabilities was principally due to a $3.3 million increase in accounts payable and accrued expenses, partially offset by a $1.0 million increase in prepaid expenses, all as a result of increased clinical activities for our ongoing clinical trials of PB2452 and PB1046. Investing Activities Net cash used in investing activities was $1.0 million for the purchase of property and equipment during the year ended December 31, 2019. Net cash used in investing activities was $0.1 million for the purchase of property and equipment during the year ended December 31, 2018. Financing Activities Net cash provided by financing activities was $53.5 million during the year ended December 31, 2019, due primarily to the receipt of $46.3 million in net proceeds from the April 2019 underwritten public offering and borrowings of $8.1 million on the 2019 Loan, partially offset by $0.9 million for partial repayment of the SVB Loan. Net cash provided by financing activities was $64.8 million during the year ended December 31, 2018, consisting primarily of $43.0 million in net proceeds from our initial public offering, $17.7 million from the issuance of the Series D redeemable convertible preferred stock and $4.0 million in proceeds from the SVB Loan. Funding Requirements To date, we have not generated any revenues from the commercial sale of approved drug products, and we do not expect to generate substantial revenue for at least the next several years. If we fail to complete the development of our product candidates in a timely manner or fail to obtain their regulatory approval, our ability to generate future revenue will be compromised. We do not know when, or if, we will generate any revenue from our product candidates, and we do not expect to generate significant revenue unless and until we obtain regulatory approval of, and commercialize, our product candidates. We expect our expenses to increase in connection with our ongoing activities, particularly as we continue the research and development of, continue or initiate clinical trials of and seek marketing approval for our product candidates. In addition, if we obtain approval for any of our product candidates, we expect to incur significant commercialization expenses related to sales, marketing, manufacturing and distribution. We anticipate that we will need substantial additional funding in connection with our continuing operations. If we are unable to raise capital when needed or on attractive terms, we could be forced to delay, reduce or eliminate our research and development programs or future commercialization efforts. We believe that our existing cash and cash equivalents as of December 31, 2019, in addition to the $10.0 million received in March 2020 and the $80.0 million in anticipated proceeds that we will receive pursuant to the SFJ Agreement, will be sufficient to fund our operating expenses and capital requirements into the second half of 2021. We intend to devote our existing cash and cash equivalents to advance our clinical and preclinical development programs. We have based our estimates on assumptions that may prove to be wrong, and we may use our available capital resources sooner than we currently expect. Because of the numerous risks and uncertainties associated with the development and commercialization of product candidates, we are unable to estimate the amounts of increased capital outlays and operating expenditures necessary to complete the development of product candidates. Our future capital requirements will depend on many factors, including: • the progress and results of our ongoing and planned future clinical trials of PB2452, PB1046, PB6440 and our other preclinical programs; • the timing and amount of payments we receive under the SFJ Agreement; • the scope, progress, results and costs of preclinical development, laboratory testing and clinical trials for any future product candidates we may decide to pursue; • the extent to which we develop, in-license or acquire other product candidates and technologies; • the number and development requirements of other product candidates that we may pursue; • the costs, timing and outcome of regulatory review of our product candidates; • the costs and timing of future commercialization activities, including product manufacturing, marketing, sales and distribution, for any of our product candidates for which we receive marketing approval; • the revenue, if any, received from commercial sales of our product candidates for which we receive marketing approval; • our ability to establish collaborations to commercialize PB1046 in the United States; • our ability to establish collaborations to commercialize PB2452, PB1046 or any of our other product candidates outside of the United States; and • the costs and timing of preparing, filing and prosecuting patent applications, maintaining and enforcing our intellectual property rights and defending any intellectual property-related claims. Identifying potential product candidates and conducting preclinical studies and clinical trials is a time-consuming, expensive and uncertain process that takes many years to complete, and we may never generate the necessary data or results required to obtain marketing approval and achieve product sales. In addition, our product candidates, if approved, may not achieve commercial success. Our commercial revenues, if any, will be derived from sales of product candidates that we do not expect to be commercially available in the near term, if at all. Our future commercial revenue, if any, will be derived from sales of products that we do not expect to be commercially available for several years, if at all. Accordingly, we will need to continue to rely on additional financing to achieve our business objectives. Adequate additional financing may not be available to us on acceptable terms, or at all. To the extent that we raise additional capital through the sale of equity or convertible debt securities, the terms of these equity securities or this debt may restrict our ability to operate. Any future debt financing and equity financing, if available, may involve agreements that include covenants limiting and restricting our ability to take specific actions, such as incurring additional debt, making capital expenditures, entering into profit-sharing or other arrangements or declaring dividends. If we raise additional funds through government or private grants, collaborations, strategic alliances or marketing, distribution or licensing arrangements with third parties, we may be required to relinquish valuable rights to our technologies, future revenue streams, research programs or product candidates or to grant licenses on terms that may not be favorable to us. Further, our ability to raise additional capital may be adversely impacted by potential worsening global economic conditions and the recent disruptions to, and volatility in, the credit and financial markets in the United States and worldwide resulting from the ongoing COVID-19 pandemic. Off-Balance Sheet Arrangements We did not have during the periods presented, and we do not currently have, any off-balance sheet arrangements, as defined in the SEC rules and regulations. Critical Accounting Policies and Significant Judgments and Estimates Our management’s discussion and analysis of our financial condition and results of operations is based on our financial statements, which have been prepared in accordance with United States generally accepted accounting policies, or GAAP. The preparation of these financial statements requires us to make estimates, judgments and assumptions that affect the reported amounts of assets and liabilities, disclosure of contingent assets and liabilities as of the dates of the balance sheets and the reported amounts of expenses during the reporting periods. In accordance with GAAP, we evaluate our estimates and judgments on an ongoing basis. Significant estimates include assumptions we have used in the determination of accrued research and development costs. 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 the carrying value of assets and liabilities that are not readily apparent from other sources. Actual results may differ from these estimates under different assumptions or conditions. We believe the following accounting policies are the most critical to the judgments and estimates used in the preparation of our financial statements. See Note 2 to the financial statements appearing elsewhere in this Annual Report for a discussion of our significant accounting policies. Accrued Research and Development Expense The majority of our operating expenses to date have been incurred in research and development activities. As part of the process of preparing our financial statements, we are required to estimate expenses resulting from obligations under contracts with vendors, consultants and research organizations, in connection with conducting clinical and preclinical activities. The financial terms of these contracts are subject to negotiations which vary from contract to contract and may result in payment flows that do not match the periods over which materials or services are provided under such contracts. We reflect preclinical study and clinical trial expenses in our financial statements by matching those expenses with the period in which services and efforts are expended. We account for these expenses according to the progress of the preclinical study or clinical trial as measured by the timing of various aspects of the preclinical study or clinical trial, or related activities. Our accrual estimates are determined through review of the underlying contracts along with preparation of financial models taking into account discussions with research and other key personnel as to the progress of preclinical studies or clinical trials, or other services being conducted. During the course of a preclinical study or clinical trial, we will adjust the rate of expense recognition if actual results differ from our original estimates. Recent Accounting Pronouncements See Note 2 to the financial statements appearing elsewhere in this Annual Report for information concerning recent accounting pronouncements. JOBS Act Transition Period In April 2012, the JOBS Act was enacted. Section 107 of the JOBS Act provides that an “emerging growth company” can take advantage of the extended transition period provided in Section 7(a)(2)(B) of the Securities Act for complying with new or revised accounting standards. Thus, an emerging growth company can delay the adoption of certain accounting standards until those standards would otherwise apply to private companies. We have irrevocably elected not to avail ourselves of this extended transition period and, as a result, we will adopt new or revised accounting standards on the relevant dates on which adoption of such standards is required for other public companies. We are in the process of evaluating the benefits of relying on other exemptions and reduced reporting requirements under the JOBS Act. Subject to certain conditions, as an emerging growth company, we may rely on certain of these exemptions, including without limitation, (i) not providing an auditor’s attestation report on our system of internal controls over financial reporting pursuant to Section 404(b) of the Sarbanes-Oxley Act and (ii) not complying with any requirement that may be adopted by the Public Company Accounting Oversight Board. We will remain an emerging growth company until the earliest to occur of (1) the last day of the fiscal year (a) ending December 31, 2023, which is the end of the fiscal year following the fifth anniversary of the completion our initial public offering, (b) in which we have total annual gross revenues of at least $1.07 billion or (c) in which we are deemed to be a “large accelerated filer” under the rules of the SEC, which means the market value of our common stock that is held by non-affiliates exceeds $700 million as of the prior June 30th, and (2) the date on which we have issued more than $1.0 billion in non-convertible debt during the prior three-year period. We are a “smaller reporting company” (and may continue to qualify as such even after we no longer qualify as an emerging growth company) and accordingly may provide less public disclosure than larger public companies, including the inclusion of only two years of audited financial statements and only two years of related selected financial data and management’s discussion and analysis of financial condition and results of operations disclosure. As a result, the information that we provide to our stockholders may be different than what they might receive from other public reporting companies in which they hold equity interests. Effect of Inflation Inflation did not have a significant impact on our net sales, revenues or income from continuing operations in 2019 or 2018.

<s>[INST] Overview We are a clinicalstage biopharmaceutical company focused on the development and commercialization of novel therapies for cardiopulmonary diseases, with an initial focus on cardiopulmonary indications. Our lead product candidate, PB2452, is a novel reversal agent for the antiplatelet drug ticagrelor, which we are developing for the reversal of the antiplatelet effects of ticagrelor in patients with uncontrolled major or lifethreatening bleeding or requiring urgent surgery or an invasive procedure. Based on feedback from the FDA we intend to seek approval of PB2452 in the United States through an accelerated approval process. In our completed Phase 2a clinical trial of PB2452, we observed immediate and complete reversal of ticagrelor’s antiplatelet activity within five minutes following initiation of infusion and sustained reversal for over 20 hours. We are developing PB2452 with SFJ pursuant to the SFJ Agreement. Under the SFJ Agreement, SFJ has agreed to pay us up to $120.0 million to support the clinical development of PB2452. During the term of the SFJ Agreement, we will have primary responsibility for clinical development and regulatory activities for PB2452 in the United States and the European Union, while SFJ will have primary responsibility for clinical development and regulatory activities for PB2452 in China and Japan and will provide clinical trials operations support in the European Union. The FDA granted Breakthrough Therapy designation for PB2452 in April 2019. The EMA granted PB2452 PRIME designation in February 2020. Based on feedback from the FDA, we intend to submit a BLA for potential accelerated approval based on an interim analysis of the first approximately 100 patients treated in our Phase 3 trial, with approximately 50 patients with uncontrolled major or lifethreatening bleeding and approximately 50 patients requiring urgent surgery or an invasive procedure. We recently commenced our pivotal Phase 3 clinical trial. Based on an 18month estimated enrollment timeline for the first 100 patients in the Phase 3 trial, we are targeting to submit our BLA for PB2452 in the second half of 2022. To support full approval for patients with uncontrolled major or lifethreatening bleeding or requiring urgent surgery or an invasive procedure, the FDA recommended enrollment of 200 total patients in the Phase 3 trial. After we submit our BLA with data from the first 100 patients, we intend to complete the Phase 3 trial and establish a postapproval registry in accordance with FDA requirements. The CHMP of the EMA has also generally agreed with our proposed development plan for PB2452. Our second product candidate, PB1046, is a onceweekly fusion protein currently in a Phase 2b clinical trial for the treatment of PAH. PB1046 utilizes our ELP technology, which also serves as an engine for our preclinical pipeline. We have temporarily paused enrollment of new patients in this trial as a precaution to minimize potential exposure of this patient population at high risk of serious illness from COVID19. However, we have also informed investigators that they may continue dosing PB1046 and performing assessments for current trial participants if they deem it appropriate and such activities are permitted by their respective institutions. Additionally, we continue to identify new trial sites for future initiation. Although we have been targeting to report results from this trial in the fourth quarter of 2020, we believe that the COVID19 outbreak will temporarily prevent us from being able to initiate new trial sites and enroll new patients, likely delaying our ability to report the results of this trial into 2021. We are also developing our preclinical product candidate, PB6440, for treatmentresistant hypertension. We retain worldwide commercial rights to all of our product candidates. We have a limited operating history. Since our inception in 2002, our operations have focused on developing our clinical and preclinical product candidates and our proprietary ELP technology, organizing and staffing our company [/INST] Negative. </s>

Livent Corp.

2019-02-28

2018-12-31

ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS You should read the following discussion and analysis in conjunction with our financial statements and the related notes included elsewhere in this Form 10-K. This discussion and analysis contains forward-looking statements that involve risks, uncertainties, and assumptions. Our actual results may differ materially from those anticipated in these forward-looking statements as a result of certain factors, including, but not limited to, those set forth under “Risk Factors” and elsewhere in this Form 10-K. Overview We are a pure-play, fully integrated lithium company, with a long, proven history of producing performance lithium compounds. Our primary products, namely battery-grade lithium hydroxide, butyllithium and high purity lithium metal are critical inputs used in various performance applications. Our strategy is to focus on supplying high performance lithium compounds to the fast growing Electric Vehicle (“EV”) battery market, while continuing to maintain our position as a leading global producer of butyllithium and high purity lithium metal. With extensive global capabilities, over 60 years of continuous production experience, applications and technical expertise and deep customer relationships, we believe we are well positioned to capitalize on the accelerating trend of vehicle electrification. We produce lithium compounds for use in applications that have specific performance requirements, including battery-grade lithium hydroxide for use in high performance lithium-ion batteries. We believe the demand for our compounds will continue to grow as the electrification of transportation accelerates, and as the use of high nickel content cathode materials increases in the next generation of battery technology products. We also supply butyllithium, which is used as a synthesizer in the production of polymers and pharmaceutical products, as well as a range of specialty lithium compounds including high purity lithium metal, which is used in the production of lightweight materials for aerospace applications and non-rechargeable batteries. It is in these applications that we have established a differentiated position in the market through our ability to consistently produce and deliver performance lithium compounds. 2018 Highlights The following are the more significant developments in our business during the year ended December 31, 2018: • The Separation - On March 31, 2017, FMC publicly announced a plan to separate Livent into a publicly traded company (the “Separation”). Prior to the completion of the initial public offering ("IPO") on October 15, 2018, we were a wholly owned subsidiary of FMC. On October 1, 2018, following a series of restructuring steps, prior to the IPO of Livent common stock, FMC transferred to us substantially all of the assets and liabilities of its lithium business (the “Lithium Business”). In exchange, we issued to FMC all 123 million shares of our common stock. On October 15, 2018 (the "Separation Date"), we completed the IPO and sold 20 million shares of Livent common stock to the public at a price of $17.00 per share. On November 8, 2018, the underwriters exercised, in full, their option (the "Over-allotment Option Exercise") to purchase an additional 3 million shares of our common stock, the closing of which was completed on November 13, 2018. Our common stock is listed on the New York Stock Exchange (the “NYSE”) under the symbol “LTHM.” • Net proceeds from the sale of 23 million shares of our common stock issued in connection with the IPO and Over-allotment Option Exercise were approximately $369 million, after deducting underwriting discounts and commissions. The net proceeds from the IPO, after payment of financing fees and other IPO related costs, were subsequently distributed to FMC. Immediately following the IPO and the Over-allotment Option Exercise, FMC owned approximately 84% of our outstanding common stock. Accordingly, we are considered a “controlled company” under the NYSE rules. Further details can be found in the final Prospectus ("Prospectus") included in our Registration Statement on Form S-1 originally filed with the Securities and Exchange Commission on October 12, 2018, as amended. • Revenue of $442.5 million in 2018 increased $95.1 million or approximately 27% versus last year. A detailed review of revenues is included under the section entitled “Results of Operations”. • Our gross margin of $205.7 million in 2018 increased $56.9 million or approximately 38% versus last year. Gross margin as a percent of revenue is approximately 46% in 2018 versus approximately 43% in 2017. The increase in gross margin was primarily driven by improved pricing and mix. • Selling, general and administrative expenses increased approximately 57% from $13.4 million in 2017 to $21.1 million 2018. The increase is primarily driven by incremental standalone company costs. • Research and development expenses of $3.8 million for 2018 increased $0.7 million or approximately 23% from $3.1 million in 2017. The increase was primarily due to increased spending in energy applications. • Net income of $126.1 million in 2018 increased $83.9 million, or approximately 199%, from $42.2 million in 2017, primarily due to revenue and gross margin growth in 2018 due to increased volumes and pricing for lithium hydroxide and carbonate. Other 2018 Highlights • We are seeing the benefits of our strategy to grow our business in the technology-driven specialty end markets, where demand continues to accelerate. In February 2018, we announced an intention to expand annual lithium hydroxide production capacity to approximately 55 kMT by the end of 2025. • We expanded production of lithium carbonate at our Argentina site through debottlenecking projects, and we continue with our previously announced plans to more than double lithium carbonate production at that same site to at least 60 kMT by the end of 2025. 2019 Outlook • The Distribution - FMC has informed us that it plans to make a tax-free distribution to its stockholders of all of its remaining equity interest in us on March 1, 2019. The Distribution is expected to be effected as a dividend to all FMC stockholders. • We believe that the demand for our products will continue to grow during 2019, primarily driven by increased production volumes of electric vehicles. The Company expects to deliver revenue growth from higher volumes and higher prices of performance lithium compounds during the 2019 period. However, we expect that the strong revenue growth will be partially offset by higher costs driven by raw materials, value-added tax on exports out of China and the impact of purchased lithium carbonate, partially offset by favorable foreign exchange. Results of Operations - Years Ended December 31, 2018, 2017 and 2016 In addition to net income, as determined in accordance with U.S. GAAP, we evaluate operating performance using certain non-GAAP measures such as EBITDA, which we define as net income plus interest expense, net, income tax expense (benefit), and depreciation and amortization, and Livent Adjusted EBITDA, on a standalone company basis, which we define as EBITDA adjusted for restructuring and other charges (income), non-operating pension expense (benefit) and settlement charges, and separation-related costs. Management believes the use of these non-GAAP measures allows management and investors to compare more easily the financial performance of its underlying business from period to period. The non-GAAP information provided may not be comparable to similar measures disclosed by other companies because of differing methods used by other companies in calculating EBITDA and Livent Adjusted EBITDA. This measure should not be considered as a substitute for net income or other measures of performance or liquidity reported in accordance with U.S. GAAP. The following table reconciles EBITDA and Livent Adjusted EBITDA from net income. ____________________ (a) We continually perform strategic reviews and assess the return on our business. This sometimes results in a plan to restructure the operations of our business. As part of these restructuring plans, demolition costs and write-downs of long-lived assets may occur. (b) Our non-operating pension expense (benefit) and settlement charges are defined as those costs (benefits) related to interest, expected return on plan assets, amortized actuarial gains and losses and the impacts of any plan curtailments or settlements. These are excluded from our results and are primarily related to changes in pension plan assets and liabilities which are tied to financial market performance and we consider these costs to be outside our operational performance. We continue to include the service cost and amortization of prior service cost in our Livent Adjusted EBITDA results noted above. These elements reflect the current year operating costs to our businesses for the employment benefits provided to active employees. (c) Represents legal, professional, transaction related fees and other separation related activity associated with the IPO and separation. Year Ended December 31, 2018 compared with Year Ended December 31, 2017 Revenue Revenue of $442.5 million for 2018 increased by $95.1 million, or approximately 27%, versus 2017, primarily driven by higher volumes particularly in lithium hydroxide. Higher volumes impacted revenue by approximately 21% while higher pricing contributed approximately 8% to the revenue increase. Foreign currency had an unfavorable impact on the change in revenue of approximately 2%. Gross Margin Gross margin of $205.7 million for 2018 increased by $56.9 million, or approximately 38%, versus 2017. The increase in gross margin was primarily driven by the higher volumes discussed above. Selling, general and administrative expenses Selling, general and administrative expenses of $21.1 million for 2018 increased by $7.7 million, or approximately 57% compared to 2017. The increase in selling, general and administrative was primarily due to costs incurred under the TSA subsequent to the Separation Date and incremental standalone company costs. Corporate allocations Corporate allocations of $15.7 million for 2018 decreased by $6.4 million or approximately 29% compared to 2017 primarily due to a partial year of allocated shared service costs allocated to Livent from FMC prior to the Separation Date in 2018. Expenses were not allocated to Livent from FMC subsequent to the Separation Date and costs incurred under the TSA subsequent to the Separation Date are direct charges to our consolidated and combined statements of operations. Research and development expenses Research and development expense of $3.8 million for 2018 increased by $0.7 million or approximately 23% compared to 2017 primarily due to increased spending in energy applications. Restructuring and other charges Restructuring and other charges of $2.6 million and $8.7 million for the years ended December 31, 2018 and 2017, respectively, were primarily comprised of asset write-downs and miscellaneous restructuring efforts related to our operations at the manufacturing site located in Bessemer City, North Carolina. Other charges of $0.2 million and $0.4 million for the years ended December 31, 2018 and 2017, respectively, related to environmental remediation activities for discontinued products in both periods. Separation-related costs Separation-related costs of $9.3 million for 2018 primarily consists of legal, professional, transaction related fees and other separation related activity associated with the IPO and Separation. No separation costs were incurred prior to 2018. Non-operating pension benefit and settlement charges Non-operating pension benefit was $0.2 million for 2018 compared to a charge of $31.4 million in the prior year. In 2017, we recorded a settlement charge of $32.5 million related to the termination of the U.K. pension plan. FMC completed the buy-out of the annuity, completing the plan termination and relieving us of the pension liability for the U.K. Plan. Provision for income taxes Provision for income taxes of $27.0 million for 2018 decreased $0.9 million or approximately 3% versus 2017 primarily due to the impact of 2017 U.S. tax reform, mainly the transition tax, materially offset by tax associated with increased earnings in 2018. Net income Net income of $126.1 million for 2018 increased $83.9 million or approximately 199% from $42.2 million in 2017 primarily due to revenue and gross margin growth and favorable tax provision for 2018 as well as the one-time charge for the termination of the U.K. pension plan in 2017 as discussed above. Year Ended December 31, 2017 compared with Year Ended December 31, 2016 Revenue Revenue of $347.4 million for 2017 increased by $83.3 million or approximately 32% compared to 2016 driven by improved pricing and mix, which accounted for a 23% increase as the business continued to shift resources into lithium hydroxide and other specialty products. Additionally, higher volumes impacted revenue by 9%. Foreign currency had a minimal impact on the change in revenue. Gross Margin Gross margin of $148.8 million for 2017 increased by $60.5 million, or approximately 69%, compared to 2016. The increase in gross margin was primarily driven by the higher volumes and improved pricing and mix of approximately $59 million, with benefits also coming from operating leverage. These increases were partially offset by higher raw material prices and energy prices which lowered margins by approximately $6 million. Foreign currency had a minimal impact on the change in gross margin. Selling, general and administrative expenses Selling, general and administrative expenses of $13.4 million for 2017 increased slightly compared to 2016. Corporate allocations Corporate allocations of $22.1 million for 2017 increased by $8.9 million or approximately 67% compared to 2016 primarily due to higher shared service costs allocated to Livent from FMC. Research and development expenses Research and development expense were $3.1 million for each of the years ended December 31, 2017 and 2016 and are primarily related to our product development costs. Restructuring and other charges Restructuring and other charges in 2017 were primarily associated with asset write-downs and miscellaneous restructuring efforts of $7.8 million related to our operations at our manufacturing site located in Bessemer City, North Carolina. The objective of these restructuring efforts was to optimize both the assets and cost structure by reducing certain production lines at the site. Additionally, there were other charges of $0.4 million related to environmental remediation activities. Non-operating pension benefit and settlement charges Non-operating pension expense and settlement charges increased in 2017 primarily due to the settlement charge of $32.5 million related to the termination of the U.K. Plan. FMC completed the buy-out of the annuity, completing the plan termination and relieving us of the pension liability for the U.K. Plan. Provision for income taxes Provision for income taxes for 2017 of $27.9 million increased $20.5 million compared to 2016 primarily due to the 2017 enactment of the Tax Cuts and Jobs Act (the "Tax Act"). The net impact of the Tax Act added approximately $11 million to income tax expense. As a result of the transition tax being paid by FMC, the associated liability is not included in consolidated and combined balance sheets, but the impact to the provision for income taxes was included in the consolidated and combined statement of operations. Net income Net income of $42.2 million decreased $4.9 million or approximately 10% from $47.1 million in 2016 primarily due to provisional income tax charges related to the 2017 enactment of the Tax Act as well as the increase in non-operating pension expense and settlement charges. These were partially offset by improved business performance. Liquidity and Capital Resources Historically, prior to the Separation, FMC provided centralized cash management and other finance services to Livent. FMC ceased providing these services following the Separation. Only cash accounts specifically owned by Livent and Livent subsidiaries are reflected on the balance sheets of our consolidated and combined financial statements. Since October 2018, our capital structure and sources of liquidity have changed significantly compared to our historical capital structure as part of FMC. We no longer participate in FMC’s capital management system and are evaluated separately in terms of credit and capital allocation by providers of financing. Our prospective success in funding our cash needs will depend on the strength of the lithium market and our continued ability to generate cash from operations and raise capital from other sources. Our primary sources of cash are currently generated from operations and borrowings under the new revolving credit facility. Cash and cash equivalents at December 31, 2018 and 2017, were $28.3 million and $1.2 million, respectively. Of the cash and cash equivalents balance at December 31, 2018, $26.7 million was held by our foreign subsidiaries. The cash held by foreign subsidiaries for permanent reinvestment is generally used to finance the subsidiaries’ operating activities and future foreign investments. We have not provided additional income taxes for any additional outside basis differences inherent in our investments in subsidiaries because the investments are essentially permanent in duration or we have concluded that no additional tax liability will arise upon disposal. We have concluded the Tax Act has not altered our assertion of indefinitely reinvested earnings. See Note 9 to the consolidated financial statements included within this Form 10-K for more information. At December 31, 2018, we had $34 million debt outstanding. On September 28, 2018, we and one of our subsidiaries entered into a credit agreement which provides for a $400 million senior secured revolving credit facility, $50 million of which is available for the issuance of letters of credit, with an option, subject to certain conditions and limitations, to increase the aggregate amount of the revolving credit commitments to $600 million. Refer to the details below for more information. As part of the IPO, we received net proceeds of approximately $369 million from the sale of an aggregate 23 million shares of our common stock, net of underwriting discounts and commissions, including the exercise by the underwriters of a 30-day option to purchase an additional 3 million shares of common stock from us. Pursuant to the terms of the separation and distribution agreement, the net proceeds from the offering, after payment of financing fees and other IPO related costs, were subsequently distributed to FMC. Revolving Credit Facility On September 28, 2018, we entered into a credit agreement among us, our subsidiary, FMC Lithium USA Corp., as borrowers (the “Borrowers”), certain of our wholly owned subsidiaries as guarantors, the lenders party thereto (the “Lenders”), Citibank, N.A., as administrative agent, and certain other financial institutions party thereto, as joint lead arrangers (the “Credit Agreement”). The Credit Agreement provides for a $400 million senior secured revolving credit facility, $50 million of which is available for the issuance of letters of credit for the account of the Borrowers, with an option, subject to certain conditions and limitations, to increase the aggregate amount of the revolving credit commitments to $600 million (the “Revolving Credit Facility”). The issuance of letters of credit and the proceeds of revolving credit loans made pursuant to the Revolving Credit Facility are available, and will be used, for general corporate purposes, including capital expenditures and permitted acquisitions, of the Borrowers and their subsidiaries. Amounts under the Revolving Credit Facility may be borrowed, repaid and re-borrowed from time to time until the final maturity date of the Revolving Credit Facility, which will be the fifth anniversary of the Revolving Credit Facility’s effective date. Voluntary prepayments and commitment reductions under the Revolving Credit Facility are permitted at any time without any prepayment premium upon proper notice and subject to minimum dollar amounts. Revolving loans under the Credit Agreement will bear interest at a floating rate, which will be either a base rate or a Eurocurrency borrowing plus applicable margin. Base rate borrowings are defined as the greatest of the rate of interest announced publicly by Citibank, N.A. in New York City from time to time as its “base rate”; the federal funds effective rate plus 0.5%; or a Eurodollar rate for a one-month interest period plus 1%. The Eurocurrency borrowing will be defined as a Eurodollar rate for one, two, three or six months. The applicable margins for the two types of loans are set by reference to Livent’s leverage ratio, calculated by dividing our debt by our cash flows. Both the debt and cash flows used in this calculation are terms defined in the Credit Agreement. Each Borrower on a joint and several basis is required to pay a commitment fee quarterly in arrears on the average daily unused amount of each Lender’s revolving credit commitment at a rate equal to an applicable percentage based on the leverage ratio, as determined in accordance with the provisions of the Credit Agreement. The applicable margin and the commitment fee are subject to adjustment as provided in the Credit Agreement. The Credit Agreement contains certain affirmative and negative covenants that are binding on the Borrowers and their subsidiaries, including, among others, restrictions (subject to exceptions and qualifications) on the ability of the Borrowers and their subsidiaries to create liens, to undertake fundamental changes, to incur debt, to sell or dispose of assets, to make investments, to make restricted payments such as dividends, distributions or equity repurchases, to change the nature of their businesses, to enter into transactions with affiliates and to enter into certain burdensome agreements. As of December 31, 2018, we were in compliance with all requirements of the covenants. Statement of Cash Flows Cash provided by operating activities was $92.0 million, $58.3 million and $51.0 million for the years ended December 31, 2018, 2017 and 2016, respectively. The table below presents the components of net cash provided by operating activities. ____________________ (1) Represents the sum of restructuring and other charges, separation-related costs and depreciation and amortization. (2) Referred to as Livent Adjusted EBITDA. (3) The change in cash flows related to trade receivables for the years ended December 31, 2018, 2017 and 2016 were primarily driven by timing of collections and the acceptance of Bank Acceptance Drafts for certain Chinese customers in 2018. See Note 17 for further details. (4) The change in cash flows related to inventories is a result of increased inventory levels due to increases in operating activities. (5) The change in cash flows related to accounts payable is primarily driven by timing of payments made to suppliers and vendors. The 2018 period is also impacted by a significant decrease in payables that built in 2017 associated with a lithium hydroxide manufacturing agreement. (6) Changes in all periods presented primarily represent timing of payments associated with all other operating assets and liabilities. Please see the consolidated and combined statements of cash flows included within these consolidated and combined financial statements for disaggregation of the components that make up this line item. (7) Tax payments in 2018 increased due to higher global earnings in the period compared to the prior year period. (8) 2018 activity represents payments for legal, professional, transaction related fees and other separation related activity associated with the IPO and separation. Cash required by investing activities of operations was $(78.4) million, $(62.5) million and $(31.3) million for the years ended December 31, 2018, 2017 and 2016, respectively. The change in cash required by investing activities is primarily due to our investments in production capacity of lithium carbonate and hydroxide resulting in increased capital expenditures. Cash provided (required) by financing activities was $13 million, $1.5 million and $(18.6) million for the years ended December 31, 2018, 2017 and 2016, respectively. Cash provided by financing activities in 2018 was due to proceeds from draws on our revolving credit line offset by expenditures of $24 million related to certain tax jurisdiction payments made to FMC Parent as reimbursement for taxes paid on Livent's behalf. The change in cash provided by financing activities in 2017 primarily related to the paydown of short-term debt in 2016. As FMC managed our cash and financing arrangements, all excess cash generated through earnings were deemed remitted to FMC and all sources of cash were deemed funded by FMC. Other potential liquidity needs Our cash needs for 2019 include operating cash requirements, capital expenditures and costs associated with being a standalone, public company. We plan to meet our liquidity needs through available cash, cash generated from operations, and borrowings under our committed Revolving Credit Facility. At December 31, 2018 our remaining borrowing capacity under our Revolving Credit Facility was $355.7 million, including letters of credit utilization. Projected 2019 capital expenditures and expenditures related to contract manufacturers are expected to be approximately $250 million. We anticipate investing between $525 million and $600 million (inclusive of the $250 million referred to above) to increase our lithium carbonate capacity to at least 60 kMT by the end of 2025. We also expect to invest between $80 million and $170 million to expand our lithium hydroxide capacity to approximately 55 kMT by the end of 2025. In the next five years, inclusive of the expenditures referenced in this paragraph, we expect to spend $1 billion on maintenance and expansion projects. We believe that our available cash and cash from operations, together with borrowing availability under the credit agreement, will provide adequate liquidity for the next twelve months. Access to capital and the availability of financing on acceptable terms in the future will be affected by many factors, including our credit rating, economic conditions, and the overall liquidity of capital markets. Contractual Obligations and Commercial Commitments As of December 31, 2018, our total significant committed contracts that we believe will affect cash over the next five years and thereafter are as follows: _________________ (1) Represents certain of our raw material commercial contract purchase obligations that are enforceable and legally binding requirements contracts with specified quantities, pricing and timing of transactions. See Note 16 to our consolidated and combined financial statements included in this Form 10-K for more information. Climate Change The potential physical impacts of climate change on our operations are highly uncertain, and would be particular to the geographic circumstances in areas in which we operate. These may include changes in rainfall and storm patterns and intensities, water shortages, changing sea levels and changing temperatures. These changes may have a material adverse effect on our operations, including brine production and transportation of raw materials. A number of governmental bodies have introduced or are contemplating legislative and regulatory change in response to the potential impacts of climate change. Such legislation or regulation, if enacted, potentially could include provisions for a “cap and trade” system of allowances and credits or a carbon tax, among other provisions. There is also a potential for climate change legislation and regulation to adversely impact the cost of purchased energy and electricity. The growing concerns about climate change and related increasingly stringent regulations may provide us with new or expanded business opportunities. We provide solutions to companies pursuing alternative fuel products and technologies (such as renewable fuels, gas-to-liquids and others), emission control technologies (including mercury emissions), alternative transportation vehicles and energy storage technologies and other similar solutions. As demand for, and legislation mandating or incentivizing the use of, alternative fuel technologies that limit or eliminate greenhouse gas emissions increase, we continue to monitor the market and offer solutions where we have appropriate technology. Recently Issued and Adopted Accounting Pronouncements and Regulatory Items See Note 3 "Recently Issued and Adopted Accounting Pronouncements and Regulatory Items" to our consolidated and combined financial statements included in this Form 10-K. Off-Balance Sheet Arrangements We do not have any off-balance sheet arrangements that have or are reasonably likely to have a current or future effect on our financial condition, changes in financial condition, revenues or expenses, results of operations, liquidity, capital expenditures or capital resources that is material to investors. Critical Accounting Policies Our consolidated and combined financial statements are prepared in conformity with U.S. GAAP. The preparation of these financial statements requires us to make estimates and judgments that affect the reported amounts of assets, liabilities, revenues and expenses. We have described our accounting policies in Note 2 "Principal Accounting Policies and Related Financial Information" to our consolidated and combined financial statements included in this Form 10-K. We have reviewed these accounting policies, identifying those that we believe to be critical to the preparation and understanding of our consolidated financial statements. We have reviewed these critical accounting policies with the Audit Committee of the Board of Directors. Critical accounting policies are central to our presentation of results of operations and financial condition in accordance with U.S. GAAP and require management to make estimates and judgments on certain matters. We base our estimates and judgments on historical experience, current conditions and other reasonable factors. Revenue recognition and trade receivables Sale of Goods Revenue from product sales is recognized when (or as) we satisfy a performance obligation by transferring the promised goods to a customer, that is, when control of the good transfers to the customer. The customer is then invoiced at the agreed-upon price with payment terms generally ranging from 30 to 180 days. In determining when the control of goods is transferred, we typically assess, among other things, the transfer of risk and title and the shipping terms of the contract. The transfer of title and risk typically occurs either upon shipment to the customer or upon receipt by the customer. As such, we typically recognize revenue when goods are shipped based on the relevant incoterm for the product order, or in some regions, when delivery to the customer’s requested destination has occurred. When we perform shipping and handling activities after the transfer of control to the customer (e.g., when control transfers prior to delivery), they are considered fulfillment activities, and accordingly, the costs are accrued for when the related revenue is recognized. For FOB shipping point terms, revenue is recognized at the time of shipment since the customer gains control at this point in time. We record amounts billed for shipping and handling fees as revenue. Costs incurred for shipping and handling are recorded as costs of sales. Amounts billed for sales and use taxes, value-added taxes, and certain excise and other specific transactional taxes imposed on revenue-producing transactions are presented on a net basis and excluded from revenue in the consolidated and combined statements of operations. We record a liability until remitted to the respective taxing authority. Variable Consideration As a part of our customary business practice, we may offer sales incentives to our customers, such as volume discounts or rebates. Variable consideration given can differ by product. For all such contracts that include any variable consideration, we estimate the amount of variable consideration that should be included in the transaction price utilizing either the expected value method or the most likely amount method depending on the nature of the variable consideration. Variable consideration is included in the transaction price if, in our judgment, it is probable that a significant future reversal of cumulative revenue under the contract will not occur. Although determining the transaction price requires significant judgment, we have significant historical experience with incentives provided to customers and estimating the expected consideration considering historical patterns of incentive payouts. These estimates are re-assessed each reporting period as required. In addition to the variable consideration described above, in certain instances, we may require our customers to meet certain volume thresholds within their contract term. We estimate what amount of variable consideration should be included in the transaction price at contract inception and continually reassesses this estimation each reporting period to determine situations when the minimum volume thresholds will not be met. Variable consideration is included in the transaction price if, in our judgment, it is probable that a significant future reversal of cumulative revenue under the contract will not occur. In those circumstances, we apply the guidance on breakage and estimate the amount of the shortfall and recognize it over the remaining performance obligations in the contract. Right of Return We warrant to our customers that our products conform to mutually agreed product specifications. This offering is accounted for as a right of return and the transaction price is adjusted for an estimate of expected returns. Per our historical experience, returns due to nonconformity are very uncommon; as such our adjustment to transaction price for our estimate of expected return is not material. Contract Asset and Contract Liability Balances We satisfy our obligations by transferring goods and services in exchange for consideration from customers. The timing of performance sometimes differs from the timing the associated consideration is received from the customer, thus resulting in the recognition of a contract liability. We recognize a contract liability if the customer’s payment of consideration is received prior to completion of our related performance obligation. We periodically enter into prepayment arrangements with customers and receive advance payments for product to be delivered in future periods. These advance payments are recorded as deferred revenue and classified as “Advance payments from customers” on the consolidated and combined balance sheet. Revenue associated with advance payments is recognized as shipments are made and title, ownership and control pass to the customer. Trade Receivables Trade receivables consist of amounts owed from customer sales and are recorded when revenue is recognized. The allowance for trade receivables represents our best estimate of the probable losses associated with potential customer defaults. In developing our allowance for trade receivables, we use a two stage process which includes calculating a general formula to develop an allowance to appropriately address the uncertainty surrounding collection risk of our entire portfolio and specific allowances for customers where the risk of collection has been reasonably identified either due to liquidity constraints or disputes over contractual terms and conditions. Our method of calculating the general formula consists of estimating the recoverability of trade receivables based on historical experience, current collection trends, and external business factors such as economic factors, including regional bankruptcy rates, and political factors. Our analysis of trade receivable collection risk is performed quarterly, and the allowance is adjusted accordingly. On January 1, 2018, Accounting Standards Update 2014-09, Revenue from Contracts with Customers, became effective. See Note 3 to our consolidated and combined financial statements in this Form 10-K for more information. Impairments and valuation of long-lived assets Our long-lived assets primarily include property, plant and equipment and intangible assets. The Company has no goodwill or indefinite-lived intangible assets as of December 31, 2018. We test for impairment whenever events or circumstances indicate that the net book value of our property, plant and equipment may not be recoverable from the estimated undiscounted expected future cash flows expected to result from their use and eventual disposition. In cases where the estimated undiscounted expected future cash flows are less than net book value, an impairment loss is recognized equal to the amount by which the net book value exceeds the estimated fair value of assets, which is based on discounted cash flows at the lowest level determinable. The estimated cash flows reflect our assumptions about selling prices, volumes, costs and market conditions over a reasonable period of time. Income taxes We have recorded a valuation allowance to reduce deferred tax assets in certain jurisdictions to the amount that we believe is more likely than not to be realized. In assessing the need for this allowance, we have considered a number of factors including future taxable income, the jurisdictions in which such income is earned and our ongoing tax planning strategies. In the event that we determine that we would not be able to realize all or part of our net deferred tax assets in the future, an adjustment to the deferred tax assets would be charged to income in the period such determination was made. Similarly, should we conclude that we would be able to realize certain deferred tax assets in the future in excess of the net recorded amount, an adjustment to the deferred tax assets would increase income in the period such determination was made. Additionally, we file income tax returns in the United States and various state and foreign jurisdictions, as part of a FMC legal entity. Certain income tax returns for FMC entities taxable in the U.S. and significant foreign jurisdictions are open for examination and adjustment. We assess our income tax positions and record a liability for all years open to examination based upon our evaluation of the facts, circumstances and information available at the reporting date. For those tax positions where it is more likely than not that a tax benefit will be sustained, we have recorded the largest amount of tax benefit with a greater than 50% likelihood of being realized upon ultimate settlement with a taxing authority that has full knowledge of all relevant information. We adjust these liabilities, if necessary, upon the completion of tax audits or changes in tax law. On December 22, 2017, the Tax Act was enacted in the United States. The Tax Act reduced the U.S. federal corporate tax rate from 35% to 21%, required companies to pay a one-time transition tax on earnings of certain foreign subsidiaries that were previously tax deferred and created new taxes on certain foreign sourced earnings. As of December 31, 2018, the Company had completed its accounting for the impacts of the Tax Act. See Note 9 to our consolidated and combined financial statements included in this Form 10-K for additional discussion surrounding income taxes.

<s>[INST] You should read the following discussion and analysis in conjunction with our financial statements and the related notes included elsewhere in this Form 10K. This discussion and analysis contains forwardlooking statements that involve risks, uncertainties, and assumptions. Our actual results may differ materially from those anticipated in these forwardlooking statements as a result of certain factors, including, but not limited to, those set forth under “Risk Factors” and elsewhere in this Form 10K. Overview We are a pureplay, fully integrated lithium company, with a long, proven history of producing performance lithium compounds. Our primary products, namely batterygrade lithium hydroxide, butyllithium and high purity lithium metal are critical inputs used in various performance applications. Our strategy is to focus on supplying high performance lithium compounds to the fast growing Electric Vehicle (“EV”) battery market, while continuing to maintain our position as a leading global producer of butyllithium and high purity lithium metal. With extensive global capabilities, over 60 years of continuous production experience, applications and technical expertise and deep customer relationships, we believe we are well positioned to capitalize on the accelerating trend of vehicle electrification. We produce lithium compounds for use in applications that have specific performance requirements, including batterygrade lithium hydroxide for use in high performance lithiumion batteries. We believe the demand for our compounds will continue to grow as the electrification of transportation accelerates, and as the use of high nickel content cathode materials increases in the next generation of battery technology products. We also supply butyllithium, which is used as a synthesizer in the production of polymers and pharmaceutical products, as well as a range of specialty lithium compounds including high purity lithium metal, which is used in the production of lightweight materials for aerospace applications and nonrechargeable batteries. It is in these applications that we have established a differentiated position in the market through our ability to consistently produce and deliver performance lithium compounds. 2018 Highlights The following are the more significant developments in our business during the year ended December 31, 2018: The Separation On March 31, 2017, FMC publicly announced a plan to separate Livent into a publicly traded company (the “Separation”). Prior to the completion of the initial public offering ("IPO") on October 15, 2018, we were a wholly owned subsidiary of FMC. On October 1, 2018, following a series of restructuring steps, prior to the IPO of Livent common stock, FMC transferred to us substantially all of the assets and liabilities of its lithium business (the “Lithium Business”). In exchange, we issued to FMC all 123 million shares of our common stock. On October 15, 2018 (the "Separation Date"), we completed the IPO and sold 20 million shares of Livent common stock to the public at a price of $17.00 per share. On November 8, 2018, the underwriters exercised, in full, their option (the "Overallotment Option Exercise") to purchase an additional 3 million shares of our common stock, the closing of which was completed on November 13, 2018. Our common stock is listed on the New York Stock Exchange (the “NYSE”) under the symbol “LTHM.” Net proceeds from the sale of 23 million shares of our common stock issued in connection with the IPO and Overallotment Option Exercise were approximately $369 million, after deducting underwriting discounts and commissions. The net proceeds from the IPO, after payment of financing fees and other IPO related costs, were subsequently distributed to FMC. Immediately following the IPO and the Overallotment Option Exercise, FMC owned approximately 84% of our outstanding common stock. Accordingly, we are considered a “controlled company” under the NYSE rules. Further details can be found in the final Prospectus ("Prospectus") included in our Registration Statement on Form S1 originally filed with the Securities and Exchange Commission on October 12, 2018, as amended. Revenue of $442.5 million in 2 [/INST] Positive. </s>

Livent Corp.

2020-02-28

2019-12-31

ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS You should read the following discussion and analysis in conjunction with our financial statements and the related notes included elsewhere in this Form 10-K. This discussion and analysis contains forward-looking statements that involve risks, uncertainties, and assumptions. Our actual results may differ materially from those anticipated in these forward-looking statements as a result of certain factors, including, but not limited to, those set forth under “Risk Factors” and elsewhere in this Form 10-K. OVERVIEW We are a pure-play, fully integrated lithium company, with a long, proven history of producing performance lithium compounds. Our primary products, namely battery-grade lithium hydroxide, lithium carbonate, butyllithium and high purity lithium metal are critical inputs used in various performance applications. Our strategy is to focus on supplying high performance lithium compounds to the fast growing Electric Vehicle (“EV”) battery market, while continuing to maintain our position as a leading global producer of butyllithium and high purity lithium metal. With extensive global capabilities, over 60 years of continuous production experience, applications and technical expertise and deep customer relationships, we believe we are well positioned to capitalize on the accelerating trend of vehicle electrification. We produce lithium compounds for use in applications that have specific performance requirements, including battery-grade lithium hydroxide for use in high performance lithium-ion batteries. We believe the demand for our compounds will continue to grow as the electrification of transportation accelerates, and as the use of high nickel content cathode materials increases in the next generation of battery technology products. We also supply butyllithium, which is used in the production of polymers and pharmaceutical products, as well as a range of specialty lithium compounds including high purity lithium metal, which is used in the production of lightweight materials for aerospace applications and non-rechargeable batteries. It is in these applications that we have established a differentiated position in the market through our ability to consistently produce and deliver performance lithium compounds. 2019 Highlights The following are the more significant developments in our business during the year ended December 31, 2019: • Revenue of $388.4 million in 2019 decreased $54.1 million or approximately 12% versus last year. A detailed review of revenues is included under the section entitled “Results of Operations”. • Our gross margin of $114.9 million in 2019 decreased $91.4 million or approximately 44% versus the prior year primarily driven by lower prices, unfavorable customer mix, lower sales volumes of lithium carbonate, higher lithium carbonate cost due to third party purchases and higher remeasurement losses in Argentina impacted by the August 2019 currency devaluation and balance sheet exposures for tax and capital expansion related activities. See the Argentina Remeasurement Impacts subsection below for additional discussion. • Selling, general and administrative expenses increased approximately 92% from $21.1 million in 2018 to $40.5 million 2019. The increase is primarily driven by incremental standalone company costs. • There were no corporate allocations in 2019 because expenses are not allocated to Livent from FMC subsequent to the Separation Date. There were $15.7 million of corporate allocations in the prior year. • Adjusted EBITDA of $99.8 million decreased $83.0 million compared to the prior year amount of $182.8 million primarily due to unfavorable customer mix, lower pricing and higher lithium carbonate cost due to third party purchases. The Distribution On March 1, 2019, FMC completed its previously announced spin-off distribution of 123 million shares of common stock of Livent as a pro rata dividend on shares of FMC common stock outstanding at the close of business on the record date of February 25, 2019 (the “Distribution”). Each share of FMC common stock received 0.935301 shares of Livent common stock in the Distribution. Immediately prior to the Distribution, FMC owned 123 million shares of Livent common stock, representing approximately 84% of the outstanding shares of Livent common stock. Effective upon the distribution, FMC no longer owns any shares of Livent common stock. Argentina Remeasurement Impacts Our wholly owned subsidiaries in Argentina use the U.S. dollar as their functional currency. Argentina peso-denominated monetary assets and liabilities are remeasured at each balance sheet date to the currency exchange rate then in effect, with currency remeasurement and other transaction gains and losses recognized in earnings. On August 12, 2019, Argentina's currency suffered a significant loss in value following the announcement of the results of Argentina's primary elections. This devaluation created an immediate loss associated with the impacts of the remeasurement of our local balance sheet at the date of the devaluation attributable to our Argentina operations. Our exposure to remeasurement gains and losses has increased in 2019 compared to 2018 due to VAT on capital expenditures, the Argentina export tax announced in September 2018, and deferred tax assets/liabilities. 2020 Outlook We believe that the demand for our products will continue to grow during 2020, primarily driven by increased production volumes of electric vehicles. The Company expects to deliver flat to a slight increase in revenue from higher volumes that we expect will be offset by lower average pricing and higher costs driven by the impact of third-party purchased lithium carbonate. As a result, we are expecting lower year-on-year profitability comparisons in 2020. The timing and scope of our capacity expansion plans for 2020 will be determined by market conditions, capital considerations, and anticipated customer commitments among other factors. In this section, we discuss the results of our operations for the year ended December 31, 2019 compared to the year ended December 31, 2018. For a discussion of the year ended December 31, 2018 compared to the year ended December 31, 2017, please refer to Part II, Item 7, “Management’s Discussion and Analysis of Financial Condition and Results of Operations” in our Annual Report on Form 10-K for the year ended December 31, 2018. Results of Operations - Years Ended December 31, 2019 and 2018 In addition to net income, as determined in accordance with U.S. GAAP, we evaluate operating performance using certain non-GAAP measures such as EBITDA, which we define as net income plus interest expense, net, income tax expense/(benefit), and depreciation and amortization, and Adjusted EBITDA, which we define as EBITDA adjusted for certain Argentina remeasurement losses/(gains), restructuring and other charges/(income), non-operating pension expense/ (benefit) and settlement charges, separation-related costs and other losses/(gains). Management believes the use of these non-GAAP measures allows management and investors to compare more easily the financial performance of its underlying business from period to period. The non-GAAP information provided may not be comparable to similar measures disclosed by other companies because of differing methods used by other companies in calculating EBITDA and Adjusted EBITDA. These measures should not be considered as a substitute for net income or other measures of performance or liquidity reported in accordance with U.S. GAAP. The following table reconciles EBITDA and Adjusted EBITDA from net income. ____________________ (a) All of the interest related to our Revolving Credit Facility was capitalized for the year ended December 31, 2019. (b) Represents impact of currency fluctuations on tax assets and liabilities and on long-term monetary assets associated with our capital expansion, as well as significant currency devaluations. The remeasurement gains/(losses) are included within "Cost of sales" in our condensed consolidated statement of operations but are excluded from our calculation of Adjusted EBITDA because of: i.) their nature as income tax related; ii.) their association with long-term capital projects which will not be operational until future periods; or iii.) the severity of the devaluations and their immediate impact on our operations in the country. (c) We continually perform strategic reviews and assess the return on our business. This sometimes results in management changes or in a plan to restructure the operations of our business. As part of these restructuring plans, demolition costs and write-downs of long-lived assets may occur. (d) Our non-operating pension expense/(benefit) and settlement charges are defined as those costs/(benefits) related to interest, expected return on plan assets, amortized actuarial gains and losses and the impacts of any plan curtailments or settlements. These are excluded from our results and are primarily related to changes in pension plan assets and liabilities which are tied to financial market performance and we consider these costs to be outside our operational performance. We continue to include the service cost and amortization of prior service cost in our Adjusted EBITDA results noted above. These elements reflect the current year operating costs to our businesses for the employment benefits provided to active employees. (e) Represents legal, professional, transaction related fees and other separation related activity. (f) Represents the portion of our nonrefundable prepaid research and development costs advanced to our unconsolidated affiliate included in "Equity in net (earnings)/loss of unconsolidated affiliate" in our consolidated and combined statement of operations but excluded from our calculation of Adjusted EBITDA because the costs represent future research and development activities of the affiliate which have not occurred as of December 31, 2019. Year Ended December 31, 2019 compared with Year Ended December 31, 2018 Revenue Revenue of $388.4 million for 2019 decreased by $54.1 million, or approximately 12%, versus 2018, primarily driven by unfavorable pricing of lithium hydroxide and lithium carbonate and lower sales volumes of lithium carbonate, partially offset by higher lithium hydroxide sales volumes. Gross Margin Gross margin of $114.9 million for 2019 decreased by $91.4 million, or approximately 44%, versus 2018. The decrease in gross margin was primarily driven by unfavorable customer mix, lower sales volumes of lithium carbonate, higher lithium carbonate cost due to third party purchases, higher VAT due to increased exports from China and higher remeasurement losses in Argentina impacted by the August 2019 currency devaluation and balance sheet exposures for tax and capital expansion related activities. See the Argentina Remeasurement Impacts discussion in the Overview section of this Management Discussion and Analysis for additional discussion. Selling, general and administrative expenses Selling, general and administrative expenses of $40.5 million for 2019 increased by $19.4 million, or approximately 92% compared to 2018. The increase in selling, general and administrative was primarily due to costs incurred under the TSA subsequent to the Separation Date and incremental stand-alone company costs which were charges for corporate allocations in the prior year. Corporate allocations There were no corporate allocations for 2019, compared to $15.7 million for the prior year because expenses are not allocated to Livent from FMC subsequent to the Separation Date and costs incurred under the TSA subsequent to the Separation Date are direct charges to our consolidated and combined statements of operations. Restructuring and other charges Restructuring and other charges of $6.2 million and $2.6 million for the years ended December 31, 2019 and 2018, respectively, 2019 costs include $3.5 million of severance-related costs including stock-based compensation expense of $1.2 million for accelerated vesting of stock awards pursuant to corporate management changes and IPO securities litigation costs not incurred in the prior year. See Note 7 to our consolidated and combined financial statements of this Form 10-K for details. 2018 costs were primarily comprised of asset write-downs and miscellaneous restructuring efforts of $2.4 million related to our operations at the manufacturing site located in Bessemer City, North Carolina. Additionally, there were other charges of $0.2 million related to environmental remediation activities in both periods. Separation-related costs Separation-related costs of $6.3 million for 2019 decreased $3.0 million compared to 2018. These costs primarily consists of legal and professional fees and other Separation related activities, including information technology infrastructure and software costs incurred by Livent as a standalone entity in preparation for the termination of the TSA. Because the Separation occurred on October 15, 2018, the prior year included three months of Separation related activities as compared to twelve months in the current year. Income tax expense Provision for income taxes of $7.6 million and $27.1 million, respectively, for the years ended December 31, 2019 and 2018, which resulted in effective tax rate of 13.1% and 17.6%, respectively. The decrease in provision for income taxes was primarily due to a reduction in income before taxes from $153.7 million for the year ended December 31, 2018 to $57.8 million for the year ended December 31, 2019. Additionally, the company recorded $3.2 million tax benefit due to revision to our tax liabilities upon completion of prior year tax return. The decrease in provision for income taxes was partially offset by the tax impacts associated with fluctuations in foreign currency remeasurement in Argentina. Refer to Note 9 for further information. Net income Net income of $50.2 million for 2019 decreased $76.4 million or approximately 60% from $126.6 million in 2018 primarily due to unfavorable customer mix and pricing, higher lithium carbonate cost due to third party purchases, higher VAT due to increased exports from China, the tax impacts associated with fluctuations in foreign currency remeasurements and higher remeasurement losses in Argentina impacted by the August 2019 currency devaluation and balance sheet exposures for tax and capital expansion related activities. See the Argentina Remeasurement Impacts discussion in the Overview section of this Management Discussion and Analysis for additional discussion. Liquidity and Capital Resources Historically, prior to the Separation, FMC provided centralized cash management and other finance services to Livent. FMC ceased providing these services following the Separation. Only cash accounts specifically owned by Livent and Livent subsidiaries are reflected on the balance sheets of our consolidated and combined financial statements. Since October 2018, our capital structure and sources of liquidity have changed significantly compared to our historical capital structure as part of FMC. We no longer participate in FMC’s capital management system and are evaluated separately in terms of credit and capital allocation by providers of financing. Our prospective success in funding our cash needs will depend on the strength of the lithium market and our continued ability to generate cash from operations and raise capital from other sources. Our primary sources of cash are currently generated from operations and borrowings under our revolving credit facility. Cash and cash equivalents at December 31, 2019 and 2018, were $16.8 million and $28.3 million, respectively. Of the cash and cash equivalents balance at December 31, 2019, $10.4 million was held by our foreign subsidiaries. The cash held by foreign subsidiaries for permanent reinvestment is generally used to finance the subsidiaries’ operating activities and future foreign investments. We have not provided additional income taxes for any additional outside basis differences inherent in our investments in subsidiaries because the investments are essentially permanent in duration or we have concluded that no additional tax liability will arise upon disposal. We have concluded the Tax Act has not altered our assertion of indefinitely reinvested earnings. See Note 9 to the consolidated financial statements included within this Form 10-K for more information. At December 31, 2019, we had $155 million debt outstanding. On September 28, 2018, Livent entered into a credit agreement which provides for a $400 million senior secured revolving credit facility, $50 million of which is available for the issuance of letters of credit, with an option, subject to certain conditions and limitations, to increase the aggregate amount of the revolving credit commitments to $600 million. Refer to the details below for more information. Revolving Credit Facility On September 28, 2018, we entered into a credit agreement among us and all of our U.S. subsidiaries as borrowers (the “Borrowers”), certain of our wholly owned subsidiaries as guarantors, the lenders party thereto (the “Lenders”), Citibank, N.A., as administrative agent, and certain other financial institutions party thereto, as joint lead arrangers (the “Credit Agreement”). The Credit Agreement provides for a $400 million senior secured revolving credit facility, $50 million of which is available for the issuance of letters of credit for the account of the Borrowers, with an option, subject to certain conditions and limitations, to increase the aggregate amount of the revolving credit commitments to $600 million (the “Revolving Credit Facility”). The issuance of letters of credit and the proceeds of revolving credit loans made pursuant to the Revolving Credit Facility are available, and will be used, for general corporate purposes, including capital expenditures and permitted acquisitions, of the Borrowers and their subsidiaries. Amounts under the Revolving Credit Facility may be borrowed, repaid and re-borrowed from time to time until the final maturity date of the Revolving Credit Facility, which will be the fifth anniversary of the Revolving Credit Facility’s effective date. Voluntary prepayments and commitment reductions under the Revolving Credit Facility are permitted at any time without any prepayment premium upon proper notice and subject to minimum dollar amounts. Revolving loans under the Credit Agreement will bear interest at a floating rate, which will be either a base rate or a Eurocurrency borrowing plus applicable margin. Base rate borrowings are defined as the greatest of the rate of interest announced publicly by Citibank, N.A. in New York City from time to time as its “base rate”; the federal funds effective rate plus 0.5%; or a Eurodollar rate for a one-month interest period plus 1%. The Eurocurrency borrowing will be defined as a Eurodollar rate for one, two, three or six months. The applicable margins for the two types of loans are set by reference to Livent’s leverage ratio, calculated by dividing our debt by our cash flows. Both the debt and cash flows used in this calculation are terms defined in the Credit Agreement. Each Borrower on a joint and several basis is required to pay a commitment fee quarterly in arrears on the average daily unused amount of each Lender’s revolving credit commitment at a rate equal to an applicable percentage based on the leverage ratio, as determined in accordance with the provisions of the Credit Agreement. The applicable margin and the commitment fee are subject to adjustment as provided in the Credit Agreement. The Borrowers’ domestic material subsidiaries (the “Guarantors”) will guarantee the obligations of the Borrowers under the Revolving Credit Facility. The obligations of the Borrowers and the Guarantors are secured by all of the present and future assets of the Borrowers and the Guarantors, including the Borrowers’ facility and real estate in Bessemer City, North Carolina, subject to certain exceptions and exclusions as set forth in the Credit Agreement and other security and collateral documents. The Credit Agreement contains certain affirmative and negative covenants that are binding on the Borrowers and their subsidiaries, including, among others, restrictions (subject to exceptions and qualifications) on the ability of the Borrowers and their subsidiaries to create liens, to undertake fundamental changes, to incur debt, to sell or dispose of assets, to make investments, to make restricted payments such as dividends, distributions or equity repurchases, to change the nature of their businesses, to enter into transactions with affiliates and to enter into certain burdensome agreements. Furthermore, the Borrowers are subject to financial covenants regarding their leverage ratio and interest coverage ratio. Under the covenants, the maximum allowable net leverage ratio is 3.5 and the minimum allowable interest coverage ratio is 3.5. We were in compliance with all covenants at December 31, 2019. Statement of Cash Flows Cash provided by operating activities was $58.1 million and $92.0 million for the years ended December 31, 2019 and 2018, respectively. The decrease in cash provided by operating activities in 2019 compared to 2018 was primarily driven by lower net income, an increase in operating inventories and decreases in our accounts payables, including a $23.7 million payment in the first quarter of 2019 to FMC related to Separation matters. This was partially offset by increased collections of our trade receivables and the discounting of Bank Acceptance Drafts for certain Chinese customers in 2019. Cash required by investing activities of operations was $(190.0) million and $(78.4) million for the years ended December 31, 2019 and 2018, respectively. The change in cash required by investing activities is primarily due to our investments in production capacity of lithium carbonate and hydroxide resulting in increased capital expenditures. Cash provided by financing activities was $120.5 million and $13.0 million for the years ended December 31, 2019 and 2018, respectively. Cash provided by financing activities increased in 2019 compared to 2018 due to proceeds from increasing draws on our revolving credit line for our capital expansion projects. As FMC managed our cash and financing arrangements during the nine months ended September 30, 2018 all excess cash generated through earnings were deemed remitted to FMC and all sources of cash were deemed funded by FMC. Other potential liquidity needs Our cash needs for 2020 include operating cash requirements and capital expenditures. We plan to meet our liquidity needs through available cash, cash generated from operations, borrowings under our committed Revolving Credit Facility, and other potential working capital financing strategies that may be available to us. At December 31, 2019 our remaining borrowing capacity under our Revolving Credit Facility, subject to meeting leverage and interest coverage ratio financial covenants, was $234.4 million, including letters of credit utilization. We expect recent market factors, including industry oversupply conditions and decreased pricing levels, to continue in 2020 as we continue our expansion and we expect our net leverage ratio under our Revolving Credit Facility covenants to increase during the next 12 months from the date of this filing. Compliance with our debt covenants will continue to be determined, in large part, by our ability to manage the timing and amount of our capital expenditures, which is within our control; as well as by our ability to achieve forecasted operating results and to pursue other working capital financing strategies that may be available to us, which is less certain and outside our control. As a result, we have slowed the pace of our carbonate expansion in Argentina resulting in the delay of phase 1 completion to the middle of 2021 and will be pausing our current lithium hydroxide expansion project to align its completion with that of phase 1 in Argentina. We also plan to pursue additional working capital financing strategies, including potential amendments or waivers to our Revolving Credit Facility, among others. Projected 2020 capital expenditures and expenditures related to contract manufacturers are expected to be between $200 million to $230 million but may need to be reduced significantly depending on the timing and success of management’s planned additional working capital financing strategies and future operating results. Beyond 2020, we currently anticipate the majority of our capital expenditures to be directed towards expanding lithium carbonate capacity at our production operations in Argentina and expanding our lithium hydroxide capacity globally. We believe that our available cash and cash from operations, together with borrowing availability under the Revolving Credit Facility and other potential working capital financing strategies that may be available to us, will provide adequate liquidity for the next 12 months. Access to capital and the availability of financing on acceptable terms in the future will be affected by many factors, including our credit rating, economic conditions, and the overall liquidity of capital markets. Contractual Obligations and Commercial Commitments As of December 31, 2019, our total significant committed contracts that we believe will affect cash over the next five years and thereafter are as follows: _________________ (1) Represents certain of our raw material commercial contract purchase obligations that are enforceable and legally binding requirements contracts with specified quantities, pricing and timing of transactions. (2) Represents the balance, as of December 31, 2019, of the Company's Revolving Credit Facility which matures in 2023. See Note 16 to our consolidated and combined financial statements included in this Form 10-K for more information. Climate Change The potential physical impacts of climate change on our operations are highly uncertain, and would be particular to the geographic circumstances in areas in which we operate. These may include changes in rainfall and storm patterns and intensities, water shortages, changing sea levels and changing temperatures. These changes may have a material adverse effect on our operations, including brine production and transportation of raw materials. A number of governmental bodies have introduced or are contemplating legislative and regulatory change in response to the potential impacts of climate change. Such legislation or regulation, if enacted, potentially could include provisions for a “cap and trade” system of allowances and credits or a carbon tax, among other provisions. There is also a potential for climate change legislation and regulation to adversely impact the cost of purchased energy and electricity. The growing concerns about climate change and related increasingly stringent regulations may provide us with new or expanded business opportunities. We provide solutions to companies pursuing alternative fuel products and technologies (such as renewable fuels, gas-to-liquids and others), emission control technologies (including mercury emissions), alternative transportation vehicles and lithium-ion battery technologies and other similar solutions. As demand for, and legislation mandating or incentivizing the use of, alternative fuel technologies that limit or eliminate greenhouse gas emissions increase, we continue to monitor the market and offer solutions where we have appropriate technology. Recently Issued and Adopted Accounting Pronouncements and Regulatory Items See Note 3 "Recently Issued and Adopted Accounting Pronouncements and Regulatory Items" to our consolidated and combined financial statements included in this Form 10-K. Off-Balance Sheet Arrangements We do not have any off-balance sheet arrangements that have or are reasonably likely to have a current or future effect on our financial condition, changes in financial condition, revenues or expenses, results of operations, liquidity, capital expenditures or capital resources that is material to investors. Critical Accounting Policies Our consolidated and combined financial statements are prepared in conformity with U.S. GAAP. The preparation of these financial statements requires us to make estimates and judgments that affect the reported amounts of assets, liabilities, revenues and expenses. We have described our accounting policies in Note 2 "Principal Accounting Policies and Related Financial Information" to our consolidated and combined financial statements included in this Form 10-K. We have reviewed these accounting policies, identifying those that we believe to be critical to the preparation and understanding of our consolidated financial statements. We have reviewed these critical accounting policies with the Audit Committee of the Board of Directors. Critical accounting policies are central to our presentation of results of operations and financial condition in accordance with U.S. GAAP and require management to make estimates and judgments on certain matters. We base our estimates and judgments on historical experience, current conditions and other reasonable factors. Revenue recognition and trade receivables Sale of Goods Revenue from product sales is recognized when (or as) we satisfy a performance obligation by transferring the promised goods to a customer, that is, when control of the good transfers to the customer. The customer is then invoiced at the agreed-upon price with payment terms generally ranging from 30 to 180 days. In determining when the control of goods is transferred, we typically assess, among other things, the transfer of risk and title and the shipping terms of the contract. The transfer of title and risk typically occurs either upon shipment to the customer or upon receipt by the customer. As such, we typically recognize revenue when goods are shipped based on the relevant incoterm for the product order, or in some regions, when delivery to the customer’s requested destination has occurred. When we perform shipping and handling activities after the transfer of control to the customer (e.g., when control transfers prior to delivery), they are considered fulfillment activities, and accordingly, the costs are accrued for when the related revenue is recognized. For FOB shipping point terms, revenue is recognized at the time of shipment since the customer gains control at this point in time. We record amounts billed for shipping and handling fees as revenue. Costs incurred for shipping and handling are recorded as costs of sales. Amounts billed for sales and use taxes, value-added taxes, and certain excise and other specific transactional taxes imposed on revenue-producing transactions are presented on a net basis and excluded from revenue in the consolidated and combined statements of operations. We record a liability until remitted to the respective taxing authority. Variable Consideration As a part of our customary business practice, we may offer sales incentives to our customers, such as volume discounts or rebates. Variable consideration given can differ by product. For all such contracts that include any variable consideration, we estimate the amount of variable consideration that should be included in the transaction price utilizing either the expected value method or the most likely amount method depending on the nature of the variable consideration. Variable consideration is included in the transaction price if, in our judgment, it is probable that a significant future reversal of cumulative revenue under the contract will not occur. Although determining the transaction price requires significant judgment, we have significant historical experience with incentives provided to customers and estimating the expected consideration considering historical patterns of incentive payouts. These estimates are re-assessed each reporting period as required. In addition to the variable consideration described above, in certain instances, we may require our customers to meet certain volume thresholds within their contract term. We estimate what amount of variable consideration should be included in the transaction price at contract inception and continually reassess this estimation each reporting period to determine situations when the minimum volume thresholds will not be met. Variable consideration is included in the transaction price if, in our judgment, it is probable that a significant future reversal of cumulative revenue under the contract will not occur. In those circumstances, we apply the guidance on breakage and estimate the amount of the shortfall and recognize it over the remaining performance obligations in the contract. Right of Return We warrant to our customers that our products conform to mutually agreed product specifications. This offering is accounted for as a right of return and the transaction price is adjusted for an estimate of expected returns. Per our historical experience, returns due to nonconformity are very uncommon; as such our adjustment to transaction price for our estimate of expected return is not material. Contract Asset and Contract Liability Balances We satisfy our obligations by transferring goods and services in exchange for consideration from customers. The timing of performance sometimes differs from the timing the associated consideration is received from the customer, thus resulting in the recognition of a contract liability. We recognize a contract liability if the customer’s payment of consideration is received prior to completion of our related performance obligation. We periodically enter into prepayment arrangements with customers and receive advance payments for product to be delivered in future periods. These advance payments are recorded as deferred revenue and classified as “Advance payments from customers” on the consolidated balance sheet. Revenue associated with advance payments is recognized as shipments are made and title, ownership and control pass to the customer. Trade Receivables Trade receivables consist of amounts owed from customer sales and are recorded when revenue is recognized. The allowance for trade receivables represents our best estimate of the probable losses associated with potential customer defaults. In developing our allowance for trade receivables, we use a two stage process which includes calculating a general formula to develop an allowance to appropriately address the uncertainty surrounding collection risk of our entire portfolio and specific allowances for customers where the risk of collection has been reasonably identified either due to liquidity constraints or disputes over contractual terms and conditions. Our method of calculating the general formula consists of estimating the recoverability of trade receivables based on historical experience, current collection trends, and external business factors such as economic factors, including regional bankruptcy rates, and political factors. Our analysis of trade receivable collection risk is performed quarterly, and the allowance is adjusted accordingly. Impairments and valuation of long-lived assets Our long-lived assets primarily include property, plant and equipment and intangible assets. The Company has no goodwill or indefinite-lived intangible assets as of December 31, 2019. We test for impairment whenever events or circumstances indicate that the net book value of our property, plant and equipment may not be recoverable from the estimated undiscounted expected future cash flows expected to result from their use and eventual disposition. In cases where the estimated undiscounted expected future cash flows are less than net book value, an impairment loss is recognized equal to the amount by which the net book value exceeds the estimated fair value of assets, which is based on discounted cash flows at the lowest level determinable. The estimated cash flows reflect our assumptions about selling prices, volumes, costs and market conditions over a reasonable period of time. Income taxes We have recorded a valuation allowance to reduce deferred tax assets in certain jurisdictions to the amount that we believe is more likely than not to be realized. In assessing the need for this allowance, we have considered a number of factors including future taxable income, the jurisdictions in which such income is earned and our ongoing tax planning strategies. In the event that we determine that we would not be able to realize all or part of our net deferred tax assets in the future, an adjustment to the deferred tax assets would be charged to income in the period such determination was made. Similarly, should we conclude that we would be able to realize certain deferred tax assets in the future in excess of the net recorded amount, an adjustment to the deferred tax assets would increase income in the period such determination was made. Additionally, we file income tax returns in the United States and various state and foreign jurisdictions, as part of a FMC legal entity for the period ended February 28, 2019. Certain income tax returns for FMC entities taxable in the U.S. and significant foreign jurisdictions are open for examination and adjustment. We assess our income tax positions and record a liability for all years open to examination based upon our evaluation of the facts, circumstances and information available at the reporting date. For those tax positions where it is more likely than not that a tax benefit will be sustained, we have recorded the largest amount of tax benefit with a greater than 50% likelihood of being realized upon ultimate settlement with a taxing authority that has full knowledge of all relevant information. We adjust these liabilities, if necessary, upon the completion of tax audits or changes in tax law. See Note 9 to our consolidated and combined financial statements included in this Form 10-K for additional discussion surrounding income taxes.

<s>[INST] You should read the following discussion and analysis in conjunction with our financial statements and the related notes included elsewhere in this Form 10K. This discussion and analysis contains forwardlooking statements that involve risks, uncertainties, and assumptions. Our actual results may differ materially from those anticipated in these forwardlooking statements as a result of certain factors, including, but not limited to, those set forth under “Risk Factors” and elsewhere in this Form 10K. OVERVIEW We are a pureplay, fully integrated lithium company, with a long, proven history of producing performance lithium compounds. Our primary products, namely batterygrade lithium hydroxide, lithium carbonate, butyllithium and high purity lithium metal are critical inputs used in various performance applications. Our strategy is to focus on supplying high performance lithium compounds to the fast growing Electric Vehicle (“EV”) battery market, while continuing to maintain our position as a leading global producer of butyllithium and high purity lithium metal. With extensive global capabilities, over 60 years of continuous production experience, applications and technical expertise and deep customer relationships, we believe we are well positioned to capitalize on the accelerating trend of vehicle electrification. We produce lithium compounds for use in applications that have specific performance requirements, including batterygrade lithium hydroxide for use in high performance lithiumion batteries. We believe the demand for our compounds will continue to grow as the electrification of transportation accelerates, and as the use of high nickel content cathode materials increases in the next generation of battery technology products. We also supply butyllithium, which is used in the production of polymers and pharmaceutical products, as well as a range of specialty lithium compounds including high purity lithium metal, which is used in the production of lightweight materials for aerospace applications and nonrechargeable batteries. It is in these applications that we have established a differentiated position in the market through our ability to consistently produce and deliver performance lithium compounds. 2019 Highlights The following are the more significant developments in our business during the year ended December 31, 2019: Revenue of $388.4 million in 2019 decreased $54.1 million or approximately 12% versus last year. A detailed review of revenues is included under the section entitled “Results of Operations”. Our gross margin of $114.9 million in 2019 decreased $91.4 million or approximately 44% versus the prior year primarily driven by lower prices, unfavorable customer mix, lower sales volumes of lithium carbonate, higher lithium carbonate cost due to third party purchases and higher remeasurement losses in Argentina impacted by the August 2019 currency devaluation and balance sheet exposures for tax and capital expansion related activities. See the Argentina Remeasurement Impacts subsection below for additional discussion. Selling, general and administrative expenses increased approximately 92% from $21.1 million in 2018 to $40.5 million 2019. The increase is primarily driven by incremental standalone company costs. There were no corporate allocations in 2019 because expenses are not allocated to Livent from FMC subsequent to the Separation Date. There were $15.7 million of corporate allocations in the prior year. Adjusted EBITDA of $99.8 million decreased $83.0 million compared to the prior year amount of $182.8 million primarily due to unfavorable customer mix, lower pricing and higher lithium carbonate cost due to third party purchases. The Distribution On March 1, 2019, FMC completed its previously announced spinoff distribution of 123 million shares of common stock of Livent as a pro rata dividend on shares of FMC common stock outstanding at the close of business on the record date of February 25, 2019 (the “Distribution”). Each share of FMC common stock received 0.935301 shares of Livent common stock in the Distribution. Immediately prior to the Distribution, FMC owned 123 million shares of Livent common stock, representing approximately 84% of the outstanding shares of Livent common stock. Effective upon the distribution, FMC no longer owns any [/INST] Negative. </s>

RMG Acquisition Corp.

2019-03-29

2018-12-31

Item 7. Management’s Discussion And Analysis Of Financial Condition And Results Of Operations References to the “Company,” “our,” “us” or “we” refer to RMG Acquisition Corp. The following discussion and analysis of the Company’s financial condition and results of operations should be read in conjunction with the financial statements and the notes thereto contained elsewhere in this report. Certain information contained in the discussion and analysis set forth below includes forward-looking statements that involve risks and uncertainties. Cautionary Note Regarding Forward-Looking Statements This Annual Report on Form 10-K includes forward-looking statements within the meaning of Section 27A of the Securities Act of 1933, as amended, and Section 21E of the Securities Exchange Act of 1934, as amended (the “Exchange Act”). We have based these forward-looking statements on our current expectations and projections about future events. These forward-looking statements are subject to known and unknown risks, uncertainties and assumptions about us that may cause our actual results, levels of activity, performance or achievements to be materially different from any future results, levels of activity, performance or achievements expressed or implied by such forward-looking statements. In some cases, you can identify forward-looking statements by terminology such as “may,” “should,” “could,” “would,” “expect,” “plan,” “anticipate,” “believe,” “estimate,” “continue,” or the negative of such terms or other similar expressions. Factors that might cause or contribute to such a discrepancy include, but are not limited to, those described in our other Securities and Exchange Commission (“SEC”) filings. Overview We are a newly organized blank check company incorporated in Delaware on October 22, 2018 (date of inception) for the purpose of effecting a merger, capital stock exchange, asset acquisition, share purchase, reorganization or similar business combination with one or more businesses (the “initial business combination”). While we may pursue an acquisition opportunity in any business, industry, sector or geographical location, it intends to focus our search for a target business in the diversified resources and industrial materials sectors. We are an emerging growth company and, as such, we are subject to all of the risks associated with emerging growth companies. Our sponsor is RMG Sponsor, LLC, a Delaware limited liability company (the “sponsor”). On February 12, 2019, we consummated our initial public offering (“initial public offering”) of 20,000,000 units (“units” and, with respect to the Class A common stock included in the units being offered, the “public shares”) at $10.00 per unit, generating gross proceeds of $200 million. On February 19, 2019, the underwriters fully exercised their over-allotment option to purchase 3,000,000 additional units to cover over-allotments at $10.00 per unit, which generated additional gross proceeds of $30.0 million. We incurred offering costs of approximately $13.5 million, inclusive of $8.1 million in deferred underwriting commissions Simultaneously with the closing of the initial public offering, we consummated the private placement (“private placement”) of 4,000,000 warrants (each, a “private placement warrant” and collectively, the “private placement warrants”) at a price of $1.50 per private placement warrant in a private placement to the sponsor and the certain funds and accounts managed by subsidiaries of BlackRock, Inc. and certain funds and accounts managed by Alta Fundamental Advisers LLC (together, the “Anchor Investors”), generating gross proceeds of $6.0 million. In connection with the full exercise of the over-allotment option by the underwriters, the sponsor and the Anchor Investors purchased an additional 600,000 private placement warrants at a price of $1.50 per private placement warrant, which generated additional gross proceeds of $900,000. Upon the closing of the initial public offering and private placement (including the exercise of the over-allotment option), $230.0 million ($10.00 per unit) of the net proceeds of the sale of the units in the initial public offering and the private placement was placed in a trust account (the “trust account”), located at Deutsche Bank Trust Company Americas, with American Stock Transfer & Trust Company acting as trustee, and were invested in U.S. government securities, within the meaning set forth in Section 2(a)(16) of the Investment Company Act of 1940, as amended (the “Investment Company Act”), with a maturity of 180 days or less, until the earlier of: (i) the completion of an initial business combination and (ii) the distribution of the trust account as described below. If we are unable to complete an initial business combination within 24 months from the closing of the initial public offering (February 12, 2021), we will (i) cease all operations except for the purpose of winding up, (ii) as promptly as reasonably possible but not more than ten business days thereafter, redeem the public shares, at a per-share price, payable in cash, equal to the aggregate amount then on deposit in the trust account including interest earned on the funds held in the trust account and not previously released to us to pay our franchise and income taxes as well as expenses relating to the administration of the trust account (less up to $100,000 of interest released to us to pay dissolution expenses), divided by the number of then outstanding public shares, which redemption will completely extinguish public stockholders’ rights as stockholders (including the right to receive further liquidating distributions, if any), subject to applicable law, and (iii) as promptly as reasonably possible following such redemption, subject to the approval of our remaining stockholders and its Board, dissolve and liquidate, subject in each case to our obligations under Delaware law to provide for claims of creditors and the requirements of other applicable law. There will be no redemption rights or liquidating distributions with respect to the warrants, which will expire worthless if we fail to complete the initial business combination within the prescribed time period. Results of Operations Our entire activity since inception was in preparation for our initial public offering, and since such offering, our activity has been limited to the search for a prospective initial business combination, and we will not be generating any operating revenues until the closing and completion of our initial business combination. We have neither engaged in any operations nor generated any revenues to date. We will not generate any operating revenues until after completion of our initial business combination. We will generate non-operating income in the form of interest income on cash and cash equivalents. We expect to incur increased expenses as a result of being a public company (for legal, financial reporting, accounting and auditing compliance), as well as for due diligence expenses. For the period from October 22, 2018 through December 31, 2018, we had net loss of approximately $2,600, which consisted mainly of general and administrative expenses. Liquidity As of December 31, 2018, we had approximately $37,000 in our operating bank account. Through December 31, 2018, our liquidity needs have been satisfied through receipt of a $25,000 capital contribution from the sponsor, and approximately $115,000 in loans from the sponsor. Subsequent to December 31, 2018, we received $2.3 million in net proceeds from the consummation of the private placement to hold outside of the trust account and fund operating expenses. Related Party Transactions Founder Shares On November 6, 2018, the sponsor purchased 7,187,500 shares (the “founder shares”) of the Company’s Class B common stock, par value $0.0001 per share (the “Class B common stock”), for an aggregate price of $25,000. On December 17, 2018, the Company effectuated an 0.8-for-1 reverse split of the founder shares, resulting in an aggregate outstanding amount of 5,750,000 founder shares. In January 2019, the sponsor forfeited to the Company 575,000 founder shares and the Anchor Investors purchased from the Company 575,000 founder shares for cash consideration of approximately $2,300. Additionally, the sponsor had agreed to forfeit up to 750,000 founder shares to the extent that the over-allotment option is not exercised in full by the underwriters. On February 19, 2019, the underwriters fully exercised their over-allotment option; thus, these founder shares were no longer subject to forfeiture. The founder shares will automatically convert into Class A common stock on a one-for-one basis at the time of the Company’s initial business combination and are subject to certain transfer restrictions. Related Party Reimbursements and Loans The sponsor agreed to cover expenses related to our formation and the initial public offering (“expenses reimbursement”), and expected to be reimbursed upon the completion of the initial public offering. As of December 31, 2018, an aggregate of approximately $115,000 in expenses reimbursement was outstanding. We repaid the expenses reimbursement to the sponsor on February 19, 2019. In addition, in order to finance transaction costs in connection with an initial business combination, the sponsor or an affiliate of the sponsor, or certain of our officers and directors may, but are not obligated to, loan us funds as may be required (“working capital loans”). If we complete an initial business combination, we would repay the working capital loans out of the proceeds held in the trust account released to us. Otherwise, the working capital loans would be repaid only out of funds held outside the trust account. In the event that an initial business combination is not completed, we may use a portion of the proceeds held outside the trust account to repay the working capital loans but no proceeds held in the trust account would be used to repay the working capital loans. Except for the foregoing, the terms of such working capital loans, if any, have not been determined and no written agreements exist with respect to such loans. The working capital loans would either be repaid upon consummation of an initial business combination, without interest, or, at the lender’s discretion, up to $1.5 million of such working capital loans may be convertible into warrants of the post initial business combination entity at a price of $1.50 per warrant. The warrants would be identical to the private placement warrants. Except for the foregoing, the terms of such working capital loans, if any, have not been determined and no written agreements exist with respect to such loans. Off-Balance Sheet Arrangements; Commitments and Contractual Obligations; Quarterly Results As of December 31, 2018, we did not have any off-balance sheet arrangements as defined in Item 303(a)(4)(ii) of Regulation S-K and did not have any commitments or contractual obligations other than obligations disclosed herein. No unaudited quarterly operating data is included in this annual report, as we have conducted no operations to date. Critical Accounting Policies and Estimates The preparation of financial statements and related disclosures in conformity with accounting principles generally accepted in the United States requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities, disclosure of contingent assets and liabilities at the date of the financial statements, and income and expenses during the periods reported. Actual results could materially differ from those estimates. The Company has identified the following as its critical accounting policies: Deferred Offering Costs Deferred offering costs consist of legal, accounting, underwriting fees and other costs incurred through the balance sheet date of approximately $412,000 that are directly related to the initial public offering. These costs were charged to stockholder’s equity upon the completion of the initial public offering in February 2019. JOBS Act On April 5, 2012, the JOBS Act was signed into law. The JOBS Act contains provisions that, among other things, relax certain reporting requirements for qualifying public companies. Section 102(b)(1) of the JOBS Act exempts emerging growth companies from being required to comply with new or revised financial accounting standards until private companies (that is, those that have not had a Securities Act registration statement declared effective or do not have a class of securities registered under the Exchange Act) are required to comply with the new or revised financial accounting standards. The JOBS Act provides that a company can elect to opt out of the extended transition period and comply with the requirements that apply to non-emerging growth companies but any such an election to opt out is irrevocable. We have elected to irrevocably opt out of such extended transition period, which means that when a standard is issued or revised and it has different application dates for public or private companies, we will adopt the new or revised standard at the time public companies adopt the new or revised standard. This may make comparison of our financial statements with another emerging growth company that has not opted out of using the extended transition period difficult or impossible because of the potential differences in accountant standards used. Additionally, we are in the process of evaluating the benefits of relying on the other reduced reporting requirements provided by the JOBS Act. Subject to certain conditions set forth in the JOBS Act, if, as an “emerging growth company”, we choose to rely on such exemptions we may not be required to, among other things, (i) provide an auditor’s attestation report on our system of internal controls over financial reporting pursuant to Section 404, (ii) provide all of the compensation disclosure that may be required of non-emerging growth public companies under the Dodd-Frank Wall Street Reform and Consumer Protection Act, (iii) comply with any requirement that may be adopted by the PCAOB regarding mandatory audit firm rotation or a supplement to the auditor’s report providing additional information about the audit and the financial statements (auditor discussion and analysis), and (iv) disclose certain executive compensation related items such as the correlation between executive compensation and performance and comparisons of the CEO’s compensation to median employee compensation. These exemptions will apply for a period of five years following the completion of our initial public offering or until we are no longer an “emerging growth company,” whichever is earlier.

<s>[INST] Cautionary Note Regarding ForwardLooking Statements This Annual Report on Form 10K includes forwardlooking statements within the meaning of Section 27A of the Securities Act of 1933, as amended, and Section 21E of the Securities Exchange Act of 1934, as amended (the “Exchange Act”). We have based these forwardlooking statements on our current expectations and projections about future events. These forwardlooking statements are subject to known and unknown risks, uncertainties and assumptions about us that may cause our actual results, levels of activity, performance or achievements to be materially different from any future results, levels of activity, performance or achievements expressed or implied by such forwardlooking statements. In some cases, you can identify forwardlooking statements by terminology such as “may,” “should,” “could,” “would,” “expect,” “plan,” “anticipate,” “believe,” “estimate,” “continue,” or the negative of such terms or other similar expressions. Factors that might cause or contribute to such a discrepancy include, but are not limited to, those described in our other Securities and Exchange Commission (“SEC”) filings. Overview We are a newly organized blank check company incorporated in Delaware on October 22, 2018 (date of inception) for the purpose of effecting a merger, capital stock exchange, asset acquisition, share purchase, reorganization or similar business combination with one or more businesses (the “initial business combination”). While we may pursue an acquisition opportunity in any business, industry, sector or geographical location, it intends to focus our search for a target business in the diversified resources and industrial materials sectors. We are an emerging growth company and, as such, we are subject to all of the risks associated with emerging growth companies. Our sponsor is RMG Sponsor, LLC, a Delaware limited liability company (the “sponsor”). On February 12, 2019, we consummated our initial public offering (“initial public offering”) of 20,000,000 units (“units” and, with respect to the Class A common stock included in the units being offered, the “public shares”) at $10.00 per unit, generating gross proceeds of $200 million. On February 19, 2019, the underwriters fully exercised their overallotment option to purchase 3,000,000 additional units to cover overallotments at $10.00 per unit, which generated additional gross proceeds of $30.0 million. We incurred offering costs of approximately $13.5 million, inclusive of $8.1 million in deferred underwriting commissions Simultaneously with the closing of the initial public offering, we consummated the private placement (“private placement”) of 4,000,000 warrants (each, a “private placement warrant” and collectively, the “private placement warrants”) at a price of $1.50 per private placement warrant in a private placement to the sponsor and the certain funds and accounts managed by subsidiaries of BlackRock, Inc. and certain funds and accounts managed by Alta Fundamental Advisers LLC (together, the “Anchor Investors”), generating gross proceeds of $6.0 million. In connection with the full exercise of the overallotment option by the underwriters, the sponsor and the Anchor Investors purchased an additional 600,000 private placement warrants at a price of $1.50 per private placement warrant, which generated additional gross proceeds of $900,000. Upon the closing of the initial public offering and private placement (including the exercise of the overallotment option), $230.0 million ($10.00 per unit) of the net proceeds of the sale of the units in the initial public offering and the private placement was placed in a trust account (the “trust account”), located at Deutsche Bank Trust Company Americas, with American Stock Transfer & Trust Company acting as trustee, and were invested in U.S. government securities, within the meaning set forth in Section 2(a)(16) of the Investment Company Act of 1940, as amended (the “Investment Company Act” [/INST] Negative. </s>

RMG Acquisition Corp.

2020-03-16

2019-12-31

Item 7. Management’s Discussion And Analysis Of Financial Condition And Results Of Operations References to the “Company,” “our,” “us” or “we” refer to RMG Acquisition Corp. The following discussion and analysis of the Company’s financial condition and results of operations should be read in conjunction with the financial statements and the notes thereto contained elsewhere in this report. Certain information contained in the discussion and analysis set forth below includes forward-looking statements that involve risks and uncertainties. Cautionary Note Regarding Forward-Looking Statements This Annual Report on Form 10-K includes forward-looking statements within the meaning of Section 27A of the Securities Act of 1933, as amended, and Section 21E of the Securities Exchange Act of 1934, as amended (the “Exchange Act”). We have based these forward-looking statements on our current expectations and projections about future events. These forward-looking statements are subject to known and unknown risks, uncertainties and assumptions about us that may cause our actual results, levels of activity, performance or achievements to be materially different from any future results, levels of activity, performance or achievements expressed or implied by such forward-looking statements. In some cases, you can identify forward-looking statements by terminology such as “may,” “should,” “could,” “would,” “expect,” “plan,” “anticipate,” “believe,” “estimate,” “continue,” or the negative of such terms or other similar expressions. Factors that might cause or contribute to such a discrepancy include, but are not limited to, those described in our other Securities and Exchange Commission (“SEC”) filings. Overview We are a blank check company incorporated in Delaware on October 22, 2018 (date of inception) for the purpose of effecting a merger, capital stock exchange, asset acquisition, share purchase, reorganization or similar business combination with one or more businesses (the “initial business combination”). While we may pursue an acquisition opportunity in any business, industry, sector or geographical location, it intends to focus our search for a target business in the diversified resources and industrial materials sectors. We are an emerging growth company and, as such, we are subject to all of the risks associated with emerging growth companies. Our sponsor is RMG Sponsor, LLC, a Delaware limited liability company (the “sponsor”). On February 12, 2019, we consummated our initial public offering (“initial public offering”) of 20,000,000 units (“units” and, with respect to the Class A common stock included in the units being offered, the “public shares”) at $10.00 per unit, generating gross proceeds of $200 million. On February 19, 2019, the underwriters fully exercised their over-allotment option to purchase 3,000,000 additional units to cover over-allotments at $10.00 per unit, which generated additional gross proceeds of $30.0 million. We incurred offering costs of approximately $13.4 million, inclusive of $8.05 million in deferred underwriting commissions. Simultaneously with the closing of the initial public offering, we consummated the private placement (“private placement”) of 4,000,000 warrants (each, a “private placement warrant” and collectively, the “private placement warrants”) at a price of $1.50 per private placement warrant in a private placement to the sponsor and the certain funds and accounts managed by subsidiaries of BlackRock, Inc. and certain funds and accounts managed by Alta Fundamental Advisers LLC (together, the “Anchor Investors”), generating gross proceeds of $6.0 million. In connection with the full exercise of the over-allotment option by the underwriters, the sponsor and the Anchor Investors purchased an additional 600,000 private placement warrants at a price of $1.50 per private placement warrant, which generated additional gross proceeds of $900,000. Upon the closing of the initial public offering and private placement (including the exercise of the over-allotment option), $230.0 million ($10.00 per unit) of the net proceeds of the sale of the units in the initial public offering and the private placement was placed in a trust account (the “Trust Account”), located at Deutsche Bank Trust Company Americas, with American Stock Transfer & Trust Company acting as trustee, and were invested in U.S. government securities, within the meaning set forth in Section 2(a)(16) of the Investment Company Act of 1940, as amended (the “Investment Company Act”), with a maturity of 180 days or less, until the earlier of: (i) the completion of an initial business combination and (ii) the distribution of the Trust Account as described below. If we are unable to complete an initial business combination within 24 months from the closing of the initial public offering, or February 12, 2021 (the “Combination Period”), we will (i) cease all operations except for the purpose of winding up, (ii) as promptly as reasonably possible but not more than ten business days thereafter, redeem the public shares, at a per-share price, payable in cash, equal to the aggregate amount then on deposit in the Trust Account including interest earned on the funds held in the Trust Account and not previously released to us to pay our franchise and income taxes as well as expenses relating to the administration of the Trust Account (less up to $100,000 of interest released to us to pay dissolution expenses), divided by the number of then outstanding public shares, which redemption will completely extinguish public stockholders’ rights as stockholders (including the right to receive further liquidating distributions, if any), subject to applicable law, and (iii) as promptly as reasonably possible following such redemption, subject to the approval of our remaining stockholders and its Board, dissolve and liquidate, subject in each case to our obligations under Delaware law to provide for claims of creditors and the requirements of other applicable law. Although we have no present intention to do so, at some point in the future we may ask our shareholders to approve an amendment to our charter that would extend the length of the Combination Period, but there are no assurances that such extension will be granted. There will be no redemption rights or liquidating distributions with respect to the warrants, which will expire worthless if we fail to complete the initial business combination within the prescribed time period. Results of Operations Our entire activity since inception was in preparation for our initial public offering, and since such offering, our activity has been limited to the search for a prospective initial business combination, and we will not be generating any operating revenues until the closing and completion of our initial business combination. We have neither engaged in any operations nor generated any revenues to date. We will not generate any operating revenues until after completion of our initial business combination. We will generate non-operating income in the form of interest income on cash and cash equivalents. We expect to incur increased expenses as a result of being a public company (for legal, financial reporting, accounting and auditing compliance), as well as for due diligence expenses. For the year ended December 31, 2019, we had net income of approximately $2.1 million, which consisted of approximately $3.6 million in gain on money market funds and marketable securities (net), dividends and interest held in Trust Account, approximately $411,000 in interest income (of which approximately $399,000 was for interest earned on restricted cash equivalents held in Trust Account), offset by approximately $893,000 in general and administrative expenses, $200,000 in franchise tax expenses and approximately $797,000 in income tax expenses. For the period from October 22, 2018 through December 31, 2018, we had net loss of approximately $2,600, which consisted mainly of general and administrative expenses. Going Concern Consideration In connection with our assessment of going concern considerations in accordance with Financial Accounting Standard Board’s Accounting Standards Updated (“ASU”) 2014-15, “Disclosure of Uncertainties about an Entity’s Ability to Continue as a Going Concern”, management has determined that the mandatory liquidation and subsequent dissolution related to the Combination Period described above raises substantial doubt about our ability to continue as a going concern. No adjustments have been made to the carrying amounts of assets or liabilities should we be required to liquidate after February 12, 2021. As of December 31, 2019, we had approximately $1.2 million in our operating bank account held outside of the Trust Account, and approximately $3.2 million of investment income earned on money market funds and marketable securities held in the Trust Account available to pay franchise tax and income tax obligations. We will use the funds available outside of the Trust Account primarily to meet our operating cash flow and working capital needs. Through December 31, 2019, our liquidity needs have been satisfied through receipt of a $25,000 capital contribution from our sponsor in exchange for the issuance of the founder shares, approximately $153,000 received from our sponsor under Expenses Reimbursement arrangement, and the proceeds from the consummation of the private placement not held in the Trust Account. We fully repaid the loans from our sponsor in 2019. We intend to use substantially all of the funds held in the Trust Account, including any amounts representing investment income earned on the Trust Account (less amounts released to us for taxes payable, expenses relating to the administration of the Trust Account and deferred underwriting commissions) to complete the Initial Business Combination. Related Party Transactions Founder Shares On November 6, 2018, the sponsor purchased 7,187,500 shares (the “founder shares”) of the Company’s Class B common stock, par value $0.0001 per share (the “Class B common stock”), for an aggregate price of $25,000. On December 17, 2018, the Company effectuated an 0.8-for-1 reverse split of the founder shares, resulting in an aggregate outstanding amount of 5,750,000 founder shares. In January 2019, the sponsor forfeited to the Company 575,000 founder shares and the Anchor Investors purchased from the Company 575,000 founder shares for cash consideration of approximately $2,300. Additionally, the sponsor had agreed to forfeit up to 750,000 founder shares to the extent that the over-allotment option is not exercised in full by the underwriters. On February 19, 2019, the underwriters fully exercised their over-allotment option; thus, these founder shares were no longer subject to forfeiture. The founder shares will automatically convert into Class A common stock on a one-for-one basis at the time of the Company’s initial business combination and are subject to certain transfer restrictions. Related Party Reimbursements and Loans The sponsor agreed to cover expenses related to our formation and the initial public offering (“expenses reimbursement”), and expected to be reimbursed upon the completion of the initial public offering. We borrowed approximately $153,000 under the expenses reimbursement and fully repaid this amount to the related parties in 2019. In addition, in order to finance transaction costs in connection with an initial business combination, the sponsor or an affiliate of the sponsor, or certain of our officers and directors may, but are not obligated to, loan us funds as may be required (“working capital loans”). If we complete an initial business combination, we would repay the working capital loans out of the proceeds held in the Trust Account released to us. Otherwise, the working capital loans would be repaid only out of funds held outside the Trust Account. In the event that an initial business combination is not completed, we may use a portion of the proceeds held outside the Trust Account to repay the working capital loans but no proceeds held in the Trust Account would be used to repay the working capital loans. Except for the foregoing, the terms of such working capital loans, if any, have not been determined and no written agreements exist with respect to such loans. The working capital loans would either be repaid upon consummation of an initial business combination, without interest, or, at the lender’s discretion, up to $1.5 million of such working capital loans may be convertible into warrants of the post initial business combination entity at a price of $1.50 per warrant. The warrants would be identical to the private placement warrants. Except for the foregoing, the terms of such working capital loans, if any, have not been determined and no written agreements exist with respect to such loans. Off-Balance Sheet Arrangements; Commitments and Contractual Obligations; Quarterly Results As of December 31, 2019, we did not have any off-balance sheet arrangements as defined in Item 303(a)(4)(ii) of Regulation S-K and did not have any commitments or contractual obligations other than obligations disclosed herein. No unaudited quarterly operating data is included in this annual report, as we have conducted no operations to date. Critical Accounting Policies and Estimates The preparation of financial statements and related disclosures in conformity with accounting principles generally accepted in the United States requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities, disclosure of contingent assets and liabilities at the date of the financial statements, and income and expenses during the periods reported. Actual results could materially differ from those estimates. The Company has identified the following as its critical accounting policies: Fair Value of Financial Instruments Fair value measurements are based on the premise that 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 following three-tier fair value hierarchy has been used in determining the inputs used in measuring fair value: Level 1 - Quoted prices in active markets for identical assets or liabilities on the reporting date. Level 2 - Pricing inputs are based on quoted prices for similar instruments in active markets, quoted prices for identical or similar instruments in markets that are not active and model-based valuation techniques for which all significant assumptions are observable in the market or can be corroborated by observable market data for substantially the full term of the assets or liabilities. Level 3 - Pricing inputs are generally unobservable and include situations where there is little, if any, market activity for the investment. The inputs into the determination of fair value require management’s judgment or estimation of assumptions that market participants would use in pricing the assets or liabilities. The fair values are therefore determined using factors that involve considerable judgment and interpretations, including but not limited to private and public comparables, third-party appraisals, discounted cash flow models, and fund manager estimates. As of December 31, 2019 and 2018, the recorded values of cash and restricted cash equivalents held in the Trust Account, prepaid expenses, accounts payable, and accrued expenses approximate the fair values due to the short-term nature of the instruments. Class A Common Stock Subject to Possible Redemption Class A common stock subject to mandatory redemption (if any) are classified as liability instruments and are measured at fair value. Conditionally redeemable Class A common stock (including Class A common stock that feature redemption rights that are either within the control of the holder or subject to redemption upon the occurrence of uncertain events not solely within our control) are classified as temporary equity. At all other times, Class A common stock are classified as stockholders’ equity. Our Class A common stock feature certain redemption rights that are considered to be outside of our control and subject to the occurrence of uncertain future events. Accordingly, at December 31, 2019, 22,061,272 shares of Class A common stock subject to possible redemption are presented as temporary equity, outside of the stockholders’ equity section of our balance sheet. Net Income Per Common Stock Net income per share is computed by dividing net income (loss) by the weighted average number of shares of common stock outstanding during the period. We have not considered the effect of the warrants sold in the Initial Public Offering and Private Placement to purchase an aggregate of 12,266,666 Class A common stock in the calculation of diluted earnings per share, since their inclusion would be anti-dilutive under the treasury stock method. As a result, diluted earnings per ordinary share is the same as basic earnings per ordinary share for the periods presented. Our statements of operations include a presentation of income per share for common stock subject to redemption in a manner similar to the two-class method of income per share. Net income per common stock, basic and diluted for Class A common stock is calculated by dividing the interest income earned on the Trust Account, by the weighted average number of Class A common stock outstanding for the period. Net loss per common stock, basic and diluted for Class B common stock is calculated by dividing the net income, less income attributable to Class A common stock and any working capital loans, by the weighted average number of Class B common stock outstanding for the periods presented. Offering Costs Offering costs consist of legal, accounting, underwriting fees and other costs incurred of approximately $13.4 million that are directly related to the Initial Public Offering. These costs were charged to stockholder's equity upon the completion of the Initial Public Offering in February 2019. JOBS Act On April 5, 2012, the JOBS Act was signed into law. The JOBS Act contains provisions that, among other things, relax certain reporting requirements for qualifying public companies. Section 102(b)(1) of the JOBS Act exempts emerging growth companies from being required to comply with new or revised financial accounting standards until private companies (that is, those that have not had a Securities Act registration statement declared effective or do not have a class of securities registered under the Exchange Act) are required to comply with the new or revised financial accounting standards. The JOBS Act provides that a company can elect to opt out of the extended transition period and comply with the requirements that apply to non-emerging growth companies but any such an election to opt out is irrevocable. We have elected to irrevocably opt out of such extended transition period, which means that when a standard is issued or revised and it has different application dates for public or private companies, we will adopt the new or revised standard at the time public companies adopt the new or revised standard. This may make comparison of our financial statements with another emerging growth company that has not opted out of using the extended transition period difficult or impossible because of the potential differences in accountant standards used. Additionally, we are in the process of evaluating the benefits of relying on the other reduced reporting requirements provided by the JOBS Act. Subject to certain conditions set forth in the JOBS Act, if, as an “emerging growth company”, we choose to rely on such exemptions we may not be required to, among other things, (i) provide an auditor’s attestation report on our system of internal controls over financial reporting pursuant to Section 404, (ii) provide all of the compensation disclosure that may be required of non-emerging growth public companies under the Dodd-Frank Wall Street Reform and Consumer Protection Act, (iii) comply with any requirement that may be adopted by the PCAOB regarding mandatory audit firm rotation or a supplement to the auditor’s report providing additional information about the audit and the financial statements (auditor discussion and analysis), and (iv) disclose certain executive compensation related items such as the correlation between executive compensation and performance and comparisons of the CEO’s compensation to median employee compensation. These exemptions will apply for a period of five years following the completion of our initial public offering or until we are no longer an “emerging growth company,” whichever is earlier.

<s>[INST] Cautionary Note Regarding ForwardLooking Statements This Annual Report on Form 10K includes forwardlooking statements within the meaning of Section 27A of the Securities Act of 1933, as amended, and Section 21E of the Securities Exchange Act of 1934, as amended (the “Exchange Act”). We have based these forwardlooking statements on our current expectations and projections about future events. These forwardlooking statements are subject to known and unknown risks, uncertainties and assumptions about us that may cause our actual results, levels of activity, performance or achievements to be materially different from any future results, levels of activity, performance or achievements expressed or implied by such forwardlooking statements. In some cases, you can identify forwardlooking statements by terminology such as “may,” “should,” “could,” “would,” “expect,” “plan,” “anticipate,” “believe,” “estimate,” “continue,” or the negative of such terms or other similar expressions. Factors that might cause or contribute to such a discrepancy include, but are not limited to, those described in our other Securities and Exchange Commission (“SEC”) filings. Overview We are a blank check company incorporated in Delaware on October 22, 2018 (date of inception) for the purpose of effecting a merger, capital stock exchange, asset acquisition, share purchase, reorganization or similar business combination with one or more businesses (the “initial business combination”). While we may pursue an acquisition opportunity in any business, industry, sector or geographical location, it intends to focus our search for a target business in the diversified resources and industrial materials sectors. We are an emerging growth company and, as such, we are subject to all of the risks associated with emerging growth companies. Our sponsor is RMG Sponsor, LLC, a Delaware limited liability company (the “sponsor”). On February 12, 2019, we consummated our initial public offering (“initial public offering”) of 20,000,000 units (“units” and, with respect to the Class A common stock included in the units being offered, the “public shares”) at $10.00 per unit, generating gross proceeds of $200 million. On February 19, 2019, the underwriters fully exercised their overallotment option to purchase 3,000,000 additional units to cover overallotments at $10.00 per unit, which generated additional gross proceeds of $30.0 million. We incurred offering costs of approximately $13.4 million, inclusive of $8.05 million in deferred underwriting commissions. Simultaneously with the closing of the initial public offering, we consummated the private placement (“private placement”) of 4,000,000 warrants (each, a “private placement warrant” and collectively, the “private placement warrants”) at a price of $1.50 per private placement warrant in a private placement to the sponsor and the certain funds and accounts managed by subsidiaries of BlackRock, Inc. and certain funds and accounts managed by Alta Fundamental Advisers LLC (together, the “Anchor Investors”), generating gross proceeds of $6.0 million. In connection with the full exercise of the overallotment option by the underwriters, the sponsor and the Anchor Investors purchased an additional 600,000 private placement warrants at a price of $1.50 per private placement warrant, which generated additional gross proceeds of $900,000. Upon the closing of the initial public offering and private placement (including the exercise of the overallotment option), $230.0 million ($10.00 per unit) of the net proceeds of the sale of the units in the initial public offering and the private placement was placed in a trust account (the “Trust Account”), located at Deutsche Bank Trust Company Americas, with American Stock Transfer & Trust Company acting as trustee, and were invested in U.S. government securities, within the meaning set forth in Section 2(a)(16) of the Investment Company Act of 1940, as amended (the “Investment Company Act [/INST] Positive. </s>

Albertsons Companies, Inc.

2018-05-11

2018-02-24

Item 7 - Management's Discussion and Analysis of Financial Condition and Results of Operations The following discussion and analysis of our financial condition and results of operations should be read in conjunction with our Consolidated Financial Statements and related notes found in Item 8 in this Form 10-K. This discussion contains forward-looking statements based upon current expectations that involve numerous risks and uncertainties. Our actual results may differ materially from those contained in any forward-looking statements. Our last three fiscal years consisted of the 52 weeks ended February 24, 2018 ("fiscal 2017"), February 25, 2017 ("fiscal 2016") and February 27, 2016 ("fiscal 2015"). In this Management's Discussion and Analysis of Financial Condition and Results of Operations of Albertsons Companies, Inc., the words "Albertsons Companies," "ACI," "we," "us," "our" and "ours" refer to Albertsons Companies, Inc., together with its subsidiaries. OVERVIEW We are one of the largest food and drug retailers in the United States, with both a strong local presence and national scale. As of February 24, 2018, we operated 2,318 stores across 35 states and the District of Columbia under 20 well-known banners including Albertsons, Safeway, Vons, Jewel-Osco, Shaw’s, Acme, Tom Thumb, Randalls, United Supermarkets, Market Street, Pavilions, Star Market, Haggen and Carrs, as well as meal kit company Plated based in New York City. Over the past five years, we have completed a series of acquisitions that has significantly increased our portfolio of stores. We operated 2,318, 2,324, 2,271, 2,382, 1,075 and 192 stores as of February 24, 2018, February 25, 2017, February 27, 2016, February 28, 2015, February 20, 2014 and February 21, 2013, respectively. In addition, as of February 24, 2018, we operated 1,777 pharmacies, 1,275 in-store branded coffee shops, 397 adjacent fuel centers, 23 dedicated distribution centers, five Plated fulfillment centers and 20 manufacturing facilities. Our operations and financial performance are affected by U.S. economic conditions such as macroeconomic conditions, credit market conditions and the level of consumer confidence. While the combination of improved economic conditions, the trend towards lower unemployment, higher wages and lower gasoline prices have contributed to improved consumer confidence, there is continued uncertainty about the strength of the economic recovery. If the current economic situation does not continue to improve or if it weakens, or if gasoline prices rebound, consumers may reduce spending, trade down to a less expensive mix of products or increasingly rely on food discounters, all of which could impact our sales growth. In addition, consumers’ perception or uncertainty related to the economic recovery and future fuel prices could also dampen overall consumer confidence and reduce demand for our product offerings. Both inflation and deflation affect our business. Food deflation could reduce sales growth and earnings, while food inflation could reduce gross profit margins. Several food items and categories, such as meat, eggs and dairy, experienced price deflation during 2017 and 2016, and such price deflation could continue in the future. We are unable to predict if the economy will continue to improve, or predict the rate at which the economy may improve, the direction of gasoline prices or if deflationary trends will occur. If the economy does not continue to improve or if it weakens or fuel prices increase, our business and results of operations could be adversely affected. We currently expect to achieve approximately $823 million of annual synergies related to the Safeway acquisition on a run-rate basis by the end of fiscal 2018, with remaining associated one-time costs of approximately $200 million, including approximately $65 million of Safeway integration-related capital expenditures. Inclusion of the projected synergies should not be viewed as a representation that we in fact will achieve this annual synergy target by the end of fiscal 2018. To the extent we fail to achieve these synergies, our results of operations may be impacted, and any such impact may be material. We achieved synergies from the Safeway acquisition of approximately $575 million during fiscal 2016 and approximately $675 million during fiscal 2017. We have identified various synergies including corporate and division overhead savings, our own brands, vendor funds, the conversion of Albertsons and NALP to Safeway’s IT systems, marketing and advertising cost reduction and operational efficiencies within our back office, distribution and manufacturing organizations. Actual synergies, the expenses and cash required to realize the synergies and the sources of the synergies could differ materially from these estimates, and we cannot assure you that we will achieve the full amount of synergies on the schedule anticipated, or that these synergy programs will not have other adverse effect on our business. In light of these significant uncertainties, you should not place undue reliance on our estimated synergies. Total debt, including both the current and long-term portions of capital lease obligations and net of deferred financing costs and debt discounts, decreased $462.1 million to $11.9 billion as of the end of fiscal 2017 compared to $12.3 billion as of the end of fiscal 2016. The decrease in fiscal 2017 was primarily due to the repurchase of certain NALP Notes and the repayment of term loans made in connection with our term loan repricing that occurred in June 2017. Our substantial indebtedness could have important consequences. For example it could: adversely affect the market price of our common stock; increase our vulnerability to general adverse economic and industry conditions; require us to dedicate a substantial portion of our cash flow from operations to payments on our indebtedness, thereby reducing the availability of our cash flow to fund working capital, capital expenditures and other general corporate purposes, including acquisitions and costs related to revenue opportunities in connection with the Mergers; limit our flexibility in planning for, or reacting to, changes in our business and the industry in which we operate; place us at a competitive disadvantage compared to our competitors that have less debt; and limit our ability to borrow additional funds. See "Debt Management" contained in "Liquidity and Financial Resources." In fiscal 2017, we spent approximately $1,547 million for capital expenditures, including approximately $200 million of Safeway integration-related capital expenditures. We expect to spend approximately $1,200 million in total for capital expenditures in fiscal 2018, or approximately 2.0% of our sales in fiscal 2017, including $65 million of Safeway integration-related capital expenditures. For fiscal 2017, we completed 166 upgrade and remodel projects and opened 15 new stores. For additional information on our capital expenditures, see the table under the caption "Projected fiscal 2018 Capital Expenditures" contained in "Liquidity and Financial Resources." Reflecting consumer preferences, we have a significant focus on perishable products. Sales of perishable products accounted for approximately 41.0% and 40.9% of our sales in fiscal 2017 and 2016, respectively. We could suffer significant perishable product inventory losses and significant lost revenue in the event of the loss of a major supplier or vendor, disruption of our distribution network, extended power outages, natural disasters or other catastrophic occurrences. Our stores rely heavily on sales of perishable products, and product supply disruptions may have an adverse effect on our profitability and operating results. We employed a diverse workforce of approximately 275,000, 273,000 and 274,000 associates as of February 24, 2018, February 25, 2017 and February 27, 2016, respectively. As of February 24, 2018, approximately 187,000 of our employees were covered by collective bargaining agreements. During fiscal 2018, collective bargaining agreements covering approximately 54,000 employees are scheduled to expire. If, upon the expiration of such collective bargaining agreements, we are unable to negotiate acceptable contracts with labor unions, it could increase our operating costs and disrupt our operations. A considerable number of our employees are paid at rates related to the federal minimum wage. Additionally, many of our stores are located in states, including California, where the minimum wage is greater than the federal minimum wage and where a considerable number of employees receive compensation equal to the state's minimum wage. For example, as of February 24, 2018, we employed approximately 71,000 associates in California, where the current minimum wage was recently increased to $11.00 per hour effective January 1, 2018, and will gradually increase to $15.00 per hour by January 1, 2022. In Maryland, where we employed approximately 8,000 associates as of February 24, 2018, the minimum wage was recently increased to $9.25 per hour, and will gradually increase to $10.10 per hour by July 1, 2018. Moreover, municipalities may set minimum wages above the applicable state standards. For example, the minimum wage in Seattle, Washington, where we employed approximately 2,000 associates as of February 24, 2018, was recently increased to $15.00 per hour effective January 1, 2017 for employers with more than 500 employees nationwide. In Chicago, Illinois, where we employed approximately 6,200 associates as of February 24, 2018, the minimum wage was recently increased to $11.00 per hour, and will gradually increase to $13.00 per hour by July 1, 2019. Any further increases in the federal minimum wage or the enactment of additional state or local minimum wage increases could increase our labor costs, which may adversely affect our results of operations and financial condition. We participate in various multiemployer pension plans for substantially all employees represented by unions that require us to make contributions to these plans in amounts established under collective bargaining agreements. In fiscal 2017, we contributed $431.2 million to multiemployer pension plans. During fiscal 2018, we expect to contribute approximately $450 million to multiemployer pension plans, subject to collective bargaining agreements. Our Strategy Our operating philosophy is simple: We run great stores with a relentless focus on sales growth. We believe there are significant opportunities to grow sales and enhance profitability and Free Cash Flow, through execution of the following strategies: Enhancing and Upgrading Our Fresh, Natural and Organic Offerings and Signature Products. We continue to enhance and upgrade our fresh, natural and organic offerings across our meat, produce, service deli and bakery departments to meet the changing tastes and preferences of our customers. We are rapidly growing our portfolio of USDA-certified organic products to include over 1,500 Own Brand products. In our recent acquisition of Plated, we added a meal kit company with leading technology and data capabilities, a strategic step for us as we continue to focus on innovation, personalization and customization. We also believe that continued innovation and expansion of our high-volume, high-quality and differentiated signature products will contribute to stronger sales growth. Expanding Our Own Brands Offerings. We continue to drive sales growth and profitability by extending our Own Brand offerings across our banners, including high-quality and recognizable brands such as O Organics, Open Nature, Signature and Lucerne. Our Own Brand products achieved over $11.5 billion in sales during fiscal 2017. Leveraging Our Effective and Scalable Loyalty Programs. We believe we can grow basket size and improve the shopping experience for our customers by expanding our just for U, MyMixx and fuel rewards programs. Over 13 million members are currently enrolled in our loyalty programs. We believe we can further enhance our merchandising and marketing programs by utilizing our customer analytics capabilities, including advanced digital marketing and mobile applications, to improve customer retention and provide targeted promotions to our customers. For example, our just for U and fuel rewards customers have demonstrated greater basket size, improved customer retention rates and an increased likelihood to redeem promotions offered in our stores. Providing Our Customers with Convenient Digital Solutions. We seek to provide our customers with the means to shop how, when and where they choose. As consumer preferences evolve towards greater convenience, we are improving our online offerings, including home delivery and “Drive Up and Go” services. We continue to enhance our delivery platform to offer more delivery options and windows across our store base, including early morning deliveries, same-day deliveries, one-to-two hour deliveries by Instacart and unattended deliveries. In addition, we are seeking to expand our curbside “Drive Up and Go” program in order to enable customers to conveniently pick up their goods on the way home or to the office. We have added to our delivery offerings with our recent alliance with Instacart, offering delivery in as little as an hour across key market areas. We believe our strategy of providing customers with a variety of in-store and online options that suit their varying individual needs will drive additional sales growth and differentiate us from many of our competitors. Capitalizing on Demand for Health and Wellness Services. We intend to leverage our portfolio of 1,777 pharmacies and our growing network of wellness clinics to capitalize on increasing customer demand for health and wellness services. Pharmacy customers are among our most loyal, and their average weekly spend on groceries is over 2.5x that of our non-pharmacy customers. We plan to continue to grow our pharmacy script counts through new patient prescription transfer programs and initiatives such as clinic, hospital and preferred network partnerships, which we believe will expand our access to more customers. To further enhance our pharmacy offerings, we recently acquired MedCart Specialty Pharmacy, a URAC- accredited specialty pharmacy with accreditation and license to operate in over 40 states, which will extend our ability to service our customers’ health needs. We believe that these efforts will drive sales and generate customer loyalty. Continuously Evaluating and Upgrading Our Store Portfolio. We plan to pursue a disciplined but committed capital allocation strategy to upgrade, remodel and relocate stores to attract customers to our stores and to increase store volumes. We opened 15 new stores in the both fiscal 2016 and 2017, and expect to open a total of 12 new stores in fiscal 2018. We completed 166 upgrade and remodel projects in fiscal 2017 and expect to complete 110 to 120 upgrade and remodel projects during fiscal 2018. We believe that our store base is in excellent condition, and we have developed a remodel strategy that is both cost-efficient and effective. In addition to store remodels, we continuously evaluate and optimize store formats to better serve the different customer demographics of each local community. We have identified approximately 300 stores across our divisions that we have started to re-merchandise to our “Premium” format, where we offer a greater assortment of unique items in our fresh and service departments, as well as more natural, organic and healthy products throughout the store. Additionally, we have started to reposition approximately 100 stores across our divisions from our “Premium” format to an “Ultra-Premium” format that also offers gourmet and artisanal products, upscale décor and experiential elements including walk-in wine cellars and wine and cheese tasting counters. Driving Innovation. We intend to drive traffic and sales growth through constant innovation. We will remain focused on identifying emerging trends in food and sourcing new and innovative products. We are adjusting our store layouts to accommodate a greater assortment of grab-and-go, individually packaged, and snack-sized meals. We are also rolling out new merchandising initiatives across our store base, including the introduction of meal kits, product sampling events, quality prepared foods and in-store dining. Sharing Best Practices Across Divisions. Our division leaders collaborate closely to ensure the rapid sharing of best practices. Recent examples include the expansion of our O Organics and Open Nature offerings across banners, the accelerated roll-out of signature products such as Albertsons’ in-store fresh-cut fruit and vegetables and implementing Safeway’s successful wine and floral shop strategies, with broader product assortments and new fixtures across many of our banners. We believe the combination of these actions and initiatives, together with the attractive industry trends will position us to achieve sales growth. Enhance Our Operating Margin. Our focus on sales growth provides an opportunity to enhance our operating margin by leveraging our fixed costs. We plan to realize further margin benefits through added scale from partnering with vendors and by achieving efficiencies in manufacturing and distribution. We are investing in our supply channel, including the automation of several of our distribution centers, in order to create efficiencies and reduce costs. In addition, we maintain a disciplined approach to expense management and budgeting. Implement Our Synergy Realization Plan. We currently expect to achieve $823 million in annual run-rate synergies by the end of fiscal 2018 from our acquisition of Safeway, with remaining associated one-time costs of approximately $200 million, including approximately $65 million of Safeway integration-related capital expenditures. Our detailed synergy plan was developed on a bottom-up, function-by-function basis by combined Albertsons and Safeway teams. The plan includes capturing opportunities from corporate and division cost savings, simplifying business processes and rationalizing headcount. By the end of fiscal 2018, we expect that Safeway’s information technology systems will support all of our stores, distribution centers and systems, including financial reporting and payroll processing, as we wind down our transition services agreement for our Albertsons, Acme, Jewel-Osco, Shaw’s and Star Market banners with SuperValu. We are extending the expansive and high-quality own brands program developed at Safeway across all of our banners. We believe our increased scale will help us to optimize and improve our vendor relationships. We also plan to achieve marketing and advertising savings from lower print, production and broadcast rates in overlapping regions and reduced agency spend. Finally, we intend to consolidate managed care provider reimbursement programs, increase vaccine penetration and leverage our combined scale. During fiscal 2016 and 2017 we achieved synergies from the Safeway acquisition of approximately $575 million and $675 million, respectively, principally from corporate and division overhead savings, our own brands vendor funds, the conversion of Albertsons and NALP onto Safeway’s IT systems, marketing and advertising cost reduction and operational efficiencies within our back office and distribution and manufacturing organizations. Selectively Grow Our Store Base Organically and Through Acquisition. We intend to continue to grow our store base organically through disciplined but committed investment in new stores. We opened 15 new stores during both fiscal 2016 and 2017 and completed 166 upgrade and remodel projects during fiscal 2017. We acquired 73 stores from A&P for our Acme banner and 35 stores from Haggen for our Albertsons banner during fiscal 2015, and we acquired an additional 29 stores from Haggen during fiscal 2016, of which 15 operate under the Haggen banner. We evaluate acquisition opportunities on an ongoing basis as we seek to strengthen our competitive position in existing markets or expand our footprint into new markets. We believe our healthy balance sheet and decentralized structure provides us with strategic flexibility and a strong platform to make acquisitions. We believe our successful track record of integration and synergy delivery provides us with an opportunity to further enhance sales growth, leverage our cost structure and increase profitability and Free Cash Flow through selected acquisitions. On November 16, 2017, we acquired an equity interest in El Rancho, a Texas-based specialty grocer with 16 stores that focuses on Latino customers. The agreement with El Rancho provides us with an opportunity to invest in the fast-growing Latino grocery sector, and complements our successful operation of a variety of store banners in neighborhoods with significant Latino populations. Consistent with this strategy, we regularly evaluate potential acquisition opportunities, including ones that would be significant to us, and we are currently participating in processes regarding several potential acquisition opportunities, including ones that would be significant to us. Fiscal 2017 Highlights • Announced merger agreement with Rite Aid Corporation ("Rite Aid"), creating a leader in food, health and wellness • Fourth quarter fiscal 2017 identical store sales were positive at 0.6% • Accelerated growth of eCommerce and digital offerings, including expansion of 'Drive-Up and Go' • Announced alliance with Instacart for same-day deliveries offered in over 1,300 stores • Acquired DineInFresh, Inc. ("Plated"), a premier provider of meal kits, and initiated roll-out of Plated meal kits in-store • Increased penetration in Own Brands by 60 basis points to 23% • Increased registered households in Company loyalty programs by 24% • Acquired an equity interest in El Rancho (as defined herein), a Texas-based Hispanic specialty grocer • Acquired MedCart Specialty Pharmacy • Supported local communities in hurricane relief efforts Reorganization Transactions Prior to December 3, 2017, ACI had no material assets or operations. On December 3, 2017, Albertsons Companies LLC ("ACL") and its parent, AB Acquisition LLC, a Delaware limited liability company ("AB Acquisition"), completed a reorganization of its legal entity structure whereby the existing equityholders of AB Acquisition each contributed their equity interests in AB Acquisition to Albertsons Investor Holdings LLC ("Albertsons Investor"), and KIM ACI, LLC ("KIM ACI"). In exchange, equityholders received a proportionate share of units in Albertsons Investor and KIM ACI, respectively. Albertsons Investor and KIM ACI then contributed all of the AB Acquisition equity interests they received to ACI in exchange for common stock issued by ACI. As a result, Albertsons Investor and KIM ACI became the parents of ACI owning all of its outstanding common stock with AB Acquisition and its subsidiary, ACL, becoming wholly-owned subsidiaries of ACI. On February 25, 2018, ACL merged with and into ACI, with ACI as the surviving corporation (such transactions, collectively, the "Reorganization Transactions"). Prior to February 25, 2018, substantially all of the assets and operations of ACI were those of its subsidiary, ACL. The Reorganization Transactions were accounted for as a transaction between entities under common control, and accordingly, there was no change in the basis of the underlying assets and liabilities. The Consolidated Financial Statements are reflective of the changes that occurred as a result of the Reorganization Transactions. Prior to February 25,2018, the Consolidated Financial Statements of ACI reflect the net assets and operations of ACL. Stores The following table shows stores operating, acquired, opened, divested and closed during the periods presented: (1) Excludes acquired stores not yet re-opened as of the end of each respective period. The following table summarizes our stores by size: (1) In millions, reflects total square footage of retail stores operating at the end of the period. ACQUISITIONS AND OTHER INVESTMENTS Pending Rite Aid Merger On February 18, 2018, we entered into a definitive merger agreement with Rite Aid, one of the nation's leading drugstore chains. At the effective time of the merger, each share of Rite Aid common stock issued and outstanding at such time will be converted into the right to receive 0.1000 of a share of ACI common stock, plus at the Rite Aid stockholder's election, either (i) an amount in cash equal to $0.1832 per share of Rite Aid common stock, without interest, or (ii) 0.0079 of a share of ACI common stock per share of Rite Aid common stock. Subject to the approval of Rite Aid's stockholders, and other customary closing conditions, the merger is expected to close early in the second half of calendar 2018. In connection with the proposed merger, we received a debt commitment letter pursuant to which, among other things, certain institutions have committed to provide ACI with (i) $4,667 million of commitments to a new $5,000 million aggregate principal amount best efforts asset-based revolving credit facility; (ii) incremental commitments under our existing asset-based loan facility in an aggregate principal amount of $1,000 million in the event that the Best-Efforts ABL Facility does not become effective on the closing date; (iii) a new asset-based term loan facility in an aggregate principal amount of $1,500 million; and (iv) a new secured bridge loan facility in an aggregate principal amount of $500 million less the gross proceeds received by us of new senior notes issued prior to the closing of the Mergers, in each case on the terms and subject to the conditions set forth in the debt commitment letter. The proceeds of the financing will be used, among other things, to partially refinance certain of Rite Aid’s existing indebtedness that is outstanding as of the closing of the Mergers. MedCart On May 31, 2017, we acquired MedCart Specialty Pharmacy, a URAC-accredited specialty pharmacy with accreditation and license to operate in over 40 states, which extends our ability to service our customers’ health needs. Plated On September 20, 2017, we acquired Plated, a provider of meal kit services. The deal advanced a shared strategy to reinvent the way consumers discover, purchase, and experience food. In teaming up with Plated, we added a meal kit company with leading technology and data capabilities. El Rancho On November 16, 2017, we acquired a 45% equity interest in each of Mexico Foods Parent LLC and La Fabrica Parent LLC ("El Rancho"), a Texas-based specialty grocer with 16 stores that focuses on Latino customers. We have the option to acquire the remaining 55% of El Rancho at any time until six months after the delivery of El Rancho’s financial results for the fiscal year ended December 31, 2021. If we elect to exercise the option to acquire the remaining equity of El Rancho, the price to be paid by us for the remaining equity will be calculated using a predetermined market-based formula. Our equity interest in El Rancho expands our presence in the fast-growing Latino grocery sector and complements our successful operation of a variety of store banners in neighborhoods with significant Latino populations. Casa Ley During the fourth quarter of fiscal 2017, we completed the sale of our equity method investment in Casa Ley, S.A. de C.V. ("Casa Ley") and distributed approximately $0.934 in cash per Casa Ley CVR (or approximately $222 million in the aggregate) pursuant to the terms of the Casa Ley CVR agreement. Haggen Transaction During the fourth quarter of fiscal 2014, in connection with the acquisition of Safeway, we announced that we had entered into agreements to sell 168 stores as required by the Federal Trade Commission (the "FTC") as a condition of closing the Safeway acquisition. We sold 146 of these stores to Haggen Holdings, LLC ("Haggen"). On September 8, 2015, Haggen commenced a case under Chapter 11 of the U.S. Bankruptcy Code in the United States Bankruptcy Court for the District of Delaware. After receiving FTC and state attorneys general clearance, and Bankruptcy Court approval, during the fourth quarter of fiscal 2015, we re-acquired 35 stores from Haggen for an aggregate purchase price of $32.6 million. Haggen also secured Bankruptcy Court approval for bidding procedures for the sale of 29 additional stores. On March 25, 2016, we entered into a purchase agreement to acquire the 29 additional stores, which included 15 stores originally sold to Haggen as part of the FTC divestitures, and certain trade names and other intellectual property, for an aggregate purchase price of approximately $114 million. We completed the acquisition of these 29 stores on June 23, 2016 (such acquisition, together with the acquisition of 35 stores from Haggen during fiscal 2015, the "Haggen Transaction"). A&P Transaction In the fourth quarter of fiscal 2015, our indirect wholly owned subsidiary, Acme Markets, completed its acquisition of 73 stores from A&P (the "A&P Transaction"). The purchase price for the 73 stores, including the cost of acquired inventory, was $292.7 million. The acquired stores, which are principally located in the northern New York City suburbs, northern New Jersey and the greater Philadelphia area, are complementary to Acme Markets' existing store and distribution base and were re-bannered as Acme stores. RESULTS OF OPERATIONS The following table and related discussion sets forth certain information and comparisons regarding the components of our Consolidated Statements of Operations for fiscal 2017, fiscal 2016 and fiscal 2015, respectively (in millions): Identical Store Sales, Excluding Fuel Identical store sales, on an actual basis, is defined as stores operating during the same period in both the current year and the prior year, comparing sales on a daily basis, excluding fuel. Acquired stores become identical on the one-year anniversary date of their acquisition. Identical store sales results, on an actual basis, for the past three fiscal years were as follows: Our identical store sales decrease in fiscal 2017 was driven by a decrease of 2.9% in customer traffic partially offset by an increase of 1.6% in average ticket size. During fiscal 2016 and the first half of fiscal 2017, our identical store sales were negatively impacted by food price deflation in certain categories, including meat, eggs and dairy, together with selective investments in price. Our fourth quarter of fiscal 2017 identical store sales were positive at 0.6%, which reflected the benefit from improvements in customer traffic trends and an increase in average ticket. We anticipate overall identical store sales growth of 1.5% to 2.0% during fiscal 2018 with such growth being weighted more to the second half of fiscal 2018. Operating Results Overview Net income was $46.3 million in fiscal 2017 compared to net loss of $373.3 million in fiscal 2016, an increase of $419.6 million. This improvement was primarily attributable to the Income tax benefit of $963.8 million, a $129.0 million reduction in interest expense and incremental synergies related to the Safeway acquisition, partially offset by a decrease in operating income of $645.4 million. The decrease in operating income was primarily driven by lower gross profit, goodwill and other asset impairment charges, higher employee related costs and increased depreciation and amortization expense. The declines in identical store sales and operating results in fiscal 2017 compared to fiscal 2016 were driven by our performance during the first three quarters of fiscal 2017 as we achieved increases in identical store sales and improved operating results in the fourth quarter of fiscal 2017 compared to the fourth quarter of fiscal 2016. We believe the recent fourth quarter improvements in the trends and operating results of our business are attributable, in part, to our selective investments in price and the continuously increasing offerings we are providing to our customers and will continue into fiscal 2018. Net Sales and Other Revenue Net sales and other revenue increased $246.4 million, or 0.4%, from $59,678.2 million in fiscal 2016 to $59,924.6 million in fiscal 2017. The components of the change in Net sales and other revenue for fiscal 2017 were as follows (in millions): (1) Primarily relates to changes in non-identical store sales and other revenue. The primary increase in Net sales and other revenue in fiscal 2017 as compared to fiscal 2016 was driven by an increase of $589.4 million from new stores and acquisitions, net of store closings, and an increase of $411.2 million in fuel sales primarily driven by higher average retail pump prices, partially offset by a decline of $740.4 million from our 1.3% decline in identical store sales. Net sales and other revenue increased $944.2 million, or 1.6%, from $58,734.0 million in fiscal 2015 to $59,678.2 million in fiscal 2016. The components of the change in net sales and other revenue for fiscal 2016 were as follows (in millions): (1) Primarily relates to changes in non-identical store sales and other revenue. The primary increase in Net sales and other revenue in fiscal 2016 as compared to fiscal 2015 was driven by an increase of $1,843.4 million from the acquired A&P and Haggen stores, partially offset by a decline of $213.3 million from our 0.4% decline in identical store sales, a decline of $444.5 million in sales related to stores sold as part of the FTC divestiture process and $261.4 million in lower fuel sales driven by lower average retail pump prices. Gross Profit Gross profit represents the portion of sales and other revenue remaining after deducting the cost of goods sold during the period, including purchase and distribution costs. These costs include inbound freight charges, purchasing and receiving costs, warehouse inspection costs, warehousing costs and other costs associated with our distribution network. Advertising, promotional expenses and vendor allowances are also components of cost of goods sold. Gross profit margin decreased 60 basis points to 27.3% in fiscal 2017 compared to 27.9% in fiscal 2016. Excluding the impact of fuel, the gross profit margin decreased 50 basis points. The decrease in fiscal 2017 as compared to fiscal 2016 was primarily attributable to our investment in promotions and price and higher shrink expense as a percentage of sales, which was partially due to system conversions related to our integration. Gross profit margin increased 60 basis points to 27.9% in fiscal 2016 compared to 27.3% in fiscal 2015. Excluding the impact of fuel, the gross profit margin increased 50 basis points. The increase was primarily attributable to synergies achieved as part of the Safeway integration related to the deployment of our own brand products across our Albertsons and New Albertsons, L.P. ("NALP") stores and improved vendor pricing and savings related to the consolidation of our distribution network. These increases were partially offset by higher shrink expense as a percentage of sales during fiscal 2016 compared to fiscal 2015. Selling and Administrative Expenses Selling and administrative expenses consist primarily of store level costs, including wages, employee benefits, rent, depreciation and utilities, in addition to certain back-office expenses related to our corporate and division offices. Selling and administrative expenses increased 30 basis points to 27.1% of Net sales and other revenue in fiscal 2017 from 26.8% in fiscal 2016. Excluding the impact of fuel, Selling and administrative expenses as a percentage of Net sales and other revenue increased 40 basis points during fiscal 2017 compared to fiscal 2016. Increased employee wage and benefit costs, asset impairments and lease exit costs, higher depreciation and amortization expense and higher store related costs during fiscal 2017 compared to fiscal 2016 were offset by lower pension costs and increased Safeway acquisition synergies. Increased employee wage and benefit costs and higher store related costs were primarily attributable to deleveraging of sales on fixed costs. Higher asset impairments and lease exit costs were primarily related to asset impairments in underperforming and closed stores. These increases were partially offset by lower pension expense, net driven by a $25.4 million settlement gain during fiscal 2017 primarily due to an annuity settlement on a portion of our defined benefit pension obligation. Selling and administrative expenses increased 10 basis points to 26.8% of Net sales and other revenue in fiscal 2016 from 26.7% in fiscal 2015. Excluding the impact of fuel, Selling and administrative expenses as a percentage of Net sales and other revenue was flat during fiscal 2016 compared to fiscal 2015. Increased depreciation and amortization expense in addition to higher pension and employee wage and benefit costs during fiscal 2016 compared to fiscal 2015 were offset by gains on property dispositions, a decrease in acquisition and integration costs and increased Safeway acquisition synergies in fiscal 2016 compared to fiscal 2015. The increase in pension expense is primarily driven by the $78.9 million charge related to the acquisition of Collington Services, LLC ("Collington") from C&S Wholesale Grocers, Inc. during fiscal 2016. The increase in depreciation and amortization expense is primarily driven by an increase in property, equipment and intangibles balances primarily related to the A&P and Haggen transactions and capital expenditures. Interest Expense, Net Interest expense, net was $874.8 million in fiscal 2017, $1,003.8 million in fiscal 2016 and $950.5 million in fiscal 2015. The decrease in Interest expense, net for fiscal 2017 compared to fiscal 2016 is primarily due to lower average interest rates on outstanding borrowings reflecting the benefit of our refinancing transactions during fiscal 2016 in addition to higher write off of deferred financing costs in fiscal 2016 related to the refinancing transactions. The following details our components of Interest expense, net for the respective fiscal years (in millions): The weighted average interest rate during the year was 6.5%, excluding amortization of debt discounts and deferred financing costs. The weighted average interest rate during fiscal 2016 and fiscal 2015 was 6.8%. (Gain) Loss on Debt Extinguishment During fiscal 2017, we repurchased NALP Notes with a par value of $160.0 million and a book value of $140.2 million for $135.5 million plus accrued interest of $3.7 million (the "NALP Notes Repurchase"). In connection with the NALP Notes Repurchase, we recorded a gain on debt extinguishment of $4.7 million. On June 24, 2016, a portion of the net proceeds from the issuance of the 2024 Notes was used to fully redeem $609.6 million of 2022 Notes (the "Redemption"). In connection with the Redemption, we recorded a $111.7 million loss on debt extinguishment comprised of an $87.7 million make-whole premium and a $24.0 million write off of deferred financing costs and original issue discount. Other Expense (Income) For fiscal 2017, other expense was $42.5 million primarily driven by changes in our equity method investment in Casa Ley, changes in the fair value of the contingent value rights, which we refer to as CVRs, and gains and losses on the sale of investments. For fiscal 2016, other income was $11.4 million primarily driven by gains on the sale of certain investments and changes in our equity method investments. For fiscal 2015, other income was $7.0 million primarily driven by equity in the earnings of Casa Ley. Income Taxes Income tax was a benefit of $963.8 million in fiscal 2017, $90.3 million in fiscal 2016, and $39.6 million in fiscal 2015. Prior to the Reorganization Transactions, a substantial portion of the businesses and assets were held and operated by limited liability companies, which are generally not subject to entity-level federal or state income taxation. On December 22, 2017, the Tax Cuts and Jobs Act (the "Tax Act") was signed into law and based on our current review of the Tax Act, we expect it to result in a significant ongoing benefit to us, primarily as the result of the reduction in the corporate tax rate from 35% to 21% and the ability to accelerate depreciation deductions for qualified property purchases. Beginning in fiscal 2018, we expect our effective tax rate to be in the mid-twenties before discrete items. The components of the change in income taxes for the last three fiscal years were as follows: The income tax benefit in fiscal 2017 includes a net $218.0 million non-cash benefit from the reversal of a valuation allowance during fiscal 2017 and a net non-cash benefit of $430.4 million in the fourth quarter of fiscal 2017 as a result of a reduction in net deferred tax liabilities due to the lower corporate income tax rate from the enactment of the Tax Act, partially offset by an increase of $46.7 million in net deferred tax liabilities from our limited liability companies related to the Reorganization Transactions. Adjusted EBITDA EBITDA, Adjusted EBITDA and Free Cash Flow (collectively, the "Non-GAAP Measures") are performance measures that provide supplemental information we believe is useful to analysts and investors to evaluate our ongoing results of operations, when considered alongside other GAAP measures such as net income, operating income, gross profit and Net cash provided by operating activities. These Non-GAAP Measures exclude the financial impact of items management does not consider in assessing our ongoing operating performance, and thereby facilitate review of our operating performance on a period-to-period basis. Other companies may have different capital structures or different lease terms, and comparability to our results of operations may be impacted by the effects of acquisition accounting on our depreciation and amortization. As a result of the effects of these factors and factors specific to other companies, we believe EBITDA, Adjusted EBITDA and Free Cash Flow provide helpful information to analysts and investors to facilitate a comparison of our operating performance to that of other companies. We also use Adjusted EBITDA, as further adjusted for additional items defined in our debt instruments, for board of director and bank compliance reporting. The presentation of Non-GAAP Measures should not be construed as an inference that our future results will be unaffected by unusual or non-recurring items. For fiscal 2017, Adjusted EBITDA was $2.4 billion, or 4.0% of Net sales and other revenue compared to $2.8 billion, or 4.7% of Net sales and other revenue, for fiscal 2016. The decrease in Adjusted EBITDA primarily reflects lower gross profit, higher employee wage and benefit costs and deleveraging of sales on fixed costs in fiscal 2017 compared to fiscal 2016. The following is a reconciliation of Net income (loss) to Adjusted EBITDA (in millions): (1) Primarily includes costs related to acquisitions, integration of acquired businesses, expenses related to management fees paid in connection with acquisition and financing activities, adjustments to tax indemnification assets and liabilities and losses on acquired contingencies in connection with the Safeway acquisition. (2) Fiscal 2017 includes asset impairment losses of $100.9 million primarily related to underperforming stores. Fiscal 2016 includes a net gain of $42.9 million related to the disposition of a portfolio of surplus properties. Fiscal 2015 includes losses of $30.6 million related to leases assigned to Haggen as part of the FTC-mandated divestitures that were subsequently rejected during the Haggen bankruptcy proceedings and additional losses of $41.1 million related to the Haggen divestitures and its related bankruptcy. (3) Fiscal 2016 charge to pension expense, net related to the settlement of a pre-existing contractual relationship and assumption of the pension plan related to the Collington acquisition. (4) Includes costs related to facility closures and the transition to our decentralized operating model. (5) Primarily includes lease adjustments related to deferred rents and deferred gains on leases. Also includes amortization of unfavorable leases on acquired Safeway surplus properties, estimated losses related to the security breach, changes in our equity method investment in Casa Ley, fair value adjustments to CVRs, foreign currency translation gains, costs related to our initial public offering and pension expense (exclusive of the charge related to the Collington acquisition) in excess of cash contributions. The following is a reconciliation of Net cash provided by operating activities to Free Cash Flow, which we define as Adjusted EBITDA less capital expenditures (in millions): LIQUIDITY AND FINANCIAL RESOURCES The following table sets forth the major sources and uses of cash and our cash and cash equivalents at the end of each period (in millions): Net Cash Provided By Operating Activities Net cash provided by operating activities was $1,018.8 million during fiscal 2017 compared to net cash provided by operating activities of $1,813.5 million during fiscal 2016. The decrease in net cash flow from operating activities during fiscal 2017 compared to fiscal 2016 was primarily due to the decrease in Adjusted EBITDA, principally reflecting the results in fiscal 2017 compared to fiscal 2016, and changes in working capital primarily related to accounts payable and accrued liabilities and the $42.3 million payment on the Rodman litigation (as further described herein), partially offset by a decrease in interest and income taxes paid of $110.7 million and $113.4 million, respectively. Fiscal 2016 cash provided by operating activities also includes a correction in the classification of certain book overdrafts resulting in an increase of $139.2 million. Net cash provided by operating activities was $1,813.5 million during fiscal 2016 compared to net cash provided by operating activities of $901.6 million during fiscal 2015. The $911.9 million increase in net cash flow from operating activities during fiscal 2016 compared to fiscal 2015 was primarily due to an increase in operating income of $238.8 million, a Safeway acquisition settlement payment of $133.7 million in fiscal 2015 and changes in working capital primarily related to inventory and accounts payable partially offset by an increase in income taxes paid of $207.5 million. Fiscal 2016 cash provided by operating activities also includes the correction in the classification of certain book overdrafts discussed above. Net Cash Used In Investing Activities Net cash used in investing activities during fiscal 2017 was $469.6 million primarily due to payments for property and equipment, including lease buyouts, of $1,547.0 million, which includes approximately $200 million of Safeway integration-related capital expenditures, and payments for business acquisitions of $148.8 million partially offset by proceeds from the sale of assets of $939.2 million and proceeds from the sale of our equity method investment in Casa Ley of $344.2 million. Asset sale proceeds primarily relate to the sale and subsequent leaseback of 94 store properties during the third and fourth quarters of fiscal 2017. Net cash used in investing activities during fiscal 2016 was $1,076.2 million primarily due to payments for property and equipment, including lease buyouts, of $1,414.9 million, which includes approximately $250 million of Safeway integration-related capital expenditures, and payments for business acquisitions of $220.6 million partially offset by proceeds from the sale of assets of $477.0 million. Asset sale proceeds include the sale and 36-month leaseback of two distribution centers in Southern California and the sale of a portfolio of surplus properties. Net cash used in investing activities was $811.8 million in fiscal 2015 primarily due to the merger consideration paid in connection with the Safeway acquisition appraisal settlement, purchase consideration paid for the A&P Transaction and the Haggen Transaction and cash paid for capital expenditures, partially offset by proceeds from the sale of our FTC-mandated divestitures in connection with the Safeway acquisition and a decrease in restricted cash due to the elimination of certain collateral requirements. In fiscal 2018, we expect to spend approximately $1,200 million in capital expenditures, including approximately $65 million of Safeway integration-related capital expenditures, as follows (in millions): Net Cash Used In Financing Activities Net cash used in financing activities was $1,098.1 million in fiscal 2017 due primarily to payments on long-term debt and capital lease obligations of $977.8 million, payment of the Casa Ley CVR and a member distribution of $250.0 million, partially offset by proceeds from the issuance of long-term debt. Net cash used in financing activities was $97.8 million in fiscal 2016 due primarily to payments on long-term debt and capital lease obligations, partially offset by proceeds from the issuance of long-term debt. Net cash used in financing activities was $635.9 million in fiscal 2015 due primarily to payments on our asset-based revolving credit facility and term loan borrowings from the proceeds of the FTC-mandated divestitures, partially offset by $300.0 million in borrowings to fund the A&P Transaction. Debt Management Total debt, including both the current and long-term portions of capital lease obligations and net of debt discounts and deferred financing costs, decreased $462.1 million to $11.9 billion as of the end of fiscal 2017 compared to $12.3 billion as of the end of fiscal 2016. The decrease in fiscal 2017 was primarily due to the repurchase of the NALP Notes and the repayment made in connection with the term loan repricing described below. Outstanding debt, including current maturities and net of debt discounts and deferred financing costs, principally consisted of (in millions): On June 16, 2017, we repaid $250.0 million of the existing term loans. In addition, on June 27, 2017, we entered into a repricing amendment to the term loan agreement which established three new term loan tranches. The new tranches currently consist of $2,998.6 million of a new Term B-4 Loan, $1,133.6 million of a new Term B-5 Loan and $1,588.0 million of a new Term B-6 Loan (collectively, the "New Term Loans"). The (i) new Term B-4 Loan will mature on August 25, 2021, and has an interest rate of LIBOR, subject to a 0.75% floor, plus 2.75%, (ii) new Term B-5 Loan will mature on December 21, 2022, and has an interest rate of LIBOR, subject to a 0.75% floor, plus 3.00%, and (iii) new Term B-6 Loan will mature on June 22, 2023, and has an interest rate of LIBOR, subject to a 0.75% floor, plus 3.00%. The New Term Loans, together with cash on hand, were used to repay the term loans then outstanding under the term loan agreement. See Note 8 - Long-term debt in our consolidated financial statements, included elsewhere in this document, for additional information related to our outstanding debt. During fiscal 2017, certain subsidiaries sold 94 of our store properties for an aggregate purchase price, net of closing costs, of approximately $962 million. In connection with the sale and subsequent leaseback, we entered into lease agreements for each of the properties for initial terms of 20 years with varying multiple five-year renewal options. The aggregate initial annual rent payments for the 94 properties will be approximately $65 million, with scheduled rent increases occurring generally every one or five years over the initial 20-year term. We qualified for sale-leaseback and operating lease accounting on 80 of the store properties and recorded a deferred gain of $360.1 million, which is being amortized over the respective lease periods. The remaining 14 stores did not qualify for sale-leaseback accounting primarily due to continuing involvement with adjacent properties that have not been legally subdivided from the store properties. We expect these store properties to qualify for sale-leaseback accounting once the adjacent properties have been legally subdivided. The financing lease liability recorded for the 14 store properties was $133.4 million. Liquidity and Factors Affecting Liquidity We estimate our liquidity needs over the next fiscal year to be in the range of $3.75 billion to $4.25 billion, which includes anticipated requirements for working capital, capital expenditures, interest payments and scheduled principal payments of debt, operating leases, capital leases and our TSA agreements with SUPERVALU INC. ("SuperValu"). Based on current operating trends, we believe that cash flows from operating activities and other sources of liquidity, including borrowings under our ABL Facility, will be adequate to meet our liquidity needs for the next 12 months and for the foreseeable future. We believe we have adequate cash flow to continue to maintain our current debt ratings and to respond effectively to competitive conditions. In addition, we may enter into refinancing transactions from time to time. There can be no assurance, however, that our business will continue to generate cash flow at or above current levels or that we will maintain our ability to borrow under our ABL Facility. See "Contractual Obligations" for a more detailed description of our commitments as of the end of fiscal 2017. As of February 24, 2018, we had no borrowings outstanding under our ABL Facility and total availability of approximately $3.1 billion (net of letter of credit usage). As of February 25, 2017, we had no borrowings outstanding under our ABL Facility and total availability of approximately $3.0 billion (net of letter of credit usage). The ABL Facility contains no financial maintenance covenants unless and until (a) excess availability is less than (i) 10% of the lesser of the aggregate commitments and the then-current borrowing base at any time or (ii) $250 million at any time or (b) an event of default is continuing. If any such event occurs, we must maintain a fixed charge coverage ratio of 1.0:1.0 from the date such triggering event occurs until such event of default is cured or waived and/or the 30th day that all such triggers under clause (a) no longer exist. During fiscal 2017 and fiscal 2016, there were no financial maintenance covenants in effect under the ABL Facility because the conditions listed above (and similar conditions in our refinanced asset-based revolving credit facilities) had not been met. CONTRACTUAL OBLIGATIONS The table below presents our significant contractual obligations as of February 24, 2018 (in millions) (1): (1) The contractual obligations table excludes funding of pension and other postretirement benefit obligations, which totaled $21.9 million in fiscal 2017 and is expected to total $55.8 million in fiscal 2018. This table excludes contributions under various multi-employer pension plans, which totaled $431.2 million in fiscal 2017 and is expected to total approximately $450 million in fiscal 2018. (2) Long-term debt amounts exclude any debt discounts and deferred financing costs. See Note 8 - Long-term debt in our consolidated financial statements, included elsewhere in this document, for additional information. (3) Amounts include contractual interest payments using the interest rate as of February 24, 2018 applicable to our variable interest term debt instruments and stated fixed rates for all other debt instruments, excluding interest rate swaps. See Note 8 - Long-term debt in our consolidated financial statements, included elsewhere in this document, for additional information. (4) Represents the minimum rents payable under operating and capital leases, excluding common area maintenance, insurance or tax payments, for which we are obligated. (5) Consists of self-insurance liabilities, which have not been reduced by insurance-related receivables, and deferred cash consideration related to Plated. Excludes the $160.1 million of assumed withdrawal liabilities related to Safeway's previous closure of its Dominick's division, and excludes the unfunded pension and postretirement benefit obligation of $564.7 million. The amount of unrecognized tax benefits of $356.0 million as of February 24, 2018 has been excluded from the contractual obligations table because a reasonably reliable estimate of the timing of future tax settlements cannot be determined. Excludes contingent consideration because the timing and settlement is uncertain. Also excludes deferred tax liabilities and certain other deferred liabilities that will not be settled in cash and other lease-related liabilities already reflected as operating lease commitments. (6) Represents minimum contractual commitments expected to be paid under the SuperValu TSA and the wind-down agreement, executed on April 16, 2015. See Note 13 - Related parties and other relationships in our consolidated financial statements, included elsewhere in this document, for additional information. (7) Purchase obligations include various obligations that have specified purchase commitments. As of February 24, 2018, future purchase obligations primarily relate to fixed asset, marketing and information technology commitments, including fixed price contracts. In addition, not included in the contractual obligations table are supply contracts to purchase product for resale to consumers which are typically of a short-term nature with limited or no purchase commitments. We also enter into supply contracts which typically include either volume commitments or fixed expiration dates, termination provisions and other customary contractual considerations. The supply contracts that are cancelable have not been included above. Guarantees We are party to a variety of contractual agreements pursuant to which it may be obligated to indemnify the other party for certain matters. These contracts primarily relate to our commercial contracts, operating leases and other real estate contracts, trademarks, intellectual property, financial agreements and various other agreements. Under these agreements, we may provide certain routine indemnifications relating to representations and warranties (for example, ownership of assets, environmental or tax indemnifications) or personal injury matters. The terms of these indemnifications range in duration and may not be explicitly defined. We believe that if it were to incur a loss in any of these matters, the loss would not have a material effect on our financial statements. We are liable for certain operating leases that were assigned to third parties. If any of these third parties fail to perform their obligations under the leases, we could be responsible for the lease obligation. See Note 14 - Commitments and contingencies and off balance sheet arrangements in our Consolidated Financial Statements, included elsewhere in this document, for additional information. Because of the wide dispersion among third parties and the variety of remedies available, we believe that if an assignee became insolvent it would not have a material effect on our financial condition, results of operations or cash flows. In the ordinary course of business, we enter into various supply contracts to purchase products for resale and purchase and service contracts for fixed asset and information technology commitments. These contracts typically include volume commitments or fixed expiration dates, termination provisions and other standard contractual considerations. Letters of Credit We had letters of credit of $576.8 million outstanding as of February 24, 2018. The letters of credit are maintained primarily to support our performance, payment, deposit or surety obligations. We typically pay bank fees of 1.25% plus a fronting fee of 0.125% on the face amount of the letters of credit. NEW ACCOUNTING POLICIES NOT YET ADOPTED See Note 1 - Description of business, basis of presentation and summary of significant accounting policies in our consolidated financial statements, included elsewhere in this document, for new accounting pronouncements which have not yet been adopted. CRITICAL ACCOUNTING POLICIES The preparation of consolidated financial statements in conformity with GAAP requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities as of the date of the consolidated financial statements and the reported amounts of revenues and expenses during the reporting period. Actual results could differ from those estimates. We have chosen accounting policies that we believe are appropriate to report accurately and fairly our operating results and financial position, and we apply those accounting policies in a fair and consistent manner. See Note 1 - Description of business, basis of presentation and summary of significant accounting policies in our consolidated financial statements, included elsewhere in this document, for a discussion of our significant accounting policies. Management believes the following critical accounting policies reflect its more subjective or complex judgments and estimates used in the preparation of our consolidated financial statements. Vendor Allowances Consistent with standard practices in the retail industry, we receive allowances from many of the vendors whose products we buy for resale in our stores. These vendor allowances are provided to increase the sell-through of the related products. We receive vendor allowances for a variety of merchandising activities: placement of the vendors' products in our advertising; display of the vendors' products in prominent locations in our stores; supporting the introduction of new products into our retail stores and distribution systems; exclusivity rights in certain categories; and compensation for temporary price reductions offered to customers on products held for sale at retail stores. We also receive vendor allowances for buying activities such as volume commitment rebates, credits for purchasing products in advance of their need and cash discounts for the early payment of merchandise purchases. The majority of the vendor allowance contracts have terms of less than one year. We recognize vendor allowances for merchandising activities as a reduction of cost of sales when the related products are sold. Vendor allowances that have been earned because of completing the required performance under the terms of the underlying agreements but for which the product has not yet been sold are recognized as reductions of inventory. The amount and timing of recognition of vendor allowances as well as the amount of vendor allowances to be recognized as a reduction of ending inventory require management judgment and estimates. We determine these amounts based on estimates of current year purchase volume using forecast and historical data and a review of average inventory turnover data. These judgments and estimates affect our reported gross profit, operating earnings (loss) and inventory amounts. Our historical estimates have been reliable in the past, and we believe the methodology will continue to be reliable in the future. Based on previous experience, we do not expect significant changes in the level of vendor support. Self-Insurance Liabilities We are primarily self-insured for workers' compensation, property, automobile and general liability. The self-insurance liability is undiscounted and determined actuarially, based on claims filed and an estimate of claims incurred but not yet reported. We have established stop-loss amounts that limit our further exposure after a claim reaches the designated stop-loss threshold. In determining our self-insurance liabilities, we perform a continuing review of our overall position and reserving techniques. Since recorded amounts are based on estimates, the ultimate cost of all incurred claims and related expenses may be more or less than the recorded liabilities. Any actuarial projection of self-insured losses is subject to a high degree of variability. Litigation trends, legal interpretations, benefit level changes, claim settlement patterns and similar factors influenced historical development trends that were used to determine the current year expense and, therefore, contributed to the variability in the annual expense. However, these factors are not direct inputs into the actuarial projection, and thus their individual impact cannot be quantified. Long-Lived Asset Impairment We regularly review our individual stores' operating performance, together with current market conditions, for indications of impairment. When events or changes in circumstances indicate that the carrying value of an individual store's assets may not be recoverable, its future undiscounted cash flows are compared to the carrying value. If the carrying value of store assets to be held and used is greater than the future undiscounted cash flows, an impairment loss is recognized to record the assets at fair value. For property and equipment held for sale, we recognize impairment charges for the excess of the carrying value plus estimated costs of disposal over the fair value. Fair values are based on discounted cash flows or current market rates. These estimates of fair value can be significantly impacted by factors such as changes in the current economic environment and real estate market conditions. Long-lived asset impairment losses were $100.9 million, $46.6 million and $40.2 million in fiscal 2017, 2016 and 2015, respectively. Business Combination Measurements In accordance with applicable accounting standards, we estimate the fair value of acquired assets and assumed liabilities as of the acquisition date of business combinations. These fair value adjustments are input into the calculation of goodwill related to the excess of the purchase price over the fair value of the tangible and identifiable intangible assets acquired and liabilities assumed in the acquisition. The fair value of assets acquired and liabilities assumed are determined using market, income and cost approaches from the perspective of a market participant. The fair value measurements can be based on significant inputs that are not readily observable in the market. The market approach indicates value for a subject asset based on available market pricing for comparable assets. The market approach used includes prices and other relevant information generated by market transactions involving comparable assets, as well as pricing guides and other sources. The income approach indicates value for a subject asset based on the present value of cash flows projected to be generated by the asset. Projected cash flows are discounted at a required market rate of return that reflects the relative risk of achieving the cash flows and the time value of money. The cost approach, which estimates value by determining the current cost of replacing an asset with another of equivalent economic utility, was used, as appropriate, for certain assets for which the market and income approaches could not be applied due to the nature of the asset. The cost to replace a given asset reflects the estimated reproduction or replacement cost for the asset, adjusted for obsolescence, whether physical, functional or economic. Goodwill As of February 24, 2018, our goodwill totaled $1.2 billion, of which $917.3 million related to our acquisition of Safeway. We review goodwill for impairment in the fourth quarter of each year, and also upon the occurrence of triggering events. We perform reviews of each of our reporting units that have goodwill balances. We review goodwill for impairment by initially considering qualitative factors to determine whether it is more likely than not that the fair value of a reporting unit is less than its carrying amount, including goodwill, as a basis for determining whether it is necessary to perform a quantitative analysis. If it is determined that it is more likely than not that the fair value of reporting unit is less than its carrying amount, a quantitative analysis is performed to identify goodwill impairment. If it is determined that it is not more likely than not that the fair value of the reporting unit is less than its carrying amount, it is unnecessary to perform a quantitative analysis. We may elect to bypass the qualitative assessment and proceed directly to performing a quantitative analysis. Beginning on February 26, 2017, ACI prospectively adopted accounting guidance that simplifies goodwill impairment testing. See Note 1 - Description of business, basis of presentation and summary of significant accounting policies in our consolidated financial statements, included elsewhere in this document, for additional information. In the second quarter of the fiscal year ended February 24, 2018, there was a sustained decline in the market multiples of publicly traded peer companies. In addition, during the second quarter of fiscal year ended February 24, 2018, we revised our short-term operating plan. As a result, we determined that an interim review of the recoverability of our goodwill was necessary. Consequently, we recorded a goodwill impairment loss of $142.3 million, substantially all within the Acme reporting unit relating to the November 2015 acquisition of stores from A&P, due to changes in the estimate of our long-term future financial performance to reflect lower expectations for growth in revenue and earnings than previously estimated. The goodwill impairment loss was based on a quantitative analysis using a combination of a discounted cash flow model (income approach) and a guideline public company comparative analysis (market approach). It is reasonably possible that future changes in judgments, assumptions and estimates we made in assessing the fair value of goodwill could cause us to recognize impairment charges at additional divisions. For example, a future decline in market conditions, continued under performance of certain divisions or other factors could negatively impact the estimated future cash flows and valuation assumptions used to determine the fair value of the goodwill for certain divisions and lead to future impairment charges. The annual evaluation of goodwill performed for our reporting units during the fourth quarters of fiscal 2017, 2016 and 2015 did not result in impairment. Employee Benefit Plans Substantially all of our employees are covered by various contributory and non-contributory pension, profit sharing or 401(k) plans, in addition to a dedicated defined benefit plan for Safeway, a plan for Shaw's and a plan for United employees. Certain employees participate in a long-term retention incentive bonus plan. We also provide certain health and welfare benefits, including short-term and long-term disability benefits to inactive disabled employees prior to retirement. Most union employees participate in multiemployer retirement plans under collective bargaining agreements, unless the collective bargaining agreement provides for participation in plans sponsored by us. We recognize a liability for the under-funded status of the defined benefit plans as a component of pension and post-retirement benefit obligations. Actuarial gains or losses and prior service costs or credits are recorded within Other comprehensive income (loss). The determination of our obligation and related expense for our sponsored pensions and other post-retirement benefits is dependent, in part, on management's selection of certain actuarial assumptions in calculating these amounts. These assumptions include, among other things, the discount rate and expected long-term rate of return on plan assets. The objective of our discount rate assumptions was intended to reflect the rates at which the pension benefits could be effectively settled. In making this determination, we take into account the timing and amount of benefits that would be available under the plans. As of February 27, 2016, we changed the method used to estimate the service and interest rate components of net periodic benefit cost for our defined benefit pension plans and other post-retirement benefit plans. Historically, the service and interest rate components were estimated using a single weighted average discount rate derived from the yield curve used to measure the benefit obligation at the beginning of the period. We have elected to use a full yield curve approach in the estimation of service and interest cost components of net pension and other post-retirement benefit plan expense by applying the specific spot rates along the yield curve used in the determination of the projected benefit obligation to the relevant projected cash flows. We utilized weighted discount rates of 4.21% and 4.25% for our pension plan expenses for fiscal 2017 and fiscal 2016, respectively. To determine the expected rate of return on pension plan assets held by us for fiscal 2017, we considered current and forecasted plan asset allocations as well as historical and forecasted rates of return on various asset categories. Our weighted assumed pension plan investment rate of return was 6.40% and 6.96% for fiscal 2017 and fiscal 2016, respectively. See Note 12 - Employee benefit plans and collective bargaining agreements in our consolidated financial statements, included elsewhere in this document, for more information on the asset allocations of pension plan assets. Sensitivity to changes in the major assumptions used in the calculation of our pension and other post-retirement plan liabilities is illustrated below (dollars in millions). In fiscal 2017 and 2016, we contributed $21.9 million and $11.5 million, respectively, to our pension and post-retirement plans. We expect to contribute $55.8 million to our pension and post-retirement plans in fiscal 2018. Income Taxes and Uncertain Tax Positions We review the tax positions taken or expected to be taken on tax returns to determine whether and to what extent a benefit can be recognized in our consolidated financial statements. See Note 11 - Income taxes in our consolidated financial statements, included elsewhere in this document, for the amount of unrecognized tax benefits and other disclosures related to uncertain tax positions. Various taxing authorities periodically examine our income tax returns. These examinations include questions regarding our tax filing positions, including the timing and amount of deductions and the allocation of income to various tax jurisdictions. In evaluating these various tax filing positions, including state and local taxes, we assess our income tax positions and record tax benefits for all years subject to examination based upon management's evaluation of the facts, circumstances and information available at the reporting date. For those tax positions where it is more likely than not that a tax benefit will be sustained, we have recorded the largest amount of tax benefit with a greater than 50% likelihood of being realized upon ultimate settlement with a taxing authority that has full knowledge of all relevant information. For those income tax positions where it is not more likely than not that a tax benefit will be sustained, no tax benefit has been recognized in our financial statements. A number of years may elapse before an uncertain tax position is examined and fully resolved. As of February 24, 2018, we are no longer subject to federal income tax examinations for fiscal years prior to 2012 and in most states, we are no longer subject to state income tax examinations for fiscal years before 2007. Tax years 2007 through 2017 remain under examination. The assessment of our tax position relies on the judgment of management to estimate the exposures associated with our various filing positions.

<s>[INST] Our last three fiscal years consisted of the 52 weeks ended February 24, 2018 ("fiscal 2017"), February 25, 2017 ("fiscal 2016") and February 27, 2016 ("fiscal 2015"). In this Management's Discussion and Analysis of Financial Condition and Results of Operations of Albertsons Companies, Inc., the words "Albertsons Companies," "ACI," "we," "us," "our" and "ours" refer to Albertsons Companies, Inc., together with its subsidiaries. OVERVIEW We are one of the largest food and drug retailers in the United States, with both a strong local presence and national scale. As of February 24, 2018, we operated 2,318 stores across 35 states and the District of Columbia under 20 wellknown banners including Albertsons, Safeway, Vons, JewelOsco, Shaw’s, Acme, Tom Thumb, Randalls, United Supermarkets, Market Street, Pavilions, Star Market, Haggen and Carrs, as well as meal kit company Plated based in New York City. Over the past five years, we have completed a series of acquisitions that has significantly increased our portfolio of stores. We operated 2,318, 2,324, 2,271, 2,382, 1,075 and 192 stores as of February 24, 2018, February 25, 2017, February 27, 2016, February 28, 2015, February 20, 2014 and February 21, 2013, respectively. In addition, as of February 24, 2018, we operated 1,777 pharmacies, 1,275 instore branded coffee shops, 397 adjacent fuel centers, 23 dedicated distribution centers, five Plated fulfillment centers and 20 manufacturing facilities. Our operations and financial performance are affected by U.S. economic conditions such as macroeconomic conditions, credit market conditions and the level of consumer confidence. While the combination of improved economic conditions, the trend towards lower unemployment, higher wages and lower gasoline prices have contributed to improved consumer confidence, there is continued uncertainty about the strength of the economic recovery. If the current economic situation does not continue to improve or if it weakens, or if gasoline prices rebound, consumers may reduce spending, trade down to a less expensive mix of products or increasingly rely on food discounters, all of which could impact our sales growth. In addition, consumers’ perception or uncertainty related to the economic recovery and future fuel prices could also dampen overall consumer confidence and reduce demand for our product offerings. Both inflation and deflation affect our business. Food deflation could reduce sales growth and earnings, while food inflation could reduce gross profit margins. Several food items and categories, such as meat, eggs and dairy, experienced price deflation during 2017 and 2016, and such price deflation could continue in the future. We are unable to predict if the economy will continue to improve, or predict the rate at which the economy may improve, the direction of gasoline prices or if deflationary trends will occur. If the economy does not continue to improve or if it weakens or fuel prices increase, our business and results of operations could be adversely affected. We currently expect to achieve approximately $823 million of annual synergies related to the Safeway acquisition on a runrate basis by the end of fiscal 2018, with remaining associated onetime costs of approximately $200 million, including approximately $65 million of Safeway integrationrelated capital expenditures. Inclusion of the projected synergies should not be viewed as a representation that we in fact will achieve this annual synergy target by the end of fiscal 2018. To the extent we fail to achieve these synergies, our results of operations may be impacted, and any such impact may be material. We achieved synergies from the Safeway acquisition of approximately $575 million during fiscal 2016 and approximately $675 million during fiscal 201 [/INST] Negative. </s>

Albertsons Companies, Inc.

2019-04-24

2019-02-23

Item 7 - Management's Discussion and Analysis of Financial Condition and Results of Operations The following discussion and analysis of our financial condition and results of operations should be read in conjunction with our Consolidated Financial Statements and related notes found in Item 8 in this Form 10-K. This discussion contains forward-looking statements based upon current expectations that involve numerous risks and uncertainties. Our actual results may differ materially from those contained in any forward-looking statements. Our last three fiscal years consisted of the 52 weeks ended February 23, 2019 ("fiscal 2018"), February 24, 2018 ("fiscal 2017") and February 25, 2017 ("fiscal 2016"). The Company's fiscal year ending February 29, 2020 will consist of 53 weeks ("fiscal 2019"). In this Management's Discussion and Analysis of Financial Condition and Results of Operations of Albertsons Companies, Inc., the words "Albertsons," "the Company," "we," "us," "our" and "ours" refer to Albertsons Companies, Inc., together with its subsidiaries. OVERVIEW We are one of the largest food and drug retailers in the United States, with both a strong local presence and national scale. As of February 23, 2019, we operated 2,269 stores across 34 states and the District of Columbia under 20 well-known banners including Albertsons, Safeway, Vons, Jewel-Osco, Shaw's, Acme, Tom Thumb, Randalls, United Supermarkets, Market Street, Pavilions, Star Market, Carrs and Haggen, as well as meal kit company Plated. Additionally, as of February 23, 2019, we operated 1,282 in-store branded coffee shops, 397 adjacent fuel centers, 23 dedicated distribution centers, six Plated fulfillment centers, 20 manufacturing facilities and various online platforms. We employed a diverse workforce of approximately 267,000, 275,000 and 273,000 associates as of February 23, 2019, February 24, 2018 and February 25, 2017, respectively. As of February 23, 2019, approximately 170,000 of our employees were covered by collective bargaining agreements. Collective bargaining agreements covering approximately 106,000 employees have expired or are scheduled to expire in fiscal 2019. If, upon the expiration of such collective bargaining agreements, we are unable to negotiate acceptable contracts with labor unions, it could increase our operating costs and disrupt our operations. Our Strategy We run a great brick and mortar supermarket business focused on fresh and local merchandising. We believe this provides the foundation for growth in both the four-wall and no-wall (eCommerce) environments as we allow our customers to shop with us whenever, wherever and however they want. We operate our business through the execution of the following strategies: Enhancing and Upgrading Our Fresh, Natural and Organic Offerings and Signature Products. We continue to enhance and upgrade our fresh, natural and organic offerings across our meat, produce, service deli and bakery departments to meet the changing tastes and preferences of our customers. We also believe that continued innovation and expansion of our high-volume, high-quality and differentiated signature products will contribute to stronger sales growth. Expanding Our Own Brands Offerings. We continue to drive sales growth and profitability by extending our Own Brand offerings across our banners, including high-quality and recognizable brands O Organics, Signature Brands, Signature Cafe and Lucerne, each of which achieved over $1 billion in sales in the fiscal year ended February 23, 2019. Our Own Brand products achieved over $12.5 billion in sales during fiscal 2018, with 25.1% own brands penetration. Leveraging Our Effective and Scalable Loyalty Programs. We believe we can grow basket size and improve the shopping experience for our customers with our just for U and fuel and grocery-based loyalty programs. Over 16.4 million members are currently enrolled in our loyalty programs. We believe we can further enhance our merchandising and marketing programs by utilizing our customer analytics capabilities, including advanced digital marketing and mobile applications, to improve customer retention and provide targeted promotions to our customers. For example, our just for U and fuel and grocery rewards customers have demonstrated greater basket size, improved customer retention rates and an increased likelihood to redeem promotions offered in our stores. Providing Our Customers with Convenient Digital Solutions. We seek to provide our customers with the means to shop how, when and where they choose. As consumer preferences evolve towards greater convenience, we are improving our online offerings, including home delivery and "Drive Up and Go" services. We continue to enhance our delivery platform to offer more delivery options and windows across our store base, including early morning deliveries, same-day deliveries, deliveries within hours and unattended deliveries. In addition, we are seeking to expand our curbside "Drive Up and Go" program in order to enable customers to conveniently pick up their goods on the way home or to the office. We have added to our delivery offerings with our alliance with Instacart, offering delivery in as little as an hour across key market areas. We believe our strategy of providing customers with a variety of in-store and online options that suit their varying individual needs will drive additional sales growth and differentiate us from many of our competitors. Capitalizing on Demand for Health and Wellness Services. We intend to leverage our portfolio of 1,739 pharmacies and our growing network of wellness clinics to capitalize on increasing customer demand for health and wellness services. Pharmacy customers are among our most loyal, and we plan to continue to grow our pharmacy script counts through new patient prescription transfer programs and initiatives such as clinic, hospital and preferred network partnerships, which we believe will expand our access to more customers. To further enhance our pharmacy offerings, in 2017 we acquired MedCart Specialty Pharmacy, a URAC-accredited specialty pharmacy with accreditation and license to operate in over 40 states, which extends our ability to service our customers' health needs. Continuously Evaluating and Upgrading Our Store Portfolio. We plan to pursue a disciplined but committed capital allocation strategy to upgrade, remodel and relocate stores to attract customers to our stores and to increase store volumes. We opened six and 15 new stores in fiscal 2018 and fiscal 2017, respectively, and expect to open approximately 15 new stores in fiscal 2019. We completed 128 upgrade and remodel projects in fiscal 2018 and expect to complete approximately 300 upgrade and remodel projects during fiscal 2019. Driving Innovation. We intend to drive traffic and sales growth through constant innovation. We will remain focused on identifying emerging trends in food and sourcing new and innovative products. We are adjusting our store layouts to accommodate a greater assortment of grab-and-go, individually packaged and snack-sized meals. We continue to roll out new merchandising initiatives across our store base, including meal kits, product sampling events, quality prepared foods and in-store dining. Sharing Best Practices Across Divisions. Our division leaders collaborate closely to ensure the rapid sharing of best practices. Recent examples include the expansion of our O Organics and Open Nature offerings across banners, the roll-out of signature products such as Albertsons' in-store fresh-cut fruit and vegetables and implementing Safeway's successful wine and floral shop strategies, with broader product assortments and new fixtures across many of our banners. Enhancing Our Operating Margin. Our focus on sales growth provides an opportunity to enhance our operating margin by leveraging our fixed costs. We plan to realize further margin benefits through added scale from partnering with vendors and by achieving efficiencies in manufacturing and distribution. We are investing in our supply channel, including the automation of several of our distribution centers, in order to create efficiencies and reduce costs. In addition, we maintain a disciplined approach to expense management and budgeting. Capitalizing on Our Fully Realized Synergy Realization Plan. We achieved approximately $823 million in annual run-rate synergies as of the end of fiscal 2018 from our acquisition of Safeway. During fiscal 2016, fiscal 2017 and fiscal 2018, we achieved synergies from the Safeway acquisition of approximately $575 million, $675 million and $775 million, respectively. Focusing on Sustainability. We strive to make every day a better day for our people, customers, communities and planet. During fiscal 2018, we raised approximately $43 million to benefit 2,000 organizations through foundation grants and donated more than $226 million to food banks and other hunger relief agencies. We also recycled more than 705 million pounds of cardboard and 22 million pounds of plastic film from our facilities. Stores The following table shows stores operating, acquired, opened, divested and closed during the periods presented: (1) Excludes acquired stores not yet re-opened as of the end of each respective period. The following table summarizes our stores by size: (1) In millions, reflects total square footage of retail stores operating at the end of the period. ACQUISITIONS AND OTHER INVESTMENTS Termination of Merger Agreement with Rite Aid As previously disclosed, on February 18, 2018, the Company and its wholly-owned subsidiaries, Ranch Acquisition II LLC and Ranch Acquisition Corp. (together with Ranch Acquisition II LLC, "Merger Subs") and Rite Aid Corporation ("Rite Aid") entered into an Agreement and Plan of Merger (the "Merger Agreement"). On August 8, 2018, the Company, Merger Subs and Rite Aid entered into a Termination Agreement (the "Termination Agreement") under which the parties mutually agreed to terminate the Merger Agreement. Subject to limited customary exceptions, the Termination Agreement also mutually releases the parties from any claims of liability to one another relating to the contemplated merger transaction. Under the terms of the Merger Agreement, neither the Company nor Rite Aid will be responsible for any payments to the other party as a result of the termination of the Merger Agreement. MedCart On May 31, 2017, we acquired MedCart Specialty Pharmacy, a URAC-accredited specialty pharmacy with accreditation and license to operate in over 40 states, which extends our ability to service our customers' health needs. Plated On September 20, 2017, we acquired Plated, a provider of meal kit services. The deal advanced a shared strategy to reinvent the way consumers discover, purchase and experience food. In teaming up with Plated, we added a meal kit company with leading technology and data capabilities. El Rancho On November 16, 2017, we acquired a 45% equity interest in each of Mexico Foods Parent LLC and La Fabrica Parent LLC ("El Rancho"), a Texas-based specialty grocer with 16 stores that focuses on Latino customers. We have the option to acquire the remaining 55% of El Rancho at any time until six months after the delivery of El Rancho's financial results for the fiscal year ended December 31, 2021. If we elect to exercise the option to acquire the remaining equity of El Rancho, the price to be paid by us for the remaining equity will be calculated using a predetermined market-based formula. Our equity interest in El Rancho expands our presence in the fast-growing Latino grocery sector and complements our successful operation of a variety of store banners in neighborhoods with significant Latino populations. Casa Ley During the fourth quarter of fiscal 2017, we completed the sale of our equity method investment in Casa Ley, S.A. de C.V. ("Casa Ley") and distributed approximately $0.934 in cash per Casa Ley contingent value right ("CVR") (or approximately $222 million in the aggregate) pursuant to the terms of the Casa Ley CVR agreement. Haggen During fiscal 2015, Haggen Holdings, LLC ("Haggen") secured Bankruptcy Court approval for bidding procedures for the sale of 29 stores. On March 25, 2016, we entered into a purchase agreement to acquire the 29 additional stores, which included 15 stores originally sold to Haggen as part of the Federal Trade Commission divestitures, and certain trade names and other intellectual property, for an aggregate purchase price of approximately $114 million. We completed the acquisition of these 29 stores on June 23, 2016. RESULTS OF OPERATIONS The following table and related discussion sets forth certain information and comparisons regarding the components of our Consolidated Statements of Operations for fiscal 2018, fiscal 2017 and fiscal 2016, respectively (in millions): Identical Sales, Excluding Fuel Identical sales include stores operating during the same period in both the current year and the prior year, comparing sales on a daily basis. Direct to consumer internet sales are included in identical sales, and fuel sales are excluded from identical sales. Acquired stores become identical on the one-year anniversary date of the acquisition. Identical sales results, on an actual basis, for the past three fiscal years were as follows: Net Sales and Other Revenue Net sales and other revenue increased $609.9 million, or 1.0%, from $59,924.6 million in fiscal 2017 to $60,534.5 million in fiscal 2018. The components of the change in Net sales and other revenue for fiscal 2018 were as follows (in millions): (1) Includes changes in non-identical sales and other miscellaneous revenue. The primary increase in Net sales and other revenue in fiscal 2018 as compared to fiscal 2017 was driven by our 1.0% increase in identical sales and an increase in fuel sales of $351.3 million, partially offset by a reduction in sales related to the closure of 55 stores in fiscal 2018. Net sales and other revenue increased $246.4 million, or 0.4%, from $59,678.2 million in fiscal 2016 to $59,924.6 million in fiscal 2017. The components of the change in Net sales and other revenue for fiscal 2017 were as follows (in millions): (1) Includes changes in non-identical sales and other miscellaneous revenue. The primary increase in Net sales and other revenue in fiscal 2017 as compared to fiscal 2016 was driven by an increase of $589.4 million from new stores and acquisitions, net of store closings, and an increase of $411.2 million in fuel sales primarily driven by higher average retail pump prices, partially offset by a decline of $740.4 million from our 1.3% decline in identical sales. Gross Profit Gross profit represents the portion of Net sales and other revenue remaining after deducting the Cost of sales during the period, including purchase and distribution costs. These costs include inbound freight charges, purchasing and receiving costs, warehouse inspection costs, warehousing costs and other costs associated with our distribution network. Advertising, promotional expenses and vendor allowances are also components of Cost of sales. Gross profit margin increased 60 basis points to 27.9% in fiscal 2018 compared to 27.3% in fiscal 2017. Excluding the impact of fuel, gross profit margin increased 70 basis points. The increase in fiscal 2018 as compared to fiscal 2017 was primarily attributable to lower shrink expense as a percentage of sales partially due to the completion of our store conversions related to the Safeway acquisition and the implementation of inventory management initiatives, lower advertising costs and improved product mix, including improved sales penetration in Own Brands. Gross profit margin decreased 60 basis points to 27.3% in fiscal 2017 compared to 27.9% in fiscal 2016. Excluding the impact of fuel, gross profit margin decreased 50 basis points. The decrease in fiscal 2017 as compared to fiscal 2016 was primarily attributable to our investment in promotions and price and higher shrink expense as a percentage of sales, which was partially due to system conversions related to our integration. Selling and Administrative Expenses Selling and administrative expenses consist primarily of store level costs, including wages, employee benefits, rent, depreciation and utilities, in addition to certain back-office expenses related to our corporate and division offices. Selling and administrative expenses decreased 50 basis points to 26.6% of Net sales and other revenue in fiscal 2018 from 27.1% in fiscal 2017. Excluding the impact of fuel, Selling and administrative expenses as a percentage of Net sales and other revenue decreased 50 basis points during fiscal 2018 compared to fiscal 2017. The decrease during fiscal 2018 compared to fiscal 2017 was primarily attributable to lower depreciation and amortization expense, higher gains related to the sale of assets and the Company's cost reduction initiatives, partially offset by increased employee wage and benefit costs and higher acquisition and integration costs. Higher gains related to the sale of assets were primarily due to the disposition of various store properties during fiscal 2018. Increased employee wage and benefit costs were primarily attributable to incentive pay as a result of improved operating performance. Higher acquisition and integration costs were primarily driven by the 506 store conversions in fiscal 2018 related to the Safeway integration compared to 219 store conversions in fiscal 2017. Selling and administrative expenses increased 20 basis points to 27.1% of Net sales and other revenue in fiscal 2017 from 26.9% in fiscal 2016. Excluding the impact of fuel, Selling and administrative expenses as a percentage of Net sales and other revenue increased 40 basis points during fiscal 2017 compared to fiscal 2016. Increased employee wage and benefit costs, asset impairments and lease exit costs, higher depreciation and amortization expense and higher store related costs during fiscal 2017 compared to fiscal 2016 were offset by lower pension costs and increased Safeway acquisition synergies. Increased employee wage and benefit costs and higher store related costs were primarily attributable to deleveraging of sales on fixed costs. Higher asset impairments and lease exit costs were primarily related to asset impairments in underperforming and closed stores. These increases were partially offset by lower pension expense, net driven by a $25.4 million settlement gain during fiscal 2017 primarily due to an annuity settlement on a portion of our defined benefit pension obligation. Goodwill Impairment No goodwill impairment was recorded in fiscal 2018 compared to $142.3 million in fiscal 2017. Interest Expense, Net Interest expense, net was $830.8 in fiscal 2018, $874.8 million in fiscal 2017 and $1,003.8 million in fiscal 2016. The decrease in Interest expense, net for fiscal 2018 compared to fiscal 2017 is primarily due to lower average outstanding borrowings as a result of our term loan paydown and other debt reduction during fiscal 2018 and lower amortization and write-off of deferred financing costs and original issue discount, partially offset by $10.9 million of interest that was due and payable on the floating rate senior secured notes that were issued in connection with the Merger Agreement and later redeemed as further described herein. The following details our components of Interest expense, net for the respective fiscal years (in millions): The weighted average interest rate during the year was 6.6%, excluding amortization of debt discounts and deferred financing costs. The weighted average interest rate during fiscal 2017 and fiscal 2016 was 6.5% and 6.8%, respectively. Loss (Gain) on Debt Extinguishment During fiscal 2018, we repurchased Safeway's 7.45% Senior Debentures due 2027 and 7.25% Debentures due 2031 with a par value of $333.7 million and a book value of $322.4 million, and NALP Notes with a par value of $108.4 million and a book value of $96.4 million for an aggregate of $424.4 million (the "2018 Repurchases"). We also redeemed Safeway's 5.00% Senior Notes due 2019 (the "2018 Redemption") for $271.7 million, which included an associated make-whole premium of $3.1 million. In connection with the 2018 Repurchases and the 2018 Redemption, we recorded a loss on debt extinguishment of $8.7 million. During fiscal 2017, we repurchased NALP Notes with a par value of $160.0 million and a book value of $140.2 million for $135.5 million plus accrued interest of $3.7 million (the "NALP Notes Repurchase"). In connection with the NALP Notes Repurchase, we recorded a gain on debt extinguishment of $4.7 million. On June 24, 2016, a portion of the net proceeds from the issuance of the 2024 Notes was used to fully redeem $609.6 million of 7.75% Senior Secured Notes due 2022 (the "2016 Redemption"). In connection with the 2016 Redemption, we recorded a $111.7 million loss on debt extinguishment comprised of an $87.7 million make-whole premium and a $24.0 million write off of deferred financing costs and original issue discount. Other Income For fiscal 2018, Other income was $104.4 million primarily driven by adjustments related to acquisition-related contingent consideration, gains related to non-operating minority investments and non-service cost components of net pension and post-retirement expense. For fiscal 2017, Other income was $9.2 million primarily driven by changes in our equity method investment in Casa Ley, changes in the fair value of the contingent value rights, which we refer to as CVRs, non-service cost components of net pension and post-retirement expense and gains and losses on the sale of non-operating minority investments. For fiscal 2016, Other income was $44.3 million primarily driven by gains on the sale of certain investments, changes in our equity method investments and non-service cost components of net pension and post-retirement expense. Income Taxes Income tax was a benefit of $78.9 million in fiscal 2018, $963.8 million in fiscal 2017 and $90.3 million in fiscal 2016. Prior to the Reorganization Transactions, a substantial portion of our businesses and assets were held and operated by limited liability companies, which are generally not subject to entity-level federal or state income taxation. See Note 1 - Description of business, basis of presentation and summary of significant accounting policies in our consolidated financial statements, included elsewhere in this document, for a discussion and definition of the "Reorganization Transactions." On December 22, 2017, the Tax Cuts and Jobs Act (the "Tax Act") was signed into law, which resulted in a significant ongoing benefit to us, primarily due to the reduction in the corporate tax rate from 35% to 21% and the ability to accelerate depreciation deductions for qualified property purchases. The components of the change in income taxes for the last three fiscal years were as follows: As a result of the Tax Act, the Company recorded a net non-cash tax benefit of $56.9 million and $430.4 million in fiscal 2018 and fiscal 2017, respectively, primarily due to the lower corporate tax rate. The income tax benefit in fiscal 2017 includes a net $218.0 million non-cash benefit from the reversal of a valuation allowance, partially offset by an increase of $46.7 million in net deferred tax liabilities from our limited liability companies related to the Reorganization Transactions. Adjusted EBITDA EBITDA, Adjusted EBITDA and Free Cash Flow (collectively, the "Non-GAAP Measures") are performance measures that provide supplemental information we believe is useful to analysts and investors to evaluate our ongoing results of operations, when considered alongside other GAAP measures such as net income, operating income, gross profit and Net cash provided by operating activities. These Non-GAAP Measures exclude the financial impact of items management does not consider in assessing our ongoing operating performance, and thereby facilitate review of our operating performance on a period-to-period basis. Other companies may have different capital structures or different lease terms, and comparability to our results of operations may be impacted by the effects of acquisition accounting on our depreciation and amortization. As a result of the effects of these factors and factors specific to other companies, we believe EBITDA, Adjusted EBITDA and Free Cash Flow provide helpful information to analysts and investors to facilitate a comparison of our operating performance to that of other companies. We also use Adjusted EBITDA, as further adjusted for additional items defined in our debt instruments, for board of director and bank compliance reporting. The presentation of Non-GAAP Measures should not be construed as an inference that our future results will be unaffected by unusual or non-recurring items. For fiscal 2018, Adjusted EBITDA was $2.7 billion, or 4.5% of Net sales and other revenue, compared to $2.4 billion, or 4.0% of Net sales and other revenue, for fiscal 2017. The increase in Adjusted EBITDA primarily reflects our identical sales increase, improved gross profit and realization of our cost reduction initiatives. The following is a reconciliation of Net income (loss) to Adjusted EBITDA (in millions): (1) Related to activities to integrate acquired businesses, primarily the Safeway acquisition. (2) Includes expenses related to acquisition and financing activities, including management fees of $13.8 million in each year. Fiscal 2018 includes expenses related to the mutually terminated merger with Rite Aid. Fiscal 2016 includes adjustments to tax indemnification assets of $12.3 million. (3) Fiscal 2018 includes gains related to various property dispositions and the amortization of deferred gains related to sale leaseback transactions. Fiscal 2017 includes asset impairment losses of $100.9 million primarily related to underperforming stores. Fiscal 2016 includes a net gain of $42.9 million related to the disposition of a portfolio of surplus properties. (4) Fiscal 2016 charge to pension expense, net related to the settlement of a pre-existing contractual relationship and assumption of the pension plan related to the acquisition of Collington Services, LLC ("Collington"). (5) Miscellaneous adjustments include the following: (a) Primarily includes lease adjustments related to deferred rents, deferred gains on leases and costs incurred on leased surplus properties. (b) Includes costs related to facility closures and the transition to our decentralized operating model. (c) Primarily includes gains and losses from interest rate and commodity hedges, and adjustments for unconsolidated equity investments The following is a reconciliation of Net cash provided by operating activities to Free Cash Flow, which we define as Adjusted EBITDA less capital expenditures (in millions): LIQUIDITY AND FINANCIAL RESOURCES The following table sets forth the major sources and uses of cash and cash equivalents and restricted cash at the end of each period (in millions): Net Cash Provided By Operating Activities Net cash provided by operating activities was $1,687.9 million during fiscal 2018 compared to net cash provided by operating activities of $1,018.8 million during fiscal 2017. The increase in net cash flow from operating activities during fiscal 2018 compared to fiscal 2017 was primarily due to the increase in Adjusted EBITDA, principally reflecting the results in fiscal 2018 compared to fiscal 2017, and changes in working capital primarily related to accounts payable and accrued liabilities, which includes $42.3 million in payments related to litigation settlements in fiscal 2017, partially offset by $199.3 million in pension contributions in fiscal 2018. Net cash provided by operating activities was $1,018.8 million during fiscal 2017 compared to net cash provided by operating activities of $1,813.5 million during fiscal 2016. The decrease in net cash flow from operating activities during fiscal 2017 compared to fiscal 2016 was primarily due to the decrease in Adjusted EBITDA, principally reflecting the results in fiscal 2017 compared to fiscal 2016, and changes in working capital primarily related to accounts payable and accrued liabilities and the $42.3 million payment on litigation settlements, partially offset by a decrease in interest and income taxes paid of $110.7 million and $113.4 million, respectively. Fiscal 2016 cash provided by operating activities also includes a correction in the classification of certain book overdrafts resulting in an increase of $139.2 million. Net Cash Used In Investing Activities Net cash used in investing activities during fiscal 2018 was $86.8 million primarily due to payments for property and equipment, including lease buyouts, of $1,362.6 million, which includes approximately $70 million of Safeway integration-related capital expenditures, partially offset by proceeds from the sale of assets of $1,252.0 million. Asset sale proceeds primarily relate to the sale and subsequent leaseback of seven of our distribution center properties during fiscal 2018 and other property dispositions. Net cash used in investing activities during fiscal 2017 was $469.0 million primarily due to payments for property and equipment, including lease buyouts, of $1,547.0 million, which includes approximately $200 million of Safeway integration-related capital expenditures, and payments for business acquisitions of $148.8 million partially offset by proceeds from the sale of assets of $939.2 million and proceeds from the sale of our equity method investment in Casa Ley of $344.2 million. Asset sale proceeds primarily relate to the sale and subsequent leaseback of 94 store properties during the third and fourth quarters of fiscal 2017. Net cash used in investing activities during fiscal 2016 was $1,079.6 million primarily due to payments for property and equipment, including lease buyouts, of $1,414.9 million, which includes approximately $250 million of Safeway integration-related capital expenditures, and payments for business acquisitions of $220.6 million partially offset by proceeds from the sale of assets of $477.0 million. Asset sale proceeds include the sale and 36-month leaseback of two distribution centers in Southern California and the sale of a portfolio of surplus properties. In fiscal 2018, we spent approximately $1,363 million for capital expenditures, including approximately $70 million of Safeway integration-related capital expenditures. For fiscal 2018, we completed 128 upgrade and remodel projects and opened six new stores. In fiscal 2019, we expect to spend approximately $1,450 million in capital expenditures, or approximately 2.4% of our sales in fiscal 2018, as follows (in millions): Net Cash Used In Financing Activities Net cash used in financing activities was $1,314.2 million in fiscal 2018 consisting of payments on long-term debt and capital leases of $3,179.8 million, partially offset by proceeds from the issuance of long-term debt of $1,969.8 million. Proceeds from the issuance of long-term debt and payments of long-term debt consisted of the issuance of the 2026 Notes, the issuance and subsequent redemption of the $750.0 million floating rate senior secured notes as a result of the mutual termination of the Merger Agreement, borrowings and repayments under our asset-based loan facility, the repayment of term loans in connection with the refinancing and repurchase of Safeway's notes described herein. Net cash used in financing activities was $1,098.1 million in fiscal 2017 due primarily to payments on long-term debt and capital lease obligations of $977.8 million, payment of the Casa Ley CVR and a member distribution of $250.0 million, partially offset by proceeds from the issuance of long-term debt. Net cash used in financing activities was $97.8 million in fiscal 2016 due primarily to payments on long-term debt and capital lease obligations, partially offset by proceeds from the issuance of long-term debt. Debt Management Total debt, including both the current and long-term portions of capital lease obligations and net of debt discounts and deferred financing costs, decreased $1.3 billion to $10.6 billion as of the end of fiscal 2018 compared to $11.9 billion as of the end of fiscal 2017. The decrease in fiscal 2018 was primarily due to the repurchase of NALP and Safeway notes, and the repayment made in connection with the term loan repricing described below, offset by the issuance of $600.0 million of principal amount of 7.5% Senior Unsecured Notes. Outstanding debt, including current maturities and net of debt discounts and deferred financing costs, principally consisted of (in millions): On November 16, 2018, the Company repaid approximately $976 million in aggregate principal amount of the $2,976.0 million term loan tranche B-4 (the "2017 Term B-4 Loan") along with accrued and unpaid interest on such amount and fees and expenses related to the Term Loan Repayment and the 2018 Term B-7 Loan (each as defined below), for which the Company used approximately $610 million of cash on hand and approximately $410 million of borrowings under the ABL Facility (such repayment, the "Term Loan Repayment"). Substantially concurrently with the Term Loan Repayment, the Company amended the Company's Second Amended and Restated Term Loan Agreement, dated as of August 25, 2014 and effective as of January 30, 2015 (as amended, the "Term Loan Agreement"), to establish a new term loan tranche and amend certain provisions of the Term Loan Agreement. The new tranche consists of $2,000.0 million of new term B-7 loans (the "2018 Term B-7 Loan"). The 2018 Term B-7 Loan, together with cash on hand, was used to repay in full the remaining principal amount outstanding under the 2017 Term B-4 Loan. During fiscal 2018, Safeway repurchased certain amounts of its 7.45% Senior Debentures due 2027 and 7.25% Debentures due 2031 with a par value of $333.7 million and a book value of $322.4 million. During fiscal 2018, the Company, through three separate transactions, completed the sale and leaseback of seven of the Company's distribution centers for an aggregate purchase price, net of closing costs, of approximately $950 million. In connection with the sale and leasebacks, the Company entered into lease agreements for each of the properties for initial terms of 15 to 20 years. The aggregate initial annual rent payment for the properties will be approximately $55 million and includes 1.50% to 1.75% annual rent increases over the initial lease terms. Liquidity and Factors Affecting Liquidity We estimate our liquidity needs over the next fiscal year to be in the range of $4.0 billion to $4.5 billion, which includes anticipated requirements for working capital, capital expenditures, interest payments and scheduled principal payments of debt, operating leases and capital leases. Based on current operating trends, we believe that cash flows from operating activities and other sources of liquidity, including borrowings under our ABL Facility, will be adequate to meet our liquidity needs for the next 12 months and for the foreseeable future. We believe we have adequate cash flow to continue to maintain our current debt ratings and to respond effectively to competitive conditions. In addition, we may enter into refinancing transactions from time to time. There can be no assurance, however, that our business will continue to generate cash flow at or above current levels or that we will maintain our ability to borrow under our ABL Facility. See "Contractual Obligations" for a more detailed description of our commitments as of the end of fiscal 2018. As of February 23, 2019, we had no borrowings outstanding under our ABL Facility and total availability of approximately $3.4 billion (net of letter of credit usage). As of February 24, 2018, we had no borrowings outstanding under our ABL Facility and total availability of approximately $3.1 billion (net of letter of credit usage). The ABL Facility contains no financial maintenance covenants unless and until (a) excess availability is less than (i) 10% of the lesser of the aggregate commitments and the then-current borrowing base at any time or (ii) $250.0 million at any time or (b) an event of default is continuing. If any such event occurs, we must maintain a fixed charge coverage ratio of 1.0:1.0 from the date such triggering event occurs until such event of default is cured or waived and/or the 30th day that all such triggers under clause (a) no longer exist. During fiscal 2018 and fiscal 2017, there were no financial maintenance covenants in effect under the ABL Facility because the conditions listed above (and similar conditions in our refinanced asset-based revolving credit facilities) had not been met. CONTRACTUAL OBLIGATIONS The table below presents our significant contractual obligations as of February 23, 2019 (in millions) (1): (1) The contractual obligations table excludes funding of pension and other postretirement benefit obligations, which totaled $199.3 million in fiscal 2018 and is expected to total $12.4 million in fiscal 2019. This table excludes contributions under various multiemployer pension plans, which totaled $451.1 million in fiscal 2018 and is expected to total approximately $475 million in fiscal 2019. (2) Long-term debt amounts exclude any debt discounts and deferred financing costs. See Note 8 - Long-term debt in our consolidated financial statements, included elsewhere in this document, for additional information. (3) Amounts include contractual interest payments using the interest rate as of February 23, 2019 applicable to our variable interest term debt instruments and stated fixed rates for all other debt instruments, excluding interest rate swaps. See Note 8 - Long-term debt in our consolidated financial statements, included elsewhere in this document, for additional information. (4) Represents the minimum rents payable under operating and capital leases, excluding common area maintenance, insurance or tax payments, for which we are obligated. (5) Consists of self-insurance liabilities, which have not been reduced by insurance-related receivables, and deferred cash consideration related to Plated. Excludes the $142.1 million of assumed withdrawal liabilities related to Safeway's previous closure of its Dominick's division, and excludes the unfunded pension and postretirement benefit obligation of $502.6 million. The amount of unrecognized tax benefits of $376.2 million as of February 23, 2019 has been excluded from the contractual obligations table because a reasonably reliable estimate of the timing of future tax settlements cannot be determined. Excludes contingent consideration because the timing and settlement is uncertain. Also excludes deferred tax liabilities and certain other deferred liabilities that will not be settled in cash and other lease-related liabilities already reflected as operating lease commitments. (6) Purchase obligations include various obligations that have specified purchase commitments. As of February 23, 2019, future purchase obligations primarily relate to fixed asset, marketing and information technology commitments, including fixed price contracts. In addition, not included in the contractual obligations table are supply contracts to purchase product for resale to consumers which are typically of a short-term nature with limited or no purchase commitments. We also enter into supply contracts which typically include either volume commitments or fixed expiration dates, termination provisions and other customary contractual considerations. The supply contracts that are cancelable have not been included above. Guarantees We are party to a variety of contractual agreements pursuant to which we may be obligated to indemnify the other party for certain matters. These contracts primarily relate to our commercial contracts, operating leases and other real estate contracts, trademarks, intellectual property, financial agreements and various other agreements. Under these agreements, we may provide certain routine indemnifications relating to representations and warranties (for example, ownership of assets, environmental or tax indemnifications) or personal injury matters. The terms of these indemnifications range in duration and may not be explicitly defined. We believe that if we were to incur a loss in any of these matters, the loss would not have a material effect on our financial statements. We are liable for certain operating leases that were assigned to third parties. If any of these third parties fail to perform their obligations under the leases, we could be responsible for the lease obligation. See Note 14 - Commitments and contingencies and off balance sheet arrangements in our consolidated financial statements, included elsewhere in this document, for additional information. Because of the wide dispersion among third parties and the variety of remedies available, we believe that if an assignee became insolvent it would not have a material effect on our financial condition, results of operations or cash flows. In the ordinary course of business, we enter into various supply contracts to purchase products for resale and purchase and service contracts for fixed asset and information technology commitments. These contracts typically include volume commitments or fixed expiration dates, termination provisions and other standard contractual considerations. Letters of Credit We had letters of credit of $520.8 million outstanding as of February 23, 2019. The letters of credit are maintained primarily to support our performance, payment, deposit or surety obligations. We typically pay bank fees of 1.25% plus a fronting fee of 0.125% on the face amount of the letters of credit. NEW ACCOUNTING POLICIES NOT YET ADOPTED See Note 1 - Description of business, basis of presentation and summary of significant accounting policies in our consolidated financial statements, included elsewhere in this document, for new accounting pronouncements which have not yet been adopted. CRITICAL ACCOUNTING POLICIES The preparation of consolidated financial statements in conformity with GAAP requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities as of the date of the consolidated financial statements and the reported amounts of revenues and expenses during the reporting period. Actual results could differ from those estimates. We have chosen accounting policies that we believe are appropriate to report accurately and fairly our operating results and financial position, and we apply those accounting policies in a fair and consistent manner. See Note 1 - Description of business, basis of presentation and summary of significant accounting policies in our consolidated financial statements, included elsewhere in this document, for a discussion of our significant accounting policies. Management believes the following critical accounting policies reflect its more subjective or complex judgments and estimates used in the preparation of our consolidated financial statements. Vendor Allowances Consistent with standard practices in the retail industry, we receive allowances from many of the vendors whose products we buy for resale in our stores. These vendor allowances are provided to increase the sell-through of the related products. We receive vendor allowances for a variety of merchandising activities: placement of the vendors' products in our advertising; display of the vendors' products in prominent locations in our stores; supporting the introduction of new products into our retail stores and distribution systems; exclusivity rights in certain categories; and compensation for temporary price reductions offered to customers on products held for sale at retail stores. We also receive vendor allowances for buying activities such as volume commitment rebates, credits for purchasing products in advance of their need and cash discounts for the early payment of merchandise purchases. The majority of the vendor allowance contracts have terms of less than one year. We recognize vendor allowances for merchandising activities as a reduction of cost of sales when the related products are sold. Vendor allowances that have been earned because of completing the required performance under the terms of the underlying agreements but for which the product has not yet been sold are recognized as reductions of inventory. The amount and timing of recognition of vendor allowances as well as the amount of vendor allowances to be recognized as a reduction of ending inventory require management judgment and estimates. We determine these amounts based on estimates of current year purchase volume using forecast and historical data and a review of average inventory turnover data. These judgments and estimates affect our reported gross profit, operating earnings (loss) and inventory amounts. Our historical estimates have been reliable in the past, and we believe the methodology will continue to be reliable in the future. Based on previous experience, we do not expect significant changes in the level of vendor support. Self-Insurance Liabilities We are primarily self-insured for workers' compensation, property, automobile and general liability. The self-insurance liability is undiscounted and determined actuarially, based on claims filed and an estimate of claims incurred but not yet reported. We have established stop-loss amounts that limit our further exposure after a claim reaches the designated stop-loss threshold. In determining our self-insurance liabilities, we perform a continuing review of our overall position and reserving techniques. Since recorded amounts are based on estimates, the ultimate cost of all incurred claims and related expenses may be more or less than the recorded liabilities. Any actuarial projection of self-insured losses is subject to a high degree of variability. Litigation trends, legal interpretations, benefit level changes, claim settlement patterns and similar factors influenced historical development trends that were used to determine the current year expense and, therefore, contributed to the variability in the annual expense. However, these factors are not direct inputs into the actuarial projection, and thus their individual impact cannot be quantified. Long-Lived Asset Impairment We regularly review our individual stores' operating performance, together with current market conditions, for indications of impairment. When events or changes in circumstances indicate that the carrying value of an individual store's assets may not be recoverable, its future undiscounted cash flows are compared to the carrying value. If the carrying value of store assets to be held and used is greater than the future undiscounted cash flows, an impairment loss is recognized to record the assets at fair value. For property and equipment held for sale, we recognize impairment charges for the excess of the carrying value plus estimated costs of disposal over the fair value. Fair values are based on discounted cash flows or current market rates. These estimates of fair value can be significantly impacted by factors such as changes in the current economic environment and real estate market conditions. Long-lived asset impairment losses were $36.3 million, $100.9 million and $46.6 million in fiscal 2018, fiscal 2017 and fiscal 2016, respectively. Business Combination Measurements In accordance with applicable accounting standards, we estimate the fair value of acquired assets and assumed liabilities as of the acquisition date of business combinations. These fair value adjustments are input into the calculation of goodwill related to the excess of the purchase price over the fair value of the tangible and identifiable intangible assets acquired and liabilities assumed in the acquisition. The fair value of assets acquired and liabilities assumed are determined using market, income and cost approaches from the perspective of a market participant. The fair value measurements can be based on significant inputs that are not readily observable in the market. The market approach indicates value for a subject asset based on available market pricing for comparable assets. The market approach used includes prices and other relevant information generated by market transactions involving comparable assets, as well as pricing guides and other sources. The income approach indicates value for a subject asset based on the present value of cash flows projected to be generated by the asset. Projected cash flows are discounted at a required market rate of return that reflects the relative risk of achieving the cash flows and the time value of money. The cost approach, which estimates value by determining the current cost of replacing an asset with another of equivalent economic utility, was used, as appropriate, for certain assets for which the market and income approaches could not be applied due to the nature of the asset. The cost to replace a given asset reflects the estimated reproduction or replacement cost for the asset, adjusted for obsolescence, whether physical, functional or economic. Goodwill As of February 23, 2019, our goodwill totaled $1.2 billion, of which $917.3 million related to our acquisition of Safeway. We review goodwill for impairment in the fourth quarter of each year, and also upon the occurrence of triggering events. We perform reviews of each of our reporting units that have goodwill balances. We review goodwill for impairment by initially considering qualitative factors to determine whether it is more likely than not that the fair value of a reporting unit is less than its carrying amount, including goodwill, as a basis for determining whether it is necessary to perform a quantitative analysis. If it is determined that it is more likely than not that the fair value of reporting unit is less than its carrying amount, a quantitative analysis is performed to identify goodwill impairment. If it is determined that it is not more likely than not that the fair value of the reporting unit is less than its carrying amount, it is unnecessary to perform a quantitative analysis. We may elect to bypass the qualitative assessment and proceed directly to performing a quantitative analysis. In the second quarter of the fiscal year ended February 24, 2018, there was a sustained decline in the market multiples of publicly traded peer companies. In addition, during the second quarter of the fiscal year ended February 24, 2018, we revised our short-term operating plan. As a result, we determined that an interim review of the recoverability of our goodwill was necessary. Consequently, we recorded a goodwill impairment loss of $142.3 million, substantially all within the Acme reporting unit relating to the November 2015 acquisition of stores from the Great Atlantic & Pacific Tea Company, Inc., due to changes in the estimate of our long-term future financial performance to reflect lower expectations for growth in revenue and earnings than previously estimated. The goodwill impairment loss was based on a quantitative analysis using a combination of a discounted cash flow model (income approach) and a guideline public company comparative analysis (market approach). Goodwill has been allocated to all of our reporting units, and none of our reporting units have a zero or negative carrying amount of net assets. As of February 23, 2019, there are two reporting units with no goodwill due to the impairment loss recorded during the second quarter of the fiscal year ended February 24, 2018. There are nine reporting units with an aggregate goodwill balance of $1,034.6 million, of which the fair value of each reporting unit was substantially in excess of its carrying value, which indicates a remote likelihood of a future impairment loss. There are two reporting units with an aggregate goodwill balance of $148.7 million where it is reasonably possible that future changes in judgments, assumptions and estimates we made in assessing the fair value of the reporting unit could cause us to recognize impairment charges on a portion of the goodwill balance within each reporting unit. For example, a future decline in market conditions, continued underperformance of these two reporting units or other factors could negatively impact the estimated future cash flows and valuation assumptions used to determine the fair value of these two reporting units and lead to future impairment charges. The annual evaluation of goodwill performed for our reporting units during the fourth quarters of fiscal 2018, fiscal 2017 and fiscal 2016 did not result in impairment. Employee Benefit Plans Substantially all of our employees are covered by various contributory and non-contributory pension, profit sharing or 401(k) plans, in addition to defined benefit plans for Safeway, Shaw's and United employees. Certain employees participate in a long-term retention incentive bonus plan. We also provide certain health and welfare benefits, including short-term and long-term disability benefits to inactive disabled employees prior to retirement. Most union employees participate in multiemployer retirement plans pursuant to collective bargaining agreements, unless the collective bargaining agreement provides for participation in plans sponsored by us. We recognize a liability for the underfunded status of the defined benefit plans as a component of pension and post-retirement benefit obligations. Actuarial gains or losses and prior service costs or credits are recorded within Other comprehensive (loss) income. The determination of our obligation and related expense for our sponsored pensions and other post-retirement benefits is dependent, in part, on management's selection of certain actuarial assumptions in calculating these amounts. These assumptions include, among other things, the discount rate and expected long-term rate of return on plan assets. The objective of our discount rate assumptions was intended to reflect the rates at which the pension benefits could be effectively settled. In making this determination, we take into account the timing and amount of benefits that would be available under the plans. As of February 27, 2016, we changed the method used to estimate the service and interest rate components of net periodic benefit cost for our defined benefit pension plans and other post-retirement benefit plans. Historically, the service and interest rate components were estimated using a single weighted average discount rate derived from the yield curve used to measure the benefit obligation at the beginning of the period. We have elected to use a full yield curve approach in the estimation of service and interest cost components of net pension and other post-retirement benefit plan expense by applying the specific spot rates along the yield curve used in the determination of the projected benefit obligation to the relevant projected cash flows. We utilized weighted discount rates of 4.12% and 4.21% for our pension plan expenses for fiscal 2018 and fiscal 2017, respectively. To determine the expected rate of return on pension plan assets held by us for fiscal 2018, we considered current and forecasted plan asset allocations as well as historical and forecasted rates of return on various asset categories. Our weighted assumed pension plan investment rate of return was 6.38% and 6.40% for fiscal 2018 and fiscal 2017, respectively. See Note 12 - Employee benefit plans and collective bargaining agreements in our consolidated financial statements, included elsewhere in this document, for more information on the asset allocations of pension plan assets. Sensitivity to changes in the major assumptions used in the calculation of our pension and other post-retirement plan liabilities is illustrated below (dollars in millions). In fiscal 2018 and fiscal 2017, we contributed $199.3 million and $21.9 million, respectively, to our pension and post-retirement plans. We expect to contribute $12.4 million to our pension and post-retirement plans in fiscal 2019. Income Taxes and Uncertain Tax Positions We review the tax positions taken or expected to be taken on tax returns to determine whether and to what extent a benefit can be recognized in our consolidated financial statements. See Note 11 - Income taxes in our consolidated financial statements, included elsewhere in this document, for the amount of unrecognized tax benefits and other disclosures related to uncertain tax positions. Various taxing authorities periodically examine our income tax returns. These examinations include questions regarding our tax filing positions, including the timing and amount of deductions and the allocation of income to various tax jurisdictions. In evaluating these various tax filing positions, including state and local taxes, we assess our income tax positions and record tax benefits for all years subject to examination based upon management's evaluation of the facts, circumstances and information available at the reporting date. For those tax positions where it is more likely than not that a tax benefit will be sustained, we have recorded the largest amount of tax benefit with a greater than 50% likelihood of being realized upon ultimate settlement with a taxing authority that has full knowledge of all relevant information. For those income tax positions where it is not more likely than not that a tax benefit will be sustained, no tax benefit has been recognized in our financial statements. A number of years may elapse before an uncertain tax position is examined and fully resolved. As of February 23, 2019, we are no longer subject to federal income tax examinations for fiscal years prior to 2012 and in most states, we are no longer subject to state income tax examinations for fiscal years before 2007. Tax years 2007 through 2017 remain under examination. The assessment of our tax position relies on the judgment of management to estimate the exposures associated with our various filing positions.

<s>[INST] Our last three fiscal years consisted of the 52 weeks ended February 23, 2019 ("fiscal 2018"), February 24, 2018 ("fiscal 2017") and February 25, 2017 ("fiscal 2016"). The Company's fiscal year ending February 29, 2020 will consist of 53 weeks ("fiscal 2019"). In this Management's Discussion and Analysis of Financial Condition and Results of Operations of Albertsons Companies, Inc., the words "Albertsons," "the Company," "we," "us," "our" and "ours" refer to Albertsons Companies, Inc., together with its subsidiaries. OVERVIEW We are one of the largest food and drug retailers in the United States, with both a strong local presence and national scale. As of February 23, 2019, we operated 2,269 stores across 34 states and the District of Columbia under 20 wellknown banners including Albertsons, Safeway, Vons, JewelOsco, Shaw's, Acme, Tom Thumb, Randalls, United Supermarkets, Market Street, Pavilions, Star Market, Carrs and Haggen, as well as meal kit company Plated. Additionally, as of February 23, 2019, we operated 1,282 instore branded coffee shops, 397 adjacent fuel centers, 23 dedicated distribution centers, six Plated fulfillment centers, 20 manufacturing facilities and various online platforms. We employed a diverse workforce of approximately 267,000, 275,000 and 273,000 associates as of February 23, 2019, February 24, 2018 and February 25, 2017, respectively. As of February 23, 2019, approximately 170,000 of our employees were covered by collective bargaining agreements. Collective bargaining agreements covering approximately 106,000 employees have expired or are scheduled to expire in fiscal 2019. If, upon the expiration of such collective bargaining agreements, we are unable to negotiate acceptable contracts with labor unions, it could increase our operating costs and disrupt our operations. Our Strategy We run a great brick and mortar supermarket business focused on fresh and local merchandising. We believe this provides the foundation for growth in both the fourwall and nowall (eCommerce) environments as we allow our customers to shop with us whenever, wherever and however they want. We operate our business through the execution of the following strategies: Enhancing and Upgrading Our Fresh, Natural and Organic Offerings and Signature Products. We continue to enhance and upgrade our fresh, natural and organic offerings across our meat, produce, service deli and bakery departments to meet the changing tastes and preferences of our customers. We also believe that continued innovation and expansion of our highvolume, highquality and differentiated signature products will contribute to stronger sales growth. Expanding Our Own Brands Offerings. We continue to drive sales growth and profitability by extending our Own Brand offerings across our banners, including highquality and recognizable brands O Organics, Signature Brands, Signature Cafe and Lucerne, each of which achieved over $1 billion in sales in the fiscal year ended February 23, 2019. Our Own Brand products achieved over $12.5 billion in sales during fiscal 2018, with 25.1% own brands penetration. Leveraging Our Effective and Scalable Loyalty Programs. We believe we can grow basket size and improve the shopping experience for our customers with our just for U and fuel and grocerybased loyalty programs. Over 16.4 million members are currently enrolled in our loyalty programs. We believe we can further enhance our merchandising and marketing programs by utilizing our customer analytics capabilities, including advanced digital marketing and mobile applications, to improve customer retention and provide targeted promotions to our customers. For example, our just for U and fuel and groc [/INST] Negative. </s>

Legacy Reserves Inc.

2019-03-22

2018-12-31

ITEM 7. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS The following discussion and analysis should be read in conjunction with the “Selected Historical Consolidated Financial Data” and the accompanying financial statements and related notes included elsewhere in this annual report on Form 10-K. The following discussion contains forward-looking statements that reflect our future plans, estimates, beliefs and expected performance. The forward-looking statements are dependent upon events, risks and uncertainties that may be outside our control. Our actual results could differ materially from those discussed in these forward-looking statements. Factors that could cause or contribute to such differences include, but are not limited to, market prices for oil and natural gas, production volumes, estimates of proved reserves, capital expenditures, economic and competitive conditions, regulatory changes and other uncertainties, as well as those factors discussed below and elsewhere in this report, particularly in “Risk Factors” and “Cautionary Statement Regarding Forward-Looking Information,” all of which are difficult to predict. In light of these risks, uncertainties and assumptions, actual results may differ materially from those anticipated or implied in the forward-looking statements. Overview Because of our historical growth through acquisitions and development of properties as well as large fluctuations in commodity prices, historical results of operations and period-to-period comparisons of these results and certain financial data may not be meaningful or indicative of future results. The operating results of the properties acquired as a part of our asset acquisition in conjunction with acceleration payment (the "Acceleration Payment") under our joint development agreement with TPG Sixth Street Partners (the "JDA") have been included since August 1, 2017. Going Concern We have significant obligations and commitments coming due in the near term. On March 21, 2019, we entered into an amendment to the Credit Agreement (as defined below) pursuant to which the lenders agreed to extend the maturity date from April 1, 2019 to May 31, 2019 and as of December 31, 2018, we had availability under the Credit Agreement of $32.9 million. Without additional sources of capital or a significant restructuring of our balance sheet, the maturity of our Credit Agreement raises substantial doubt about our ability to continue as a going concern, which means that we may be unable to continue operations for the foreseeable future or realize assets and discharge liabilities in the ordinary course of operation. The report of our independent registered public accounting firm that accompanies our audited consolidated financial statements in this annual report on Form 10-K contains an explanatory paragraph regarding the substantial doubt about our ability to continue as a going concern. The consolidated financial statements do not include any adjustments that might result from the outcome of the going concern uncertainty. In order to improve our liquidity position, we are currently evaluating financial, transactional and other strategic alternatives. In the first quarter of 2019, we retained financial and legal advisors who specialize in such alternatives. There can be no assurance that sufficient liquidity can be raised from any one or more of these transactions or that these transactions can be consummated within the period needed to meet our obligations or at all. Please see “Risk Factors-Risks Related to Our Business-We have engaged financial and legal advisors to assist us in, among other things, evaluating financial, transactional and other strategic alternatives to address our liquidity and capital structure that may be time consuming, disruptive and costly to our business, and -We may need to seek relief under the U.S. Bankruptcy Code, even if we are successful in effecting a financial, transactional or other strategic alternative. Any bankruptcy proceeding may result in holders of our equity securities and our other stakeholders receiving little or no consideration,” in Item 1A. We continue to focus on maintaining efficient operations to minimize production declines, improve lifting costs and well economics while regularly reviewing our asset portfolio and divesting non-core assets. Trends Affecting Our Business and Operations Irrespective of our balance sheet constraints, sustained periods of low prices for oil or natural gas have and could materially and adversely affect our financial position, our results of operations, the quantities of oil and natural gas reserves that we can economically produce and our access to capital. We face the challenge of natural production declines. As initial reservoir pressures are depleted, oil and natural gas production from a given well or formation decreases. We attempt to overcome this natural decline by drilling to find additional reserves, acquiring more reserves than we produce, utilizing multiple types of recovery techniques such as secondary (waterflood) and tertiary recovery methods to re-pressure the reservoir and recover additional oil, recompleting or adding pay in existing wellbores and improving artificial lift. Outlook. The oil and natural gas industry is in a challenging environment, especially over the past five years, as evidenced by volatility in the crude oil prices that ranged from over $100 per barrel in early 2014 to less than $30 per barrel in early 2016. While prices in 2017 and 2018 have recovered off the lows experienced in 2016 they have experienced a sharp decline at the end of 2018 from levels seen in 2017 and are still well below levels seen in 2014. Sustained development activity in the Permian Basin has created certain basin-wide operational challenges. Crude oil and associated natural gas production growth has strained existing takeaway capacity and caused widening basis differentials in the Permian Basin relative to benchmark crude oil and natural gas prices, which affect the prices we realize for our crude oil and natural gas production. The narrowing of these basis differentials is largely dependent on the construction of new takeaway capacity and other factors beyond our control. While we believe that a significant number of these projects will be completed in 2019, there is no guarantee that these projects will be completed on time or at all. In addition, the availability of services related to drilling, completion and other well site activity is becoming tighter. We do not have the ability to control the supply of these services and if we are unable to find adequate services for our operations at economic prices, there could be a material adverse impact on our financial condition. Also, production from our horizontal development within the Permian Basin has, from time to time, been temporarily shut-in or constrained due to proximate development operations. We cannot control or accurately forecast the timing, duration or other operational impositions associated with such well interference but the impacts could have a material adverse effect on our financial condition. Our development capital expenditures are expected to be approximately $135 million, subject to any limitations contained in the agreements governing our indebtedness, in 2019 and will continue to be focused on the development of our Permian Basin horizontal development assets, subject to any constraints imposed by our Term Loan Credit Agreement that may limit our capital expenditures as discussed in “Capital Resources and Liquidity-Future Liquidity Considerations”. We intend to continue to prudently manage our historical low-decline proved developed producing oil and gas properties to support the development of our high return prospects as we pursue additional cash flow and increase oil and natural gas reserves. To illustrate the sensitivity of our proved reserves to fluctuations in commodity prices, we recalculated our proved reserves as of December 31, 2018, using the five-year average forward price as of February 25, 2019 for both WTI oil and NYMEX natural gas. While this 5-year NYMEX forward strip price is not necessarily indicative of our overall outlook on future commodity prices, this commonly used methodology may help provide investors with an understanding of the impact of a volatile commodity price environment. Under such assumptions, we estimate the cumulative projected production from our year-end proved reserves would decrease by approximately 8.0% to 151.7 MMBoe from the reported 164.9 MMBoe, which is calculated as required by the SEC. We may breach certain financial covenants under Legacy LP's $1.5 billion secured revolving credit facility with Wells Fargo Bank, National Association, as administrative agent and the lenders party thereto as amended most recently by the Twelfth Amendment thereto (as amended, the “Credit Agreement”) and Legacy LP's second lien term loan credit agreement (as amended, our “Term Loan Credit Agreement”), which would constitute a default under our Credit Agreement or our Term Loan Credit Agreement. Further, while we received a waiver of the covenant under our Term Loan Credit Agreement that requires us to deliver audited financial statements without a “going concern” or like qualification or exception, such waiver expires on May 31, 2019 and such default cannot be remedied. Upon delivery of our financial statements for the quarter ended March 31, 2019, we expect to be in violation of the current ratio covenant under our Credit Agreement, which would constitute a default under the Credit Agreement. Defaults, if not remedied, would require a waiver from our lenders in order for us to avoid an event of default and subsequent acceleration of all amounts outstanding under our Credit Agreement or our Term Loan Credit Agreement or foreclosure on our oil and natural gas properties. Certain payment defaults or acceleration under our Credit Agreement or our Term Loan Credit Agreement could cause a cross-default or cross-acceleration of all of our indebtedness. While no assurances can be made that, in the event of a covenant breach, such a waiver will be granted, we believe the long-term global outlook for commodity prices and our efforts to date will be viewed positively by our lenders. For further discussion on the consequences of a breach of such covenants, including a potential cross-default of all our existing indebtedness, please read “Risk Factors-Risks Related to Our Business-If we are unable to refinance or repay our indebtedness under our Credit Agreement when it comes due or otherwise fail to comply with certain restrictions and financial covenants in our Credit Agreement and Term Loan Credit Agreement, we could be in default under our Credit Agreement and Term Loan Credit Agreement which may result in acceleration or repayment of all of our outstanding indebtedness,” in Item 1A. Considering the current environment for the oil and natural gas industry, our goals in 2019 are to: • reposition our balance sheet by evaluating and opportunistically pursuing strategic alternatives to materially reduce our outstanding indebtedness and restructure our near term maturity indebtedness. • minimize production declines and operating costs through efficient operations; and • efficiently develop our horizontal inventory in the Permian Basin to generate strong cash-on-cash investment returns. In the event that cash flows from operations are greater than we currently anticipate, whether as a result of increased commodity prices, reduced interest expense or otherwise, or additional external financing sources become available to us, we intend to pay down debt, accelerate our development plan, and increase development capital expenditures. Our future growth will depend on our ability to continue to add reserves in excess of production. We will maintain our focus on adding reserves through organic development projects and acquisitions. Our ability to add reserves through organic development projects and acquisitions is dependent upon many factors including our ability to raise capital, obtain regulatory approvals and contract drilling rigs and completions equipment and personnel. Our revenues are highly sensitive to changes in oil and natural gas prices and to levels of production. As set forth under “Investing Activities,” we have entered into oil and natural gas derivatives designed to mitigate the effects of price fluctuations covering a portion of our expected production, which allows us to mitigate, but not eliminate, oil and natural gas price risk. By removing a portion of our price volatility on our future oil and natural gas production through 2019, we have mitigated, but not eliminated, the potential effects of changing oil and natural gas prices on our cash flows from operations for those periods. Commodity prices may decrease, which could alter our acquisition and development plans, and adversely affect our growth strategy and ability to access additional capital in the capital markets and through our revolving credit facility. We continuously conduct financial sensitivity analyses to assess the effect of changes in pricing and production. These analyses allow us to determine how changes in oil and natural gas prices will affect our ability to execute our development plans and to meet future financial obligations. Further, the financial analyses allow us to monitor any impact such changes in oil and natural gas prices may have on the value of our proved reserves and their impact on any redetermination to our borrowing base under our revolving credit facility. Operating Data The following table sets forth our selected financial and operating data for the periods indicated. ____________________ (a) We primarily report and account for our Permian Basin natural gas volumes inclusive of the NGL content contained within those natural gas volumes. Given the price disparity between an equivalent amount of NGLs compared to natural gas, our realized natural gas prices in the Permian Basin and for Legacy as a whole are higher than Henry Hub natural gas index prices due to this NGL content. (b) Includes the production and operating results of the properties acquired as a part of our asset acquisition in conjunction with the Acceleration Payment from the closing date on August 1, 2017 through December 31, 2017 and thereafter. Results of Operations Year Ended December 31, 2018 Compared to Year Ended December 31, 2017 Legacy’s revenues from the sale of oil were $375.4 million and $239.4 million for the years ended December 31, 2018 and 2017, respectively. Legacy’s revenues from the sale of NGLs were $27.8 million and $24.8 million for the years ended December 31, 2018 and 2017, respectively. Legacy’s revenues from the sale of natural gas were $151.7 million and $172.1 million for the years ended December 31, 2018 and 2017, respectively. The $136.0 million increase in oil revenue reflects an increase in oil production of 1,597 MBbls (32%) and an increase in average realized price of $9.05 per Bbl (19%) to $56.64 for the year ended December 31, 2018 from $47.59 for the year ended December 31, 2017. The increase in realized oil price was primarily caused by an increase in the average WTI crude oil price of $14.43 and partially offset by worsening realized regional differentials. The increase in production is due to continued development of our Permian Basin horizontal assets as well as an increase in net well count under our JDA following the Acceleration Payment in 2017. The increase was partially offset by individually immaterial divestitures and natural declines. The $3.0 million increase in NGL revenues reflects an increase in realized NGL price of $0.02 per Gal (3%) to $0.67 per Gal for the year ended December 31, 2018 from $0.65 per Gal for the year ended December 31, 2017 and an increase in NGL production of 3,390 MGals (9%) during 2018. The increase in NGL production is primarily due to increased ethane recoveries from our Piceance natural gas properties. The $20.4 million decrease in natural gas revenues reflects a decrease of our realized natural gas prices as well as a decrease in our natural gas production volumes. Average realized gas prices decreased by $0.15 per Mcf (5%) to $2.59 per Mcf for the year ended December 31, 2018 from $2.74 per Mcf for the year ended December 31, 2017, primarily due to worsening realized regional differentials partially offset by an increase in the average NYMEX Henry Hub natural gas price of $0.16 per Mcf. Our natural gas production decreased by approximately 4,376 MMcf (7%), primarily due to natural production declines in our East Texas and Piceance Basin properties partially offset by increased production from the assets developed by our Permian Basin horizontal development program. For the year ended December 31, 2018, Legacy recorded $49.2 million of net gains on oil and natural gas derivatives. Commodity derivative gains and losses represent the changes in fair value of our commodity derivative contracts during the period and are primarily based on oil and natural gas futures prices. The net gain recognized during 2018 was primarily due to the decrease in oil futures prices for periods beyond 2018, which increased the fair value of our derivatives in such periods, partially offset by cash payments on oil derivative contracts during the year. For the year ended December 31, 2017, Legacy recorded $17.8 million of net gains on oil and natural gas derivatives. The net gain recognized during 2017 was primarily due to cash receipts and the decrease in natural gas futures prices for periods beyond 2017, which increased the fair value of our derivatives in such periods. Settlements of such contracts resulted in cash (payments)/receipts of $(11.7) million and $24.2 million during 2018 and 2017, respectively. Legacy’s oil and natural gas production expenses, excluding ad valorem taxes, increased to $191.3 million ($11.02 per Boe) for the year ended December 31, 2018 from $173.6 million ($10.58 per Boe) for the year ended December 31, 2017. This increase is primarily attributable to increased workover and repair activity across all operating regions as well as general cost increases due to higher commodity prices and field activity. These increases resulted in increased production expenses per Boe during 2018 compared to 2017. Legacy’s ad valorem tax expense decreased period over period primarily due to reductions in ad valorem tax expenses on certain non-operated properties. Legacy’s production and other taxes were $29.5 million and $19.8 million for the years ended December 31, 2018 and 2017, respectively. Production and other taxes increased due to higher oil revenues in 2018. On a per Boe basis, production and other taxes increased to $1.70 for the year ended December 31, 2018 from $1.21 for the year ended December 31, 2017 due to higher realized oil prices. Legacy’s general and administrative expenses were $73.0 million and $49.4 million for the years ended December 31, 2018 and 2017, respectively. General and administrative expenses increased approximately $23.7 million between periods primarily due to a $21.8 million increase in long-term incentive compensation expense due to the acceleration of expense in conjunction with the Corporate Reorganization. Legacy’s depletion, depreciation, amortization and accretion expense, or DD&A, was $160.0 million and $126.9 million for the years ended December 31, 2018 and 2017, respectively. DD&A increased primarily due to higher depletion rates across our historical properties primarily related to increased production rates combined with decreased reserves. Our depletion rate per Boe for the year ended December 31, 2018 was $9.22 compared to $7.73 for the year ended December 31, 2017. This increase is primarily driven by the increased depletion rates as discussed above. Impairment expense was $68.0 million and $37.3 million for the years ended December 31, 2018 and 2017, respectively. In 2018, Legacy recognized $58.7 million of impairment expense in 50 separate producing fields, due primarily to the further decline in oil and natural gas futures prices in late 2018 as well as increased expenses and well performance during the year ended December 31, 2018, which decreased the expected future cash flows below the carrying value of the assets. Additionally, we recorded impairment of $9.3 million related to unproved properties acquired since 2010 that, in the current and expected future commodity price environment, are no loger economically viable. In 2017, Legacy recognized impairment expense of $37.3 million in 47 separate producing fields, due primarily to the further decline in oil and natural gas futures prices in early 2017 as well as increased expenses and well performance during the year ended December 31, 2017, which decreased the expected future cash flows below the carrying value of the assets. Interest expense was $117.0 million and $89.2 million for the years ended December 31, 2018 and 2017, respectively. The increase in interest expense is primarily due to interest expense on our Second Lien Term Loans issued in October 2016 partially offset by a reduction in bond interest expense due to repurchases of our 6.625% senior unsecured notes maturing on December 1, 2020 (the "2021 Senior Notes") completed during 2018. Cash (receipts)/payments on our interest rate swaps were $(1.3) million and $0.8 million in 2018 and 2017, respectively. During the year ended December 31, 2018, we recorded a gain on extinguishment of debt of $66.1 million due to the repurchase of 2021 Senior Notes and the exchange of Senior Notes for Convertible Senior Notes. Income tax expense was $3.0 million and $1.4 million for the years ended December 31, 2018 and 2017, respectively. Income tax expense for both periods is primarily related to certain subsidiaries which were subject to corporate income tax prior to the Corporate Reorganization. The change in our income tax provision in 2018 was due to the Corporate Reorganization along with Legacy’s position to record a full valuation allowance. The effective income tax rates for the years ended December 31, 2018, and 2017 were 6.3% and (2.7)%, respectively. Our effective tax rate differed from the statutory rate primarily due to Legacy LP’s income not being subject to U.S. federal income tax, 2023 Convertible Notes issuance, Texas margins tax, and the valuation allowance. For the year ended December 31, 2017, our effective tax rate differed from the statutory rate primarily due to Legacy LP’s loss not being subject to U.S. federal income tax and Texas margins tax. As a result of the items described above, Legacy recorded net income/(losses) of $43.8 million and $(53.9) million for the years ended December 31, 2018 and 2017, respectively. Year Ended December 31, 2017 Compared to Year Ended December 31, 2016 Legacy’s revenues from the sale of oil were $239.4 million and $152.5 million for the years ended December 31, 2017 and 2016, respectively. Legacy’s revenues from the sale of NGLs were $24.8 million and $15.4 million for the years ended December 31, 2017 and 2016, respectively. Legacy’s revenues from the sale of natural gas were $172.1 million and $146.4 million for the years ended December 31, 2017 and 2016, respectively. The $86.9 million increase in oil revenue reflects an increase in oil production of 1,013 MBbls (25%) and an increase in average realized price of $9.64 per Bbl (25%) to $47.59 for the year ended December 31, 2017 from $37.95 for the year ended December 31, 2016. The increase in realized oil price was primarily caused by an increase in the average WTI crude oil price of $7.51 and improved realized regional differentials. The increase in production is due to an increase in net well count under our JDA following the Acceleration Payment and continued development of our Permian Basin horizontal assets. The increase was partially offset by individually immaterial divestitures and natural declines. The $9.4 million increase in NGL revenues reflects an increase in realized NGL price of $0.23 per Gal (55%) to $0.65 per Gal for the year ended December 31, 2017 from $0.42 per Gal for the year ended December 31, 2016 and an increase in NGL production of 1,402 MGals (4%) during 2017. The $25.6 million increase in natural gas revenues reflects an increase our realized natural gas prices partially offset by a decrease in our natural gas production volumes. Average realized gas prices increased by $0.55 per Mcf (25%) to $2.74 per Mcf for the year ended December 31, 2017 from $2.19 per Mcf for the year ended December 31, 2016, primarily due to an increase in the average NYMEX Henry Hub natural gas price of $0.47 per Mcf over the same time period and increased natural gas volumes produced from assets in the Permian Basin which are accounted for inclusive of the NGL content contained within the natural gas volumes, resulting in a realized gas price for those assets that is higher than the NYMEX Henry Hub index price. Our natural gas production decreased by approximately 3,991 MMcf (6%), primarily due to natural production declines in our East Texas and Piceance Basin properties partially offset by increased production from the assets developed by our Permian Basin horizontal development program. For the year ended December 31, 2017, Legacy recorded $17.8 million of net gains on oil and natural gas derivatives. Commodity derivative gains and losses represent the changes in fair value of our commodity derivative contracts during the period and are primarily based on oil and natural gas futures prices. The net gain recognized during 2017was primarily due to cash receipts and the decrease in natural gas futures prices for periods beyond 2017, which increased the fair value of our derivatives in such periods. For the year ended December 31, 2016, Legacy recorded $41.2 million of net losses on oil and natural gas derivatives. The net loss recognized during 2016 was primarily due to the increase in futures prices for periods beyond 2016, which reduced the fair value of our derivatives in such periods. Settlements of such contracts resulted in cash receipts of $24.2 million and $64.5 million during 2017 and 2016, respectively. Legacy’s oil and natural gas production expenses, excluding ad valorem taxes, increased to $173.6 million ($10.58 per Boe) for the year ended December 31, 2017 from $169.8 million ($10.59 per Boe) for the year ended December 31, 2016. This increase is primarily attributable to increased workover and repair activity across all operating regions, increased well count due to our Permian horizontal drilling program and increased working interests under our JDA following the Acceleration Payment partially offset by general cost reduction efforts. These reduction efforts, as well as the increase in oil and NGL production, resulted in decreased production expenses per Boe during 2017compared to 2016. Legacy’s ad valorem tax expense remained consistent period over period due to increased oil and natural gas property valuations offset by immaterial divestitures. Legacy’s production and other taxes were $19.8 million and $14.3 million for the years ended December 31, 2017 and 2016, respectively. Production and other taxes increased due to higher total revenues in 2017. On a per Boe basis, production and other taxes increased to $1.21 for the year ended December 31, 2017 from $0.89 for the year ended December 31, 2016 due to higher realized prices. Legacy’s general and administrative expenses were $49.4 million and $43.6 million for the years ended December 31, 2017 and 2016, respectively. General and administrative expenses increased approximately $5.7 million between periods primarily due to a $3.5 million increase in transaction-related expenses and other general cost increases. Legacy’s depletion, depreciation, amortization and accretion expense, or DD&A, was $126.9 million and $150.4 million for the years ended December 31, 2017 and 2016, respectively. DD&A decreased primarily due to lower depletion rates across our historical properties primarily related to impairment charges incurred in 2016 and 2017, which reduced our depletable cost basis. This decrease was partially offset by additional well count from our Permian Basin horizontal development program. Our depletion rate per Boe for the year ended December 31, 2017 was $7.73 compared to $9.38 for the year ended December 31, 2016. This decrease is primarily driven by a lower net cost basis on our historical assets due to previously recognized depletion and impairment. Impairment expense was $37.3 million and $61.8 million for the years ended December 31, 2017 and 2016, respectively. In 2017, Legacy recognized $37.3 million of impairment expense in 47 separate producing fields, due primarily to the further decline in oil and natural gas futures prices in early 2017 as well as increased expenses and well performance during the year ended December 31, 2017, which decreased the expected future cash flows below the carrying value of the assets. In 2016, Legacy recognized impairment expense of $61.8 million in 43 separate producing fields, due primarily to well performance and the further decline in commodity prices during the year ended December 31, 2016, which decreased the expected future cash flows below the carrying value of the assets. Interest expense was $89.2 million and $79.1 million for the years ended December 31, 2017 and 2016, respectively. The increase in interest expense is primarily due to interest expense on our Second Lien Term Loans issued in October 2016 partially offset by a reduction in bond interest expense due to repurchases and exchanges of our 8% senior unsecured notes maturing on December 1, 2020 (the "2020 Senior Notes") and our 6.625% senior unsecured notes maturing on December 1, 2021 (the "2021 Senior Notes", together with the 2020 Senior Notes, the "Senior Notes") completed during 2016. Additionally, interest expenses related to the gains (losses) on our interest rate swaps decreased by $3.3 million to $1.2 million in 2017 from $(2.1) million in 2016. Cash payments on our interest rate swaps were $0.8 million and $2.7 million in 2017 and 2016, respectively. As a result of the items described above, Legacy recorded net losses of $53.9 million and $55.8 million for the years ended December 31, 2017 and 2016, respectively. The decrease in net loss was primarily due to a decrease in impairment expense to $37.3 million during the year ended December 31, 2017 from $61.8 million for the year ended December 31, 2016 as well as increased revenue from our oil, natural gas and NGL production. These factors were partially offset by a decrease in the gain on extinguishment of debt in 2017 as compared to 2016. Non-GAAP Financial Measure Legacy’s management uses Adjusted EBITDA as a tool to provide additional information and a metric relative to the performance of Legacy’s business. Legacy’s management believes that Adjusted EBITDA is useful to investors because this measure is used by many companies in the industry as a measure of operating and financial performance and is commonly employed by financial analysts and others to evaluate the operating and financial performance of Legacy from period to period and to compare it with the performance of our peers. Adjusted EBITDA may not be comparable to a similarly titled measure of such peers because all entities may not calculate Adjusted EBITDA in the same manner. The following presents a reconciliation of “Adjusted EBITDA,” which is a non-GAAP measure, to its nearest comparable GAAP measure. Adjusted EBITDA should not be considered as an alternative to GAAP measures, such as net income, operating income, cash flow from operating activities, or any other GAAP measure of financial performance. Adjusted EBITDA is defined as net income (loss) plus: • Interest expense; • (Gain) loss on extinguishment of debt; • Income tax expense (benefit); • Depletion, depreciation, amortization and accretion; • Impairment of long-lived assets; • Loss (gain) on disposal of assets; • Equity in (income) loss of equity method investees; • Share-based compensation expense (benefit) related to LTIP unit awards accounted for under the equity or liability methods; • Minimum payments received in excess of overriding royalty interest earned; • Net (gains) losses on commodity derivatives; • Net cash settlements received (paid) on commodity derivatives; and • Transaction costs. The following table presents a reconciliation of Legacy’s consolidated net income (loss) to Adjusted EBITDA for the years ended December 31, 2018, 2017 and 2016, respectively. ____________________ (a) A portion of minimum payments received in excess of overriding royalties earned under a contractual agreement expiring December 31, 2019. The remaining amount of the minimum payments are recognized in net income. For the year ended December 31, 2018, Adjusted EBITDA increased 22% to $276.9 million from $226.2 million for the year ended December 31, 2017. This increase is due primarily to increased oil and natural gas production as well as increased realized commodity prices partially offset by lower commodity derivative realizations and increased production costs. For the year ended December 31, 2017, Adjusted EBITDA increased 45% to $226.2 million from $155.6 million for the year ended December 31, 2016. This increase is due primarily to increased oil and natural gas production as well as increased realized commodity prices partially offset by lower commodity derivative realizations and increased production costs. Capital Resources and Liquidity Legacy’s primary sources of capital and liquidity have been cash flow from operations, the issuance of the Senior Notes, the issuance of additional equity securities, our second lien term loans and bank borrowings, or a combination thereof. To date, Legacy’s primary use of capital has been for the acquisition and development of oil and natural gas properties, the repayment of bank borrowings and repurchases of Senior Notes. Based upon current oil and natural gas price expectations and our commodity derivatives positions, we anticipate that our cash on hand and cash flow from operations will provide us sufficient liquidity to fund our operations in 2019 including our planned capital expenditures of approximately $135 million, subject to any limitations contained in the agreements governing our indebtedness. However, we could breach certain covenants under our Credit Agreement or our Term Loan Credit Agreement, which would constitute a default under our Credit Agreement or our Term Loan Credit Agreement. While we have received a waiver under our Term Loan Credit Agreement that requires us to deliver audited financial statements without a “going concern” or like qualification or exception, such waiver expires on May 31, 2019 and such default cannot be remedied. Further, upon delivery of our financial statements for the quarter ended March 31, 2019, we expect to be in violation of the current ratio covenant under our Credit Agreement, which would constitute a default under the Credit Agreement. Defaults, if not remedied, would require a waiver from our lenders in order for us to avoid an event of default and potential subsequent acceleration of all amounts outstanding under our Credit Agreement or our Term Loan Credit Agreement or foreclosure on our oil and natural gas properties. Certain payment defaults or acceleration under our Credit Agreement or Term Loan Credit Agreement could cause a cross-default or cross-acceleration of all of our other indebtedness. If an event of default occurs, or if other debt agreements cross-default, and the lenders under the affected debt agreements accelerate the maturity of any loans or other debt outstanding, we will not have sufficient liquidity to repay all of our outstanding indebtedness. Future cash flows are subject to a number of variables, including the level of oil and natural gas production and prices. There can be no assurance that operations and other capital resources will provide cash in sufficient amounts to operate or to maintain planned levels of capital expenditures. Please see “-Cash Flow from Financing Activities-Credit Facility.” Our Credit Agreement initially became a current liability as of April 1, 2018 as the Credit Agreement was set to mature on April 1, 2019. On March 21, 2019, we entered into the Twelfth Amendment (the “Twelfth Amendment”) to our Credit Agreement, providing for, among other things, (i) an extension of the maturity of the Credit Agreement to May 31, 2019, (ii) an increase in the applicable interest rate by 2.25%, (iii) the payment of a fee equal to 0.35% of the amount of the current borrowing base under the Credit Agreement, payable on the effective date of the Twelfth Amendment, (iv) the mandatory termination of our derivative contracts three days prior to the maturity of the Credit Agreement, (vi) the reduction in the borrowing base from $575 million to $570 million, effective May 22, 2019, (vii) the reduction in the maximum consolidated cash balance we can maintain without prepaying the loans to $15 million, effective April 1, 2019 and (viii) the payment of a fee equal to 0.15% of the amount of the current borrowing base under the Credit Agreement, payable on the earliest to occur of (x) May 31, 2019 or (y) an acceleration of the outstanding indebtedness under the Credit Agreement. Additionally, the Amendment waives certain deviations from the requirements of the Credit Agreement, including the delivery of fiscal year 2018 audited financial statements with a “going concern” or like qualification or exception and non-compliance with the current ratio covenant for the fourth quarter of 2018. Our commodity derivatives position, which we use to mitigate commodity price volatility and (if positive) support our borrowing capacity, resulted in $11.7 million of cash payments in the year ended December 31, 2018. As market conditions warrant, we may, subject to certain restrictions, repurchase, exchange or otherwise pay down our outstanding debt, including our Senior Notes, in open market transactions, privately negotiated transactions, by tender offer or otherwise which may impact the trading liquidity of such securities. The amounts involved in any such transactions, individually or in the aggregate, may be material. In January 2018, we repurchased approximately $187.1 million of original principal amount of our 2021 Senior Notes from certain holders in a single transaction. During the fourth quarter 2018, we exchanged $3.1 million and $5.3 million of 2020 Senior Notes and 2021 Senior Notes, respectively, for 1 million shares of common stock and 2 million shares of our common stock, respectively. During 2016, Legacy LP repurchased approximately $52.0 million of original principal amount of 2020 Senior Notes and $117.3 million of original principal amount of 2021 Senior Notes on the open market, and exchanged 2,719,124 units for $15.0 million of face amount of our 2020 Senior Notes. Future Liquidity Considerations Our Term Loan Credit Agreement contains a number of restrictive covenants and limitations that impose significant operating and financial restrictions on us. Under the Term Loan Credit Agreement, if as of the last day of any fiscal quarter, our “First Lien Debt to EBITDA” ratio is less than (i) 1.50:1.00 between March 31, 2018 and June 30, 2019 and (ii) 1.25:1.00 between September 30, 2019 and December 31, 2019, then we are restricted from spending more than $60 million on capital expenditures, acquisitions or investments for the subsequent four quarters. As of December 31, 2018, our First Lien Debt to EBITDA ratio was 1.95. Interest payments on our Senior Notes are payable on June 1, 2019 and December 1, 2019 through the respective maturities. In order to improve our liquidity position, we are currently evaluating financial, transactional and other strategic alternatives which include, among others, a sale or other business combination transaction, sales of assets, financing transactions, or some combination of these. There can be no assurance that sufficient liquidity can be raised from any one or more of these transactions or that these transactions can be consummated within the period needed to meet our obligations. The significant risks and uncertainties described under “Risk Factors-Risks Related to the Business” raise substantial doubt about our ability to continue as a going concern. The report of our independent registered public accounting firm that accompanies our audited consolidated financial statements in this annual report on Form 10-K contains an explanatory paragraph regarding the substantial doubt about Legacy’s ability to continue as a going concern. Cash Flow from Operations Our net cash provided by operating activities was $175.9 million and $99.8 million for the years ended December 31, 2018 and 2017, respectively, with the 2018 period being favorably impacted by higher realized commodity prices, partially offset by higher production expenses. Our net cash provided by (used in) operating activities was $100.2 million and $(0.3) million for the years ended December 31, 2017 and 2016, respectively, with the 2017 period being favorably impacted by higher realized commodity prices, partially offset by higher production expenses. Our cash flow from operations is subject to many variables, the most significant of which is the volatility of oil, NGL and natural gas prices. Oil, NGL and natural gas prices are determined primarily by prevailing market conditions, which are dependent on regional and worldwide economic activity, weather and other factors beyond our control. Our future cash flow from operations will depend on our ability to maintain and increase production through acquisitions and development projects, as well as the prices of oil, NGLs and natural gas. Investing Activities Our cash capital expenditures were $227.9 million for the year ended December 31, 2018. The total includes $13.2 million related to individually immaterial acquisitions and $221.5 million of development projects. Our cash capital expenditures were $313.9 million for the year ended December 31, 2017. The total includes $163.4 million related to the Acceleration Payment and 6 individually immaterial acquisitions and $150.6 million of development projects. We currently anticipate that our development capital budget, which predominantly consists of drilling, recompletion and well stimulation projects related to our horizontal Permian Basin inventory will be approximately $135 million, subject to any limitations contained in the agreements governing our indebtedness, for the year ending December 31, 2019. Our available borrowing capacity under our Revolving Credit Agreement is $2.9 million as of March 13, 2019. The amount and timing of our capital expenditures is largely discretionary and within our control, with the exception of certain projects managed by other operators. Accordingly, we routinely monitor and adjust our capital expenditures in response to changes in oil and natural gas prices, drilling and acquisition costs, industry conditions, non-operated capital requirements and internally generated cash flow. Matters outside our control that could affect the timing of our capital expenditures include obtaining required permits and approvals in a timely manner as well as other regulatory matters. We enter into oil and natural gas derivatives to reduce the impact of oil and natural gas price volatility on our operations. At March 13, 2019, we had in place oil, natural gas and price differential derivatives covering portions of our estimated 2019 oil and natural gas production. However, our Credit Agreement provides for the mandatory termination of our derivative contracts three days prior to the maturity date of our Credit Agreement. By reducing the cash flow effects of price volatility from a portion of our oil and natural gas production, we have mitigated, but not eliminated, the potential effects of changing prices on our cash flow from operations for those periods. While mitigating negative effects of falling commodity prices, these derivative contracts also limit the benefits we would receive from increases in commodity prices. It is our policy to enter into derivative contracts only with counterparties that are major, creditworthy institutions deemed by management as competent and competitive market makers. In addition, none of our current counterparties require us to post margin. However, we cannot be assured that all of our counterparties will meet their obligations under our derivative contracts. Due to this uncertainty, we routinely monitor the creditworthiness of our counterparties. The following tables summarize, for the periods indicated, our oil and natural gas derivatives in place as of March 13, 2019 covering the period from January 1, 2019 through December 31, 2019. We use derivatives, including swaps, enhanced swaps and three-way collars, as our mechanism for offsetting the cash flow effects of changes in commodity prices whereby we pay the counterparty floating prices and receive fixed prices from the counterparty, which serves to reduce the effects on cash flow of the floating prices we are paid by purchasers of our oil and natural gas. These transactions are mostly settled based upon the monthly average closing price of front-month NYMEX WTI oil and the price on the last trading day of front-month NYMEX Henry Hub natural gas. Oil Swaps: We have entered into regional crude oil differential swap contracts in which we have swapped the floating WTI-ARGUS (Midland) crude oil price for floating WTI-ARGUS (Cushing) less a fixed-price differential. As noted above, we receive a discount to the NYMEX WTI crude oil price at the point of sale. Due to refinery downtimes and limited takeaway capacity that has impacted the Permian Basin, the difference between the WTI-ARGUS (Midland) price, which is the price we receive on almost all of our Permian crude oil production, and the WTI-ARGUS (Cushing) price reached historic highs in late 2012 and early 2013 and again in late 2014. We entered into these differential swaps to negate a portion of this volatility. The following table summarizes the oil differential swap contracts currently in place as of March 13, 2019, covering the period from January 1, 2018 through December 31, 2019: We have entered into regional crude oil differential enhanced swap contracts in which we have swapped the floating WTI-ARGUS (Midland) crude oil price for floating WTI-ARGUS (Cushing) crude oil price less a fixed-price differential combined with a short call option to enhance the price of the differential swap. The following table summarizes the oil differential contracts currently in place as of March 13, 2019, covering the period from January 1, 2019 through December 31, 2019: Natural Gas Swaps: We have also entered into regional natural gas differential swap contracts in which we have swapped the floating CIG natural gas price for a floating NYMEX Henry Hub price less a fixed differential. The following table summarizes these type of enhanced swap contracts currently in place as of March 13, 2019, covering the period from January 1, 2019 through December 31, 2019: Financing Activities Our net cash provided by financing activities was $12.1 million for the year ended December 31, 2018 and $177.7 million for the year ended December 31, 2017. During the year ended December 31, 2018, total net borrowings under our Credit Agreement were $42.0 million. We raised $131.0 million in proceeds, net of original issue discount, but excluding other offering expenses paid by us, from a draw under our Term Loan Credit Agreement and used the proceeds to repurchase $187.1 million of Senior Notes for $132.1 million, inclusive of accrued but unpaid interest. Legacy’s net cash provided by financing activities was $177.7 million for the year ended December 31, 2017, compared to $119.1 million used in financing activities for the year ended December 31, 2016. During the year ended December 31, 2017, total net borrowings under our Credit Agreement were $36.0 million. We raised $142.1 million in proceeds, net of original issue discount, but excluding other offering expenses paid by us, from a draw under our Term Loan Credit Agreement. Our net cash used in financing activities was $119.1 million for the year ended December 31, 2016. During the year ended December 31, 2016, total net repayments under our Revolving Credit Agreement were $145.0 million. We raised $58.8 million in proceeds, net of original issue discount, but excluding other offering expenses paid by us, from a draw under our Term Loan Credit Agreement. Our Revolving Credit Facility On April 1, 2014, Legacy LP entered into a five-year $1.5 billion secured revolving credit facility with Wells Fargo Bank, National Association, as administrative agent, Compass Bank, as syndication agent, UBS Securities LLC and U.S. Bank National Association, as co-documentation agents and the lenders party thereto (as amended, the “Credit Agreement”). On March 21, 2019, the maturity of the Credit Agreement was extended from April 1, 2019 to May 31, 2019. Our obligations under the Credit Agreement are secured by mortgages on over 95% of the total value of its oil and natural gas properties as well as a pledge of all of its ownership interests in our operating subsidiaries and Legacy's ownership interests in the General Partner. Concurrently with the Corporate Reorganization, the General Partner and Legacy Inc. provided guarantees of Legacy LP's obligations under the Credit Agreement. The amount available for borrowing at any one time is limited to the borrowing base and contains a $2 million sub-limit for letters of credit. The borrowing base is currently set at $575 million, and as of March 13, 2019, we have approximately $571 million drawn under the Credit Agreement leaving approximately $2.9 million of current availability. Under the terms of the Credit Agreement, our borrowing base reduces to $570 million on May 22, 2019. Additionally, either Legacy or the lenders may, once during each calendar year, elect to redetermine the borrowing base between scheduled redeterminations. Legacy also has the right, once during each calendar year, to request the redetermination of the borrowing base upon the proposed acquisition of certain oil and natural gas properties where the purchase price is greater than 10% of the borrowing base then in effect. Any increase in the borrowing base requires the consent of all the lenders, and any decrease in or maintenance of the borrowing base must be approved by the lenders holding at least 66-2/3% of the outstanding aggregate principal amounts of the loans or participation interests in letters of credit issued under the Credit Agreement. If the requisite lenders do not agree on an increase or decrease, then the borrowing base will be the highest borrowing base acceptable to the lenders holding 66-2/3% of the outstanding aggregate principal amounts of the loans or participation interests in letters of credit issued under the Credit Agreement so long as it does not increase the borrowing base then in effect. As of December 31, 2018, our ratio of consolidated current assets to consolidated current liabilities was less than 1.0 to 1.0, in violation of a covenant contained in our Credit Agreement. On March 21, 2019, we received waivers with respect to compliance with such covenant for the fiscal quarter ended December 31, 2018 and the requirement of delivery of fiscal year 2018 audited financials without a "going concern" qualification or exception. Except with respect to compliance with the financial covenant that has been waived, as of December 31, 2018, we were in compliance with all covenants of the Credit Agreement. Depending on future oil and natural gas prices, we could breach certain financial covenants under our Credit Agreement, which would constitute a default under our Credit Agreement. Such default, if not remedied, would require a waiver from our lenders in order for us to avoid an event of default and subsequent acceleration of all amounts outstanding under our Credit Agreement and potential foreclosure on our oil and natural gas properties. As previously noted, if the lenders under our Credit Agreement were to accelerate, subject to certain limitations, the indebtedness under our Credit Agreement as a result of a default, such acceleration could cause a cross-default of all of our other outstanding indebtedness, and permit the holders of such indebtedness to accelerate the maturities of such indebtedness. While no assurances can be made that, in the event of a covenant breach, such a waiver will be granted, we believe the long-term global outlook for commodity prices and our efforts to date, which include asset sales completed and anticipated as of the date of this filing, will be viewed positively by our lenders. If an event of default would occur and were continuing, we would be unable to make borrowings under the Credit Agreement, may be unable to make distributions to our shareholders and our financial condition and liquidity would be adversely affected. For further information related to our Credit Agreement, please refer to "-Footnote 3-Debt" in the Notes to Condensed Consolidated Financial Statements. The Credit Agreement permits us to issue additional senior notes in order to refinance our currently outstanding Senior Notes as well as to issue an additional $300 million in aggregate principal amount of new senior notes, in each case, subject to specified conditions in the Credit Agreement (including pro forma compliance with the first lien debt to EBITDA ratio and interest coverage ratio described below), which include that the borrowing base shall be reduced by an amount equal to (i) (A) in the case of new senior notes, 25% of the stated principal amount of such senior notes and (B) in the case of refinancing our currently outstanding Senior Notes, 100% of the portion of the new debt that exceeds the original principal amount of the senior notes being refinanced or (ii) in the sole discretion of the lenders holding at least 66-2/3% of the outstanding aggregate principal amounts of the loans or participation interests in letters of credit issued under the Credit Agreement prior to the issuance of the senior notes or new debt, an amount less than the amount specified in clause (A). In addition, we must prepay any amount outstanding under the Credit Agreement in excess of the redetermined borrowing base upon such a reduction. Prior to the Twelfth Amendment, Legacy could elect that borrowings be comprised entirely of alternate base rate ("ABR") loans or Eurodollar loans. Interest on the loans is determined as follows: • with respect to ABR loans, the alternate base rate equals the highest of the prime rate, the Federal funds effective rate plus 0.50%, or the one-month London Interbank Offered Rate (“LIBOR”) plus 1.00%, plus an applicable margin ranging from and including 1.00% to 2.00% per annum, determined by the percentage of the borrowing base then in effect that is utilized, provided, that if the ratio of our first lien debt as of the last day of any fiscal quarter to our EBITDA (as defined in the Credit Agreement) for the four fiscal quarters ending on such day is greater than 3.00 to 1.00, then the applicable margin shall be increased by 0.50% during the next succeeding fiscal quarter, or • with respect to any Eurodollar loans, one-, two-, three- or six-month LIBOR plus an applicable margin ranging from and including 2.00% to 3.00% per annum, determined by the percentage of the borrowing base then in effect that is utilized. Effective March 21, 2019, the Twelfth Amendment provides an increase of 2.25% to the interest rate paid on all ABR and Eurodollar loans. We pay a commitment fee ranging from and including 0.375% to 0.50% per annum on the average daily amount of the unused amount of the commitments under the Credit Agreement, determined by the percentage of the borrowing base then in effect that is utilized, payable quarterly. Interest is generally payable quarterly for ABR loans and on the last day of the applicable interest period for any Eurodollar loans. Our Credit Agreement also contains various covenants that limit our ability to: • incur indebtedness; • enter into certain leases; • grant certain liens; • enter into certain derivatives; • make certain loans, acquisitions, capital expenditures and investments; • make distributions other than from available cash; • merge, consolidate or allow certain material changes in the character of our business; • repurchase Senior Notes or repay second lien term loans; • engage in certain asset dispositions, including a sale of all or substantially all of our assets; or • maintain a consolidated cash balance in excess of $20 million, or, effective April 1, 2019, $15 million, without prepaying the loans in an amount equal to such excess. Our Credit Agreement also contains covenants that, among other things, require us to maintain specified ratios or conditions as follows: • as of any day, first lien debt to EBITDA for the four fiscal quarters ending on the last day of the fiscal quarter immediately preceding the date of determination for which financial statements are available to not be greater than: 2.50 to 1.00; • as of the last day of any fiscal quarter, secured debt to EBITDA for the four fiscal quarters ending on the last day of the fiscal quarter immediately preceding the date of determination to not be greater than 4.50 to 1.00 beginning with the fiscal quarter ending December 31, 2018; • as of the last day of any fiscal quarter, total EBITDA over the last four quarters to total interest expense over the last four quarters to be greater than 2.00 to 1.00; • consolidated current assets, as of the last day of the most recent quarter and including the unused amount of the total commitments, to consolidated current liabilities as of the last day of the most recent quarter of not less than 1.00 to 1.00, excluding current maturities under the Credit Agreement and non-cash assets and liabilities under ASC 815, which includes the current portion of oil, natural gas and interest rate derivatives; • as of the last day of any fiscal quarter, the ratio of (a) the sum of (i) the net present value using NYMEX forward pricing, discounted at 10 percent per annum, of our proved developed producing oil and gas properties (“PDP PV-10”), as reflected in the most recent reserve report delivered either July 1 or December 31 of each year, as the case may be, beginning with the reserve report to be delivered on July 1, 2017 (giving pro forma effect to material acquisitions or dispositions since the date of such reports), (ii) the net mark to market value of our swap agreements and (iii) our cash and cash equivalents to (b) Secured Debt to not be equal to or less than 1.00 to 1.00 . If an event of default exists under our Credit Agreement, the lenders will be able to accelerate the maturity of the credit agreement and exercise other rights and remedies. Each of the following would be an event of default: • failure to pay any principal when due or any reimbursement amount, interest, fees or other amount within certain grace periods; • a representation or warranty is proven to be incorrect when made; • failure to perform or otherwise comply with the covenants or conditions contained in the Credit Agreement or other loan documents, subject, in certain instances, to certain grace periods; • default by us on the payment of any other indebtedness in excess of $15.0 million, or any event occurs that permits or causes the acceleration of the indebtedness; • bankruptcy or insolvency events involving us or any of our subsidiaries; • the loan documents cease to be in full force and effect; • our failing to create a valid lien, except in limited circumstances; • a change in control, which will occur upon (a) Legacy Inc. ceasing to (i) be the beneficial owner of 100% of the equity interests of the General Partner, (ii) control the General Partner or (iii) be the beneficial owner of 100% of the limited partner equity interests in Legacy LP; (b) the General Partner ceases to be the sole general partner of Legacy LP; (c) the direct or indirect sale, lease, transfer, conveyance or other disposition (other than by way of merger or consolidation), in one or a series of related transactions, of all or greater than 50% of the properties or assets of Legacy LP and its subsidiaries taken as a whole; (d) the adoption of a plan relating to the liquidation or dissolution of Legacy Inc. or Legacy LP; (e) the consummation of any transaction that results in any person becoming the beneficial owner of more than 50% of the aggregate voting power of Legacy Inc.; or (f) the first day on which a majority of the members of the Board are not continuing directors; • the entry of, and failure to pay, one or more adverse judgments in excess of $15.0 million or one or more non-monetary judgments that could reasonably be expected to have a material adverse effect and for which enforcement proceedings are brought or that are not stayed pending appeal; • specified ERISA events relating to our employee benefit plans that could reasonably be expected to result in liabilities in excess of $2.0 million in any year; • the Intercreditor Agreement (as defined below) ceases to be in effect, except to the extent permitted by the terms thereof; and • if an “Event of Default” occurs under the Term Loan Credit Agreement (as defined below). On September 14, 2018 and September 20, 2018, Legacy entered into the Tenth Amendment and Eleventh Amendment, respectively, to the Credit Agreement (the “Credit Agreement Amendments”). The Credit Agreement Amendments amend certain provisions set forth in the Credit Agreement to, among other items: • permit the issuance of the 2023 Convertible Notes; • provide that the 2023 Convertible Notes constitute debt that is permitted refinancing debt; • allow for the payment of a cash conversion incentive in connection with the early cashless conversion of the 2023 Convertible Notes into common shares; and • permit the redemption of certain senior notes or permitted refinancing debt of such senior notes with any combination of the following: (i) proceeds of certain permitted refinancing debt: (ii) net cash proceeds of any sale of equity interests (other than disqualified capital stock) of Legacy Inc.; and/or (iii) in exchange for equity interests (other than disqualified capital stock) of Legacy Inc. On March 21, 2019, we entered into the Twelfth Amendment, providing for, among other things, (i) an extension of the maturity of the Credit Agreement to May 31, 2019, (ii) an increase in the applicable interest rate by 2.25%, (iii) the payment of a fee equal to 0.35% of the amount of the current borrowing base under the Credit Agreement, payable on the effective date of the Twelfth Amendment, (iv) the mandatory termination of our derivative contracts three days prior to the maturity of the Credit Agreement, (vi) the reduction in the borrowing base from $575 million to $570 million, effective May 22, 2019, (vii) the reduction in the maximum consolidated cash balance we can maintain without prepaying the loans to $15 million, effective April 1, 2019 and (viii) the payment of a fee equal to 0.15% of the amount of the current borrowing base under the Credit Agreement, payable on the earliest to occur of (x) May 31, 2019 or (y) an acceleration of the outstanding indebtedness under the Credit Agreement. Additionally, the Amendment waives certain deviations from the requirements of the Credit Agreement, including the delivery of fiscal year 2018 audited financial statements with a “going concern” or like qualification or exception and non-compliance with the current ratio covenant for the fourth quarter of 2018. As of December 31, 2018, we were in compliance with all financial and other covenants of the Credit Agreement other than the ratio of consolidated current assets to consolidated current liabilities. On March 21, 2019, we received a waiver of the covenant that required us to deliver audited financial statements without a "going concern" or like qualification or exception. We could breach certain financial covenants under our Credit Agreement, which would constitute a default under our Credit Agreement. Such default, if not remedied, would require a waiver from our lenders in order for us to avoid an event of default and subsequent acceleration of all amounts outstanding under our Credit Agreement or foreclosure on our oil and natural gas properties. As previously noted, if the lenders under our Credit Agreement were to accelerate the indebtedness under our Credit Agreement as a result of a default, such acceleration could cause a cross-default of all of our other outstanding indebtedness, including our second lien term loans and Senior Notes, and permit the holders of such indebtedness to accelerate the maturities of such indebtedness. Our Second Lien Term Loans On October 25, 2016, Legacy entered into a Second Lien Term Loan Credit Agreement (as amended, the "Term Loan Credit Agreement") among Legacy, as borrower, Cortland Capital Market Services LLC ("Cortland"), as administrative agent and second lien collateral agent, and the lenders party thereto, providing for term loans up to an aggregate principal amount of $300.0 million (the Second Lien Term Loans"). The Term loans under the Term Loan Credit Agreement are issued with an upfront fee of 2% and bear interest at a rate of 12.00% per annum payable quarterly in cash or, prior to the 18 month anniversary of the Term Loan Credit Agreement, Legacy may elect to pay in kind up to 50% of the interest payable. Effective March 21, 2019, the Seventh Amendment (as defined below) to the Term Loan Credit Agreement provides an increase of 2.25% to the interest rate paid on all term loans. GSO Capital Partners L.P. (“GSO”) and certain funds and accounts managed, advised or sub-advised, by GSO are the initial lenders thereunder. The Term Loan Credit Agreement matures on August 31, 2021; provided that, if on July 1, 2020, Legacy has greater than or equal to a face amount of $15.0 million of Senior Notes that were outstanding on the date the Term Loan Credit Agreement was entered into or any other senior notes with a maturity date that is earlier than August 31, 2021, the Term Loan Credit Agreement will mature on August 1, 2020. The Second Lien Term Loans are secured on a second lien priority basis by the same collateral that secures the Legacy's Credit Agreement and are unconditionally guaranteed on a joint and several basis by the same wholly owned subsidiaries of Legacy that are guarantors under the Credit Agreement. In addition, upon consummation of the Corporate Reorganization, the General Partner and Legacy Inc. became guarantors. As of December 31, 2018, Legacy had approximately $338.6 million drawn under the Term Loan Credit Agreement. On December 31, 2017, Legacy entered into the Third Amendment to the Term Loan Credit Agreement (the "Third Amendment") among Legacy, as borrower, Cortland, as administrative agent and second lien collateral agent, and the lenders party thereto, including GSO and certain funds and accounts managed, advised or sub-advised by GSO, which, among other things, increased the maximum amount available for borrowing under the Second Lien Term Loans to $400.0 million, extended the availability of undrawn principal ($61.4 million of availability as of December 31, 2018) to October 25, 2019 and relaxed the asset coverage ratio to 0.85 to 1.00 until the fiscal quarter ended December 31, 2018. Borrowings of additional amounts under the Term Loan Credit Agreement are subject to the consent of the lenders thereunder. The Third Amendment became effective on January 5, 2018. We used the initial $60.0 million of gross loan proceeds from our Term Loan Credit Agreement to repay outstanding indebtedness and pay associated transaction expenses. We used subsequent draws to fund the acceleration payment under our JDA and repurchase a portion of our 2021 Senior Notes. The Second Lien Term Loans under the Term Loan Credit Agreement will be issued with an upfront fee of 2% and bear interest at a rate of 12.00% per annum payable quarterly in cash. The Second Lien Term Loans may be used for general corporate purposes and for the repayment of outstanding indebtedness, in each case as may be approved by us and GSO. The Term Loan Credit Agreement contains customary prepayment provisions and make-whole premiums. The Term Loan Credit Agreement also contains covenants that, among other things, require us to maintain specified ratios or conditions as follows: • not permit, as of the last day of the fiscal quarter, the ratio of the sum of (i) PDP PV-10, (ii) the net mark to market value of our swap agreements and (iii) our cash and cash equivalents to Secured Debt to be less than (i) 0.85 to 1.00 through and including the fiscal quarter ended December 31, 2018 and (ii) 1.00 to 1.00 thereafter; • not permit, as of the last day of any fiscal quarter beginning with the fiscal quarter ending December 31, 2018, our ratio of Secured Debt as of such day to EBITDA for the four fiscal quarters then ending to be greater than 4.50 to 1.00; • We are required to mortgage 95% of the total value of all of its Oil and Gas Properties set forth in the most recently evaluated Reserve Report and grant a mortgage on certain identified undeveloped acreage in the Permian Basin; and • require us to grant a perfected security interest in its cash and securities accounts, subject to certain customary exceptions. On September 14, 2018 and September 20, 2018, Legacy entered into the Fifth Amendment and Sixth Amendment, respectively to the Term Loan Credit Agreement (the "Term Loan Amendments"). The Term Loan Amendments amend certain provisions set forth in the Term Loan Credit Agreement to, among other items: • permit the issuance of the 2023 Convertible Notes; • provide that the 2023 Convertible Notes constitute debt that is permitted refinancing of debt; • allow for the payment of a cash conversion incentive in connection with the early cashless conversion of the 2023 Convertible Notes into common shares; and • permit the redemption of certain senior notes or permitted refinancing debt of such senior notes with any combination of the following: (i) proceeds of certain permitted refinancing debt; (ii) net cash proceeds of any sale of equity interests (other than disqualified capital stock) of Legacy Inc.; and/or (iii) in exchange for equity interests (other than disqualified capital stock) of Legacy Inc. On March 21, 2019, we entered into the Seventh Amendment (the “Seventh Amendment”) to our Term Loan Credit Agreement. The Seventh Amendment waives, through May 31, 2019, the requirement of the Term Loan Credit Agreement that the delivery of fiscal year 2018 audited financial statements not include a “going concern” or like qualification or exception. The Seventh Amendment also provides for, among other things, (i) an increase in the applicable interest rate by 2.25%, (ii) a fee equal to 0.35% of the aggregate amount of term loans currently outstanding under the Term Loan Credit Agreement, to be paid in kind by increasing the aggregate amount of term loans outstanding as of the effective date of the Seventh Amendment and (iii) a fee equal to 0.15% of the aggregate amount of term loans currently outstanding under the Term Loan Credit Agreement, to be paid in kind by increasing the aggregate amount of term loans outstanding on the earliest to occur of (x) May 31, 2019 or (y) an acceleration of the outstanding indebtedness under the Term Loan Credit Agreement. All capitalized terms used but not defined in the foregoing description have the meaning assigned to them in the Term Loan Credit Agreement. As of December 31, 2018, we were in compliance with all financial and other covenants of the Term Loan Credit Agreement. On March 21, 2019, we received a waiver of the covenant that required us to deliver audited financial statements without a "going concern" or like qualification or exception. A customary intercreditor agreement was entered into by Wells Fargo Bank, National Association, as priority lien agent, and Cortland Capital Markets Services LLC, as junior lien agent and acknowledged and accepted by Legacy and the subsidiary guarantors (the "Intercreditor Agreement"). If an event of default exists under the Term Loan Credit Agreement, subject to the terms of the Intercreditor Agreement, the lenders will be able to accelerate the maturity of the Term Loan Credit Agreement and exercise other rights and remedies. 8% Senior Notes Due 2020 On December 4, 2012, Legacy and its 100% owned subsidiary Legacy Reserves Finance Corporation (together, the "Issuers") completed a private placement offering to eligible purchasers of an aggregate principal amount of $300.0 million of its 2020 Senior Notes, which were subsequently registered through a public exchange offer that closed on January 8, 2014. The 2020 Senior Notes were issued at 97.848% of par. We received net proceeds of approximately $286.7 million, after deducting the discount to initial purchasers and offering expense paid by us. Legacy has the option to redeem the 2020 Senior Notes, in whole or in part, at any time at par with any accrued and unpaid interest, if any, to the date of redemption. Legacy may be required to offer to repurchase the 2020 Senior Notes at a purchase price of 101% of the principal amount, plus accrued and unpaid interest, if any, to the redemption date, in the event of a change of control as defined by the indenture as supplemented. The Issuer's obligations under the 2020 Senior Notes are guaranteed by Legacy Inc., The General Partner, and Legacy LP's 100% owned subsidiaries Legacy Reserves Operating GP LLC, Legacy Reserves Operating LP, Legacy Reserves Services LLC, Legacy Reserves Energy Services LLC, Legacy Reserves Marketing LLC, Dew Gathering LLC and Pinnacle Gas Treating LLC (collectively, the "Guarantors"). In the future, the guarantees may be released or terminated under the following circumstances: (i) in connection with any sale or other disposition of all or substantially all of the properties of the guarantor; (ii) in connection with any sale or other disposition of sufficient capital stock of the guarantor so that it no longer qualifies as our Restricted Subsidiary (as defined in the indenture); (iii) if designated to be an unrestricted subsidiary; (iv) upon legal defeasance, covenant defeasance or satisfaction and discharge of the indenture; (v) upon the liquidation or dissolution of the guarantor provided no default or event of default has occurred or is occurring; (vi) at such time the guarantor does not have outstanding guarantees of its, or any other guarantor's, other debt; or (vii) upon merging into, or transferring all of its properties to Legacy or another guarantor and ceasing to exist. Refer to Note 17 - Subsidiary Guarantors in the Notes to the Consolidated Financial Statements for further details on our guarantors. The indenture governing the 2020 Senior Notes (as supplemented, the "2020 Notes Indenture") limits Legacy's ability and the ability of certain of its subsidiaries to (i) sell assets; (ii) pay distributions or dividends on, repurchase or redeem equity interests or purchase or redeem Legacy's subordinated debt, provided that such subsidiaries may pay dividends to the holders of their equity interests (including Legacy) and Legacy may pay distributions to the holders of its equity interests subject to the absence of certain defaults, the satisfaction of a fixed charge coverage ratio test and certain other conditions; (iii) make certain investments; (iv) incur or guarantee additional indebtedness or issue preferred securities; (v) create or incur certain liens; (vi) enter into agreements that restrict distributions or other payments from certain of its subsidiaries to Legacy; (vii) consolidate, merge or transfer all or substantially all of Legacy's assets; (viii) engage in certain transactions with affiliates; (ix) create unrestricted subsidiaries; and (x) engage in certain business activities. These covenants are subject to a number of important exceptions and qualifications. If at any time when the 2020 Senior Notes are rated investment grade by each of Moody's Investors Service, Inc. and Standard & Poor's Ratings Services and no Default (as defined in the indenture) has occurred and is continuing, many of such covenants will terminate and Legacy and its subsidiaries will cease to be subject to such covenants. The 2020 Notes Indenture also includes customary events of default. Legacy is in compliance with all financial and other covenants of the 2020 Senior Notes. However, if the lenders under Legacy's Credit Agreement or Term Loan Credit Agreement were to accelerate the indebtedness under the Credit Agreement or Term Loan Credit Agreement as a result of a default, such acceleration could cause a cross-default of all of the 2020 Senior Notes and permit the holders of such notes to accelerate the maturities of such indebtedness. Interest is payable on June 1 and December 1 of each year. During the year ended December 31, 2016, we repurchased a face amount of $52.0 million of our 2020 Senior Notes on the open market. We treated these repurchases as an extinguishment of debt. Accordingly, we recognized a gain for the difference between (1) the face amount of the 2020 Senior Notes repurchased net of the unamortized portion of both the original issuer's discount and issuance costs and (2) the repurchase price. On June 1, 2016, we exchanged 2,719,124 units for $15.0 million of face amount of its outstanding 2020 Senior Notes. We treated this exchange as an extinguishment of debt. Accordingly, we recognized a gain for the difference between (1) the face amount of the 2020 Senior Notes repurchased net of the unamortized portion of both the original issuer's discount and issuance costs and (2) the fair value of the units issued in the exchange based on the closing price on June 1, 2016. We previously repurchased and exchanged, and have not retired, $67.0 million of our 2020 Senior Notes. Subject to certain restrictions, we retain our voting rights under the indenture governing the 2020 Senior Notes. On September 20, 2018, Legacy exchanged approximately $21.0 million aggregate principal amount of 2020 Senior Notes for $21.0 million aggregate principal amount of 2023 Convertible Notes. On November 21, 2018, Legacy exchanged $3.1 million aggregate principal amount of 2020 Senior Notes for 1 million shares of our common stock. 6.625% Senior Notes Due 2021 On May 28, 2013, the Issuers completed a private placement offering to eligible purchasers of an aggregate principal amount of $250 million of its 2021 Senior Notes. The 2021 Senior Notes were issued at 98.405% of par. We received approximately $240.7 million of net cash proceeds, after deducting the discount to initial purchasers and offering expenses paid by us. On May 13, 2014, the Issuers completed a private placement offering to eligible purchasers of an aggregate principal amount of an additional $300 million of its 6.625% 2021 Senior Notes. This issuance of the additional 2021 Senior Notes was at 99.0% of par. We received approximately $291.8 million of net cash proceeds, after deducting the discount to initial purchasers and offering expenses payable by us. The terms of the 2021 Senior Notes, including the Guarantors, are substantially identical to the terms of the 2020 Senior Notes with the exception of the interest rate and redemption provisions noted below. Legacy will have the option to redeem the 2021 Senior Notes, in whole or in part, at par together with any accrued and unpaid interest, if any, to the date of redemption. Legacy may be required to offer to repurchase the 2021 Senior Notes at a purchase price of 101% of the principal amount, plus accrued and unpaid interest, if any, to the redemption date, in the event of a change of control as defined by the indenture, as supplemented. Legacy is in compliance with all financial and other covenants of the 2021 Senior Notes. However, if the lenders under our Credit Agreement or Term Loan Credit Agreement were to accelerate the indebtedness under our Credit Agreement or Term Loan Credit Agreement as a result of a default, such acceleration could cause a cross-default of all of the 2021 Senior Notes and permit the holders of such notes to accelerate the maturities of such indebtedness. Interest is payable on June 1 and December 1 of each year. On September 20, 2018, the Issuers exchanged $109.0 million aggregate principal amount of 2021 Senior Notes for $109.0 million aggregate principal amount of 2023 Convertible Notes. On December 17, 2018, Legacy exchanged $5.3 million aggregate principal amount of 2021 Senior Notes for 2 million shares of our common stock. On December 31, 2017, we entered into an agreement to repurchase a face amount of $187.1 million of our 2021 Senior Notes from certain holders in a single transaction. The transaction was settled on January 5, 2018 and was therefore recognized in 2018. We treated these repurchases as an extinguishment of debt. Accordingly, we recognized a gain for the difference between (1) the face amount of the 2021 Senior Notes repurchased net of the unamortized portion of both the original issuer's discount and issuance costs and (2) the repurchase price. During the year ended December 31, 2016, we repurchased a face amount of $117.3 million of our 2021 Senior Notes on the open market. We treated these repurchases as an extinguishment of debt. Accordingly, we recognized a gain for the difference between (1) the face amount of the 2021 Senior Notes repurchased net of the unamortized portion of both the original issuer's discount and issuance costs and (2) the repurchase price. We previously repurchased, and have not retired, $304.4 million of our 2021 Senior Notes. Subject to certain restrictions, we retain our voting rights under the indenture governing the 2021 Senior Notes. 8% Convertible Senior Notes Due 2023 ("2023 Convertible Notes") On September 20, 2018, the Issuers, completed private exchanges with certain holders of senior notes, pursuant to which the Issuers exchanged (i) $21.004 million aggregate principal amount of 2020 Senior Notes for $21.004 million aggregate principal amount of 2023 Convertible Notes and 105,020 shares of common stock and (ii) $109.0 million aggregate principal amount of 2021 Senior Notes for $109.0 million aggregate principal amount of 2023 Convertible Notes. The 2023 Convertible Notes were issued pursuant to an Indenture, dated as of September 20, 2018 (the “2023 Convertible Note Indenture”) Upon issuance, the Company separately accounted for the liability and equity components in accordance with Accounting Standards Codification 470-20. The initial fair value of the 2023 Convertible Notes in its entirety (inclusive of the equity component related to the conversion option) was estimated using observable inputs such as trades that occurred on the day of the transaction. The liability component was recorded at the estimated fair value of a similar debt instrument without the conversion feature. The difference between the aggregate principal amount of the 2023 Convertible Notes and the fair value of the liability component was recorded as a debt discount and is being amortized to interest expense over the term of the notes using the effective interest method. The fair value of the liability component of the 2023 Convertible Notes was estimated at $101.0 million, resulting in a debt discount of $29.0 million The equity component, representing the value of the conversion option, was computed by deducting the fair value of the liability component from the initial fair value of the 2023 Convertible Notes. The equity component was recorded in additional paid-in capital within stockholders’ equity and will not be remeasured as long as it continues to meet the conditions for equity classification. The 2023 Convertible Notes mature on September 20, 2023, unless earlier repurchased or redeemed by the Issuers or converted. The 2023 Convertible Notes are subject to redemption for cash, in whole or in part, at the Issuers’ option at a redemption price equal to 100% of the 2023 Convertible Notes to be redeemed, plus any accrued and unpaid interest. In addition, the Issuers are required to make an offer to holders of the 2023 Convertible Notes upon a change of control at a price equal to 101%, plus any accrued and unpaid interest, and an offer to holders of the 2023 Convertible Notes upon consummation by the Issuers or any restricted subsidiaries of certain asset sales at a price equal to 100%, plus any accrued and unpaid interest. The 2023 Convertible Notes are convertible into shares of common stock at an initial conversion rate of 166.6667 shares per $1,000 principal amount of 2023 Convertible Notes, which is equal to an initial conversion price of $6.00 per share of common stock (the "Conversion Price"). The 2023 Convertible Notes are convertible, at the option of the holders, into shares of common stock at any time from the date of issuance up until the close of business on the earlier of (i) the business day prior to the date of a mandatory conversion notice, (ii) with respect to a 2023 Convertible Note called for redemption, the business day immediately preceding the redemption date or (iii) the business day immediately preceding the maturity date. In addition, if a holder exercises its right to convert on or prior to September 19, 2019, such holder will receive an early conversion payment, in cash, per $1,000 principal amount as follows: Subject to compliance with certain conditions, the Issuers have the right to mandatorily convert all of the 2023 Convertible Notes if the volume weighted average price of the common stock equals or exceeds the conversion price for at least 20 trading days (whether or not consecutive) during any period of 30 consecutive trading days commencing on or after the initial issuance date. The 2023 Convertible Notes are guaranteed by Legacy Inc., the General Partner, Legacy Reserves Operating GP LLC, Legacy Reserves Operating LP, Legacy Reserves Services LLC, Legacy Reserves Energy Services LLC, Dew Gathering LLC and Pinnacle Gas Treating LLC. The terms of the 2023 Convertible Notes, including the Guarantors, are substantially identical to the terms of the 2020 Senior Notes and 2021 Senior Notes with the exception of the interest rate, conversion and redemption provisions noted above. Additionally, if the lenders under Legacy's Credit Agreement or Term Loan Credit Agreement were to accelerate the indebtedness under the Credit Agreement or Term Loan Credit Agreement as a result of a default, such acceleration could cause a cross-default of all of the 2023 Senior Notes and permit the holders of such notes to accelerate the maturities of such indebtedness. During the year ended December 31, 2018, certain holders of the 2023 Convertible Notes exercised their option to convert $1.9 million of face amount of 2023 Convertible Notes in exchange for 316,828 shares of our common stock. Interest is payable on June 1 and December 1 of each year. Off-Balance Sheet Arrangements None. Contractual Obligations A summary of our contractual obligations as of December 31, 2018 is provided in the following table. ____________________ (a) Represents amounts outstanding under our revolving credit facility as of December 31, 2018. (b) Based upon our weighted average interest rate of 5.44% under our revolving credit facility as of December 31, 2018. Critical Accounting Policies and Estimates The discussion and analysis of our financial condition and results of operations is based upon the consolidated financial statements, which have been prepared in accordance with accounting principles generally accepted in the United States. The preparation of our consolidated financial statements requires us to make estimates and assumptions that affect the reported amounts of assets, liabilities, revenues and expenses, and related disclosure of contingent assets and liabilities. Certain accounting policies involve judgments and uncertainties to such an extent that there is a reasonable likelihood that materially different amounts could have been reported under different conditions, or if different assumptions had been used. Estimates and assumptions are evaluated on a regular basis. We based our estimates on historical experience and various other assumptions that are believed to be reasonable under the circumstances, the results of which form the basis for making judgments about the carrying values of assets and liabilities that are not readily apparent from other sources. Actual results may differ from these estimates and assumptions used in preparation of the financial statements. Changes in these estimates and assumptions could materially affect our financial position, results of operations or cash flows. Management considers an accounting estimate to be critical if: • it requires assumptions to be made that were uncertain at the time the estimate was made, and • changes in the estimate or different estimates that could have been selected could have a material impact on our consolidated results of operations or financial condition. Please read Note 1 of the Notes to Consolidated Financial Statements for a detailed discussion of all significant accounting policies that we employ and related estimates made by management. Nature of Critical Estimate Item: Oil and Natural Gas Reserves - Our estimate of proved reserves is based on the quantities of oil and gas which geological and engineering data demonstrate, with reasonable certainty, to be recoverable in future years from known reservoirs under existing economic and operating conditions. LaRoche prepares a reserve and economic evaluation of all our properties in accordance with Securities and Exchange Commission, or “SEC,” guidelines on a lease, unit or well-by-well basis, depending on the availability of well-level production data. The accuracy of our reserve estimates is a function of many factors including the following: the quality and quantity of available data, the interpretation of that data, the accuracy of various mandated economic assumptions, and the judgments of the individuals preparing the estimates. In addition, we must estimate the amount and timing of future operating costs, severance taxes, development costs, and workover costs, all of which may in fact vary considerably from actual results. In addition, as prices and cost levels change from year to year, the economics of producing the reserves may change and therefore the estimate of proved reserves also may change. Any significant variance in these assumptions could materially affect the estimated quantity and value of our reserves. Despite the inherent imprecision in these engineering estimates, our reserves are used throughout our financial statements. Reserves and their relation to estimated future net cash flows impact our depletion and impairment calculations. As a result, adjustments to depletion rates are made concurrently with changes to reserve estimates. Assumptions/Approach Used: Units-of-production method to deplete our oil and natural gas properties - The quantity of reserves could significantly impact our depletion expense. Any reduction in proved reserves without a corresponding reduction in capitalized costs will increase the depletion rate. Effect if Different Assumptions Used: Units-of-production method to deplete our oil and natural gas properties - A 10% increase or decrease in reserves would have decreased or increased, respectively, our depletion expense for the year ended December 31, 2018 by approximately 10%. Nature of Critical Estimate Item: Asset Retirement Obligations - We have certain obligations to remove tangible equipment and restore land at the end of oil and gas production operations. Our removal and restoration obligations are primarily associated with plugging and abandoning wells. GAAP requires us to estimate asset retirement costs for all of our assets, adjust those costs for inflation to the forecast abandonment date, discount that amount using a credit-adjusted-risk-free rate back to the date we acquired the asset or obligation to retire the asset and record an asset retirement obligation ("ARO") liability in that amount with a corresponding addition to our asset value. When new obligations are incurred, i.e. a new well is drilled or acquired, we add a layer to the ARO liability. We then accrete the liability layers quarterly using the applicable effective credit-adjusted-risk-free rate for each layer. Should either the estimated life or the estimated abandonment costs of a property change materially upon our periodic review, a new calculation is performed using the same methodology of taking the abandonment cost and inflating it forward to its abandonment date and then discounting it back to the present using our credit-adjusted-risk-free rate. The carrying value of the ARO is adjusted to the newly calculated value, with a corresponding offsetting adjustment to the asset retirement cost. When well obligations are relieved by sale of the property or plugging and abandoning the well, the related liability and asset costs are removed from our balance sheet. Any difference in the cost to plug and the related liability is recorded as a gain or loss on our income statement in the disposal of assets line item. Assumptions/Approach Used: Estimating the future asset removal costs is difficult and requires management to make estimates and judgments because most of the removal obligations are many years in the future and contracts and regulations often have vague descriptions of what constitutes removal. Asset removal technologies and costs are constantly changing, as are regulatory, political, environmental, safety and public relations considerations. Inherent in the estimate of the present value calculation of our AROs are numerous assumptions and judgments including the ultimate settlement amounts, inflation factors, credit-adjusted-risk-free rates, timing of settlement, and changes in the legal, regulatory, environmental and political environments. Effect if Different Assumptions Used: Since there are so many variables in estimating AROs, we attempt to limit the impact of management’s judgment on certain of these variables by developing a standard cost estimate based on historical costs and industry quotes updated annually. Unless we expect a well’s plugging to be significantly different than a normal abandonment, we use this estimate. The resulting estimate, after application of a discount factor and present value calculation, could differ from actual results, despite our efforts to make an accurate estimate. We engage independent engineering firms to evaluate our properties annually. We consider the remaining estimated useful life from the year-end reserve report prepared by our independent reserve engineers in estimating when abandonment could be expected for each property. On an annual basis we evaluate our latest estimates against actual abandonment costs incurred. Nature of Critical Estimate Item: Derivative Instruments and Hedging Activities - We use derivative financial instruments to achieve a more predictable cash flow from our oil and natural gas production and interest expense by reducing our exposure to price fluctuations and interest rate changes. Currently, these transactions are swaps, enhanced swaps and collars whereby we exchange our floating price for our oil and natural gas for a fixed price and floating interest rates for fixed rates with qualified and creditworthy counterparties. The contracts with our counterparties enable us to avoid margin calls for out-of-the-money positions. We do not specifically designate derivative instruments as cash flow hedges, even though they reduce our exposure to changes in oil and natural gas prices and interest rate changes. Therefore, the mark-to-market of these instruments is recorded in current earnings. We estimate market values utilizing software provided by a third party firm, which specializes in valuing derivatives, and validate these estimates by comparison to counterparty estimates as the basis for these end-of-period mark-to-market adjustments. In order to estimate market values, we use forward commodity price curves, if available, or estimates of forward curves provided by third party pricing experts. For our interest rate swaps, we use a yield curve based on money market rates and interest swap rates to estimate market value. When we record a mark-to-market adjustment resulting in a gain or loss in a current period, this change in fair value represents a current period mark-to-market adjustment for commodity derivatives which will be settled in future periods. As shown in the previous tables, we have hedged a portion of our future production through 2019. Nature of Critical Estimate Item: Oil and Natural Gas Property Impairments - Oil and natural gas properties are reviewed for impairment when facts and circumstances indicate that their carrying value may not be recoverable. Legacy compares net capitalized costs of proved oil and natural gas properties to estimated undiscounted future net cash flows using management’s expectations of future oil and natural gas prices. These future price scenarios reflect Legacy’s estimation of future price volatility. If net capitalized costs exceed estimated undiscounted future net cash flows, the measurement of impairment is based on estimated fair value, using estimated discounted future net cash flows. Significant inputs used to determine the fair values of proved properties include estimates of: (i) reserves; (ii) future operating and development costs; (iii) future commodity prices and (iv) a market-based weighted average cost of capital rate. The underlying commodity prices embedded in Legacy's estimated cash flows are the product of a process that begins with NYMEX forward curve pricing, adjusted for estimated location and quality differentials, as well as other factors that Legacy's management believes will impact realizable prices. As of December 31, 2018, a 10% decrease in net cash flows attributable to our production caused by any one or a combination of variables, including commodity prices, development costs, changes in production levels or other factors, would increase our recognized oil and natural gas property impairments by $21.1 million. Recently Issued Accounting Pronouncements In February 2016, the FASB issued ASU No. 2016-02, "Leases" ("ASU 2016-02"). ASU 2016-02 establishes a right-of-use (ROU) model that requires a lessee to record a ROU asset and a lease liability on the balance sheet for all leases with terms at commencement longer than twelve months. Legacy engaged a third party consultant to assist with its implementation of ASU 2016-02. Leases will be classified as either finance or operating, with that classification affecting the pattern of expense recognition in the income statement. ASU 2016-02 is effective for fiscal years beginning after December 15, 2018, including interim periods within those fiscal years. Legacy will adopt ASU 2016-02 using a modified retrospective approach in the first quarter of 2019 (that is, the period of adoption). At transition, Legacy will utilize the package of practical expedients provided in ASU 2016-02 that allow companies, among other things, to not reassess contracts that commenced prior to adoption. In addition, Legacy expects to utilize the practical expedient to not evaluate land easements that existed or expired before the adoption of ASU 2016-02 and that were not previously accounted for as leases under currently effective lease accounting guidance. Legacy is evaluating the provisions of ASU 2016-02 and finalizing the impact it will have on its consolidated results of operations, financial position and financial disclosures. Legacy believes that the new guidance will impact its consolidated balance sheet due to the recognition of right-of-use assets and lease liabilities that are not recognized under currently effective guidance (for example, operating leases). The adjustments that will be required upon implementation of ASU 2016-02, which Legacy anticipates to be less than $15 million, have not been finalized. Legacy commonly enters into lease agreements in support of its operations for assets such as office space, vehicles, drilling rigs, compressors and other well equipment. In its efforts to determine the impact of ASU 2016-02, Legacy developed an implementation approach that included educating key stakeholders within the organization, analyzing systems reports to identify the types and volume of contracts that may meet the definition of a lease and performing a detailed review of material contracts identified through that analysis. Legacy is also implementing a financial lease accounting system solution to facilitate compliance with ASU 2016-02.

<s>[INST] The following discussion and analysis should be read in conjunction with the “Selected Historical Consolidated Financial Data” and the accompanying financial statements and related notes included elsewhere in this annual report on Form 10K. The following discussion contains forwardlooking statements that reflect our future plans, estimates, beliefs and expected performance. The forwardlooking statements are dependent upon events, risks and uncertainties that may be outside our control. Our actual results could differ materially from those discussed in these forwardlooking statements. Factors that could cause or contribute to such differences include, but are not limited to, market prices for oil and natural gas, production volumes, estimates of proved reserves, capital expenditures, economic and competitive conditions, regulatory changes and other uncertainties, as well as those factors discussed below and elsewhere in this report, particularly in “Risk Factors” and “Cautionary Statement Regarding ForwardLooking Information,” all of which are difficult to predict. In light of these risks, uncertainties and assumptions, actual results may differ materially from those anticipated or implied in the forwardlooking statements. Overview Because of our historical growth through acquisitions and development of properties as well as large fluctuations in commodity prices, historical results of operations and periodtoperiod comparisons of these results and certain financial data may not be meaningful or indicative of future results. The operating results of the properties acquired as a part of our asset acquisition in conjunction with acceleration payment (the "Acceleration Payment") under our joint development agreement with TPG Sixth Street Partners (the "JDA") have been included since August 1, 2017. Going Concern We have significant obligations and commitments coming due in the near term. On March 21, 2019, we entered into an amendment to the Credit Agreement (as defined below) pursuant to which the lenders agreed to extend the maturity date from April 1, 2019 to May 31, 2019 and as of December 31, 2018, we had availability under the Credit Agreement of $32.9 million. Without additional sources of capital or a significant restructuring of our balance sheet, the maturity of our Credit Agreement raises substantial doubt about our ability to continue as a going concern, which means that we may be unable to continue operations for the foreseeable future or realize assets and discharge liabilities in the ordinary course of operation. The report of our independent registered public accounting firm that accompanies our audited consolidated financial statements in this annual report on Form 10K contains an explanatory paragraph regarding the substantial doubt about our ability to continue as a going concern. The consolidated financial statements do not include any adjustments that might result from the outcome of the going concern uncertainty. In order to improve our liquidity position, we are currently evaluating financial, transactional and other strategic alternatives. In the first quarter of 2019, we retained financial and legal advisors who specialize in such alternatives. There can be no assurance that sufficient liquidity can be raised from any one or more of these transactions or that these transactions can be consummated within the period needed to meet our obligations or at all. Please see “Risk FactorsRisks Related to Our BusinessWe have engaged financial and legal advisors to assist us in, among other things, evaluating financial, transactional and other strategic alternatives to address our liquidity and capital structure that may be time consuming, disruptive and costly to our business, and We may need to seek relief under the U.S. Bankruptcy Code, even if we are successful in effecting a financial, transactional or other strategic alternative. Any bankruptcy proceeding may result in holders of our equity securities and our other stakeholders receiving little or no consideration,” in Item 1A. We continue to focus on maintaining efficient operations to minimize production declines, improve lifting costs and well economics while regularly reviewing our asset portfolio and divesting noncore assets. Trends Affecting Our Business and Operations Irrespective of our balance sheet constraints, sustained periods of low prices for oil or natural gas have and could materially and adversely affect our financial position, our results of operations, the quantities of oil and natural gas reserves that we can economically produce and our access to capital. We face the challenge of natural production declines. As initial reservoir pressures are depleted, oil and natural [/INST] Negative. </s>

Guardant Health, Inc.

2019-03-19

2018-12-31

Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations You should read the following discussion and analysis of financial condition and results of operations together with the consolidated financial statements and related notes included elsewhere in this Annual Report on Form 10-K. This discussion and other parts of this report contain forward-looking statements that involve risk and uncertainties, such as statements of our plans, objectives, expectations and intentions. Our actual results could differ materially from those discussed in these forward-looking statements. Factors that could cause or contribute to such differences include, but are not limited to, those discussed in Part I, Item 1A,“Risk Factors,” of this Annual Report on Form 10-K. Overview We are a leading precision oncology company focused on helping conquer cancer globally through use of our proprietary blood tests, vast data sets and advanced analytics. We believe that the key to conquering cancer is unprecedented access to its molecular information throughout all stages of the disease, which we intend to enable by a routine blood draw, or liquid biopsy. Our Guardant Health Oncology Platform is designed to leverage our capabilities in technology, clinical development, regulatory and reimbursement to drive commercial adoption, improve patient clinical outcomes and lower healthcare costs. In pursuit of our goal to manage cancer across all stages of the disease, we launched our Guardant360 and GuardantOMNI liquid biopsy-based tests for advanced stage cancer. Our Guardant360 test, launched in 2014, has been used by more than 6,000 oncologists, over 50 biopharmaceutical companies and all 28 National Comprehensive Cancer Network, or NCCN, Centers. Our GuardantOMNI test, launched in 2017, is specifically built for our biopharmaceutical customers as a comprehensive genomic profiling tool to help accelerate clinical development programs in both immuno-oncology and targeted therapy. Our LUNAR-1 and LUNAR-2 programs are developing tests for minimal residual disease and recurrence monitoring and for early detection screening, respectively. In late 2018 we launched our LUNAR assay for research use by biopharmaceutical and academic researchers. Since our inception, we have devoted substantially all of our resources to research and development activities related to our Guardant360 and GuardantOMNI tests and our LUNAR programs, including clinical and regulatory initiatives to obtain approval by the FDA, as well as sales and marketing activities. We have over 40 approved, completed or active clinical outcomes studies, more than 100 peer-reviewed publications and more than 300 scientific abstracts. We are pioneering the clinical comprehensive liquid biopsy market with our Guardant360 and GuardantOMNI tests, both of which analyze circulating tumor DNA in blood. Our Guardant360 test is a molecular diagnostic test measuring 73 cancer-related genes and has been used by clinicians to help inform which therapy may be effective for advanced stage cancer patients with solid tumors and by biopharmaceutical companies for a range of applications, including identifying target patient populations to accelerate translational science research, clinical trial enrollment, and drug development, and post-approval commercialization. Our GuardantOMNI test has a broader 500-gene panel, including genes associated with homologous recombination repair deficiency and biomarkers for immuno-oncology applications, such as tumor mutational burden and microsatellite instability, and has achieved comparable analytical performance in clinical studies, including for translational science applications in collaboration with several biopharmaceutical companies, including Merck MSD, Merck KGaA, Pfizer, AstraZeneca and Bristol-Myers Squibb. The FDA granted designation as a breakthrough device for our Guardant360 test in January 2018 and for our GuardantOMNI test in December 2018. An expedited access pathway and potentially faster review are provided for breakthrough medical devices that address unmet medical needs. Our Guardant360 and GuardantOMNI tests are both being developed as companion diagnostics under collaborations with biopharmaceutical companies. We perform our Guardant360, GuardantOMNI and other tests in our clinical laboratory located in Redwood City, California. Our laboratory is accredited by the Clinical Laboratory Improvement Amendments of 1988, or CLIA, permitted by the New York State Department of Health, or NYSDOH, and licensed in California and four other states. The analytical and clinical data that we have generated in our efforts to establish clinical utility, combined with the support we have developed with key opinion leaders, or KOLs, in the oncology space have led to positive coverage decisions by a number of commercial payers. Our Guardant360 test is currently covered by Cigna, Priority Health and multiple Blue Cross Blue Shield plans, which have adopted reimbursement policies that specifically cover Guardant360 test for non-small cell lung cancer, or NSCLC, which we believe gives us a competitive advantage with these payers. We anticipate approval by the FDA, if obtained, may support improvements in coverage and reimbursement for Guardant360 test. In July 2018, Palmetto GBA, the Medicare Administrative Contractor, or MAC, responsible for administering Medicare’s Molecular Diagnostic Services Program, or MolDx, issued a local coverage determination, or LCD, for Guardant360 test for NSCLC patients who meet certain clinical criteria. We worked with Palmetto GBA to obtain this positive coverage decision through the submission of a detailed dossier of analytical and clinical data to substantiate that the test meets Medicare’s medical necessity requirements. We estimate that approximately 75% of Medicare patients tested for NSCLC are covered by the LCD. Approximately 46% of our U.S. clinical tests in both 2018 and 2017 were for patients tested for NSCLC. Noridian Healthcare Solutions, the MAC responsible for adjudicating claims in California, where our laboratory is located, and a participant in the MolDx, recently finalized its LCD for Guardant360 test. In September 2018, we began to submit claims for reimbursement for Guardant360 clinical testing performed for Medicare beneficiaries covered under the LCDs, and in October 2018, we began to receive payments from Medicare. In the United States, we market our tests to clinical customers through our sales organization, which is engaged in sales efforts and promotional activities primarily targeting oncologists and cancer centers. Outside the United States, we market our tests to clinical customers through distributors and direct contracts with healthcare institutions. We also market our tests to biopharmaceutical customers globally through our business development team, which promotes the broad utility of our tests throughout drug development and commercialization. Additionally, we have established a joint venture with SoftBank to accelerate commercialization of our products including in Asia, the Middle East and Africa, with our initial focus being on Japan. Our products are currently marketed in approximately 40 countries. We generated total revenue of $90.6 million, $49.8 million and $25.2 million for the years ended December 31, 2018, 2017 and 2016, respectively. We also incurred net losses of $84.3 million, $83.2 million and $46.1 million for the years ended December 31, 2018, 2017 and 2016, respectively. We have funded our operations to date principally from the sale of our stock and revenue from our precision oncology testing and development services. In 2017, we raised $320.4 million through the sale of our Series E convertible preferred stock. In October 2018, we completed our initial public offering, or IPO, selling 14,375,000 shares of our common stock and raising $249.5 million net of underwriting discounts and commissions and other expenses payable by us. As of December 31, 2018, we had cash, cash equivalents and marketable securities of $496.5 million. Factors affecting our performance We believe there are several important factors that have impacted and that we expect will impact our operating performance and results of operations, including: • Testing volume, pricing and customer mix. Our revenue and costs are affected by the volume of testing and mix of customers from period to period. We evaluate both the volume of tests that we perform for patients on behalf of clinicians and the number of tests we perform for biopharmaceutical companies. Our performance depends on our ability to retain and broaden adoption with existing customers, as well as attract new customers. We believe that the test volume we receive from clinicians and biopharmaceutical companies are indicators of growth in each of these customer verticals. Customer mix for our tests has the potential to significantly affect our results of operations, as the average selling price for biopharmaceutical sample testing is currently higher than our average selling price for clinical tests since we are not a contracted provider for, or our tests are not covered by clinical patients’ insurance for, the majority of the tests that we perform for patients on behalf of clinicians. Approximately 38% of our U.S. clinical tests in both 2018 and 2017 were for Medicare beneficiaries. Prior to the third quarter of 2018, Medicare did not cover our tests and we did not submit claims for reimbursement. In September 2018, we began to submit claims to Medicare for reimbursement for Guardant360 clinical tests for certain Medicare beneficiaries, and in October 2018, we began to receive payments from Medicare for these clinical tests. • Regulatory approval . Our Guardant360 test was the first comprehensive liquid biopsy test approved by NYSDOH. In addition, we believe our facility was the first comprehensive liquid biopsy laboratory to be CLIA-certified, CAP-accredited and NYSDOH-permitted. The FDA granted designation as a breakthrough device for our Guardant360 test in January 2018 and for our GuardantOMNI test in December 2018. An expedited access pathway and potentially faster review are provided for breakthrough devices that address unmet medical needs. While FDA approval is currently not required to market our tests in the United States, we intend to submit an application for a pre-market approval, or PMA, for each of our Guardant360 and GuardantOMNI tests. In March 2018, the Centers for Medicare and Medicaid Services, or CMS, published a Decision Memorandum for next-generation sequencing tests for patients with advanced cancer who meet certain clinical criteria, or the NGS Decision Memorandum. The NGS Decision Memorandum states that coverage would be available for next-generation sequencing FDA-approved tests offered within the FDA-approved labeling. FDA approval therefore provides a path to reimbursement by Medicare through the NGS Decision Memorandum. We believe that this establishes a competitive advantage for tests receiving FDA approval and that FDA approval will be increasingly necessary for diagnostic tests to gain adoption, both in the United States and abroad. We believe FDA approval, if obtained, will help increase adoption of our tests and facilitate favorable reimbursement decisions by Medicare and commercial payers. Any negative regulatory decisions or changes in regulatory requirements affecting our business could adversely impact our operations and financial results. • Payer coverage and reimbursement. Our revenue depends on achieving broad coverage and reimbursement for our tests from third-party payers, including both commercial and government payers. Payment from commercial payers differs depending on whether we have entered into a contract with the payers as a “participating provider” or do not have a contract and are considered a "non-participating provider.” Payers often reimburse non-participating providers, if at all, at a lower amount than participating providers. We have received a substantial portion of our revenue from a limited number of commercial payers, most of which have not contracted with us to be a participating provider. We have received reimbursement for tests of patients with a variety of cancers, though for amounts that on average are significantly lower than for participating providers. Historically, we have experienced situations where commercial payers proactively reduced the amounts they were willing to reimburse for our tests, and in other situations, commercial payers have determined that the amounts they previously paid were too high and have sought to recover those perceived excess payments by deducting such amounts from payments otherwise being made. When we contract with a payer to serve as a participating provider, reimbursements by the payer are generally made pursuant to a negotiated fee schedule and are limited to only covered indications or where prior approval has been obtained. Becoming a participating provider generally results in higher reimbursement for covered indications and lack of reimbursement for non-covered indications. As a result, the impact of becoming a participating provider with a specific payer will vary based on historical reimbursement as a non-participating provider for that payer, and in some situations, the benefit of increased reimbursement for covered testing could be offset by the loss of reimbursement on tests for non-covered indications previously received when we served as a non-participating provider. Recently, Cigna, Priority Health and multiple regional Blue Cross Blue Shield plans adopted reimbursement policies that cover our Guardant360 test for the majority of NSCLC patients we test. If their reimbursement policies were to change in the future to cover additional cancer indications, we anticipate that our total reimbursement would increase. In September 2018, we began to submit claims for reimbursement at the rate of $3,500 per test with respect to Guardant360 clinical testing performed for NSCLC patients covered under Medicare’s Molecular Diagnostic Services Program who meet certain clinical criteria, and in October 2018, we began to receive payments from Medicare. If we fail to obtain or maintain coverage and adequate reimbursement from third-party payers, we may be unable to increase our testing volume and revenue as expected. Retrospective reimbursement adjustments can also negatively impact our revenue and cause our financial results to fluctuate.We have experienced situations where commercial payers proactively reduce the amounts they were willing to reimburse for our tests or determine that the amounts they previously paid were too high and have sought to recover those perceived excess payments by deducting such amounts from payments otherwise being made. • Biopharmaceutical customers. Our revenue also depends on our ability to attract new, and to maintain and expand relationships with existing, biopharmaceutical customers, and we expect to increase our sales and marketing expense in furtherance of this goal. As we continue to develop these relationships, we expect to support a growing number of clinical trials both in the United States and internationally. If our relationships expand with biopharmaceutical customers, we believe we may continue to have opportunities to offer our platform to such customers for companion diagnostic development and for novel target discovery and validation, and to grow into other business opportunities. For example, we believe genomic data, in combination with clinical outcomes or claims data, has revenue-generating potential, including for novel target identification and clinical trial enrollment. • Research and development. A significant aspect of our business is our investment in research and development, including the development of new products, such as those being developed as part of our LUNAR programs. In particular, we have invested heavily in clinical studies, including more than 40 clinical outcomes studies, the largest-ever liquid-to-tissue concordance study, and a prospective interventional clinical utility study demonstrating clinical overall response rates in line with tissue biopsy approaches. Our clinical research has resulted in over 100 peer-reviewed publications. In addition to clinical studies, we are collaborating with investigators from multiple academic cancer centers, including MD Anderson Cancer Center, the University of Colorado, Memorial Sloan Kettering Cancer Center, Massachusetts General Cancer Center, Wake Forest Cancer Center and the University of California San Francisco, as well as several international institutions. We believe these studies are critical to gaining physician adoption and driving favorable coverage decisions by payers, and expect our investments to increase. We expect to increase our research and development expense with the goal of fueling further innovation. • International expansion. A component of our long-term growth strategy is to expand our commercial footprint internationally, and we expect to increase our sales and marketing expense to execute on this strategy. We currently offer our tests in countries outside the United States primarily through distributor relationships or direct contracts with hospitals. In May 2018, we formed and capitalized a joint venture, Guardant Health AMEA, Inc., which we refer to as the Joint Venture, with SoftBank, relating to the sale, marketing and distribution of our tests generally outside the Americas and Europe. We expect to rely on the Joint Venture to accelerate commercialization of our products in Asia, the Middle East and Africa, with our initial focus being on Japan. While each of these areas presents significant opportunities for us, they also pose significant risks and challenges that we must address. See Part I, Item 1A, “Risk Factors” of this Annual Report on Form 10-K for more information. Components of results of operations Revenue We derive our revenue from two sources: (i) precision oncology testing and (ii) development services. Precision oncology testing. Precision oncology testing revenue is generated from sales of our Guardant 360 and GuardantOMNI tests. In the United States, through 2018, we generally performed tests as an out-of-network service provider without contracts with health insurance companies. We submit claims for payment for tests performed for patients covered by U.S. private payers. Prior to the third quarter of 2018, Medicare did not cover our tests and we did not submit claims for reimbursement for these tests. In September 2018, we began to submit claims to Medicare for reimbursement for Guardant360 clinical testing performed for NSCLC patients covered under Medicare’s Molecular Diagnostic Services Program who meet certain clinical criteria. Tests for patients covered by Medicare represented approximately 38% of our U.S. clinical tests in both 2018 and 2017. Due to the historical general lack of contracts with U.S. private payers and variability in payments received for claims submitted to them, as well as the limited claims experience to date with Medicare, revenue has not been recognized by us at the time the service has been performed as the price of the transaction was not fixed or determinable and collectability was not reasonably assured. As we provide precision oncology testing to biopharmaceutical customers under contracts for which all recognition criteria are met, we have recognized revenue on an accrual basis for those services. Development services. Development services revenue represents services, other than precision oncology testing, that we provide to biopharmaceutical companies and large medical institutions. It includes companion diagnostic development and regulatory approval services, clinical trial referrals and liquid biopsy testing development and support. We collaborate with biopharmaceutical companies in the development and clinical trials of new drugs. As part of these collaborations, we provide services related to regulatory filings with the FDA to support companion diagnostic device submissions for our liquid biopsy panels. Under these arrangements, we generate revenue from progression of our collaboration efforts, as well as from provision of on-going support. Development services revenue can vary over time as different projects start and complete. Costs and operating expenses Cost of precision oncology testing. Cost of precision oncology testing generally consists of cost of materials, direct labor, including bonus, benefit and stock-based compensation; equipment and infrastructure expenses associated with processing liquid biopsy test samples, including sample accessioning, library preparation, sequencing, quality control analyses and shipping charges to transport blood samples; freight; curation of test results for physicians; and license fees due to third parties. Infrastructure expenses include depreciation of laboratory equipment, rent costs, amortization of leasehold improvements and information technology costs. Costs associated with performing our tests are recorded as the tests are performed regardless of whether revenue was recognized with respect to the tests. Royalties for licensed technology are calculated as a percentage of revenues generated using the associated technology and recorded as expense at the time the related revenue is recognized. One-time royalty payments related to signing of license agreements or other milestones, such as issuance of new patents, are amortized to expense over the expected useful life of the patents. While we do not believe the technologies underlying these licenses are necessary to permit us to provide our tests, we do believe these technologies are potentially valuable and of possible strategic importance to us or our competitors. Cost of precision oncology testing revenue included royalty expense of $1.4 million, $1.1 million and $0.7 million for the years ended December 31, 2018, 2017 and 2016, respectively. We expect the cost of precision oncology testing to generally increase in line with the increase in the number of tests we perform, but the cost per test to decrease modestly over time due to the efficiencies we may gain as test volume increases, and from automation and other cost reductions. Cost of development services. Cost of development services includes costs incurred for the performance of development services requested by our customers. For development of new products, costs incurred before technological feasibility has been achieved are reported as research and development expenses, while costs incurred thereafter are reported as cost of revenue. Cost of development services will vary depending on the nature, timing and scope of customer projects. Research and development expense. Research and development expenses consist of costs incurred to develop technology and include salaries and benefits, reagents and supplies used in research and development laboratory work, infrastructure expenses, including allocated facility occupancy and information technology costs, contract services, other outside costs and costs to develop our technology capabilities. Research and development expenses also include costs related to activities performed under contracts with biopharmaceutical companies before technological feasibility has been achieved. Research and development costs are expensed as incurred. Payments made prior to the receipt of goods or services to be used in research and development are deferred and recognized as expense in the period in which the related goods are received or services are rendered. Costs to develop our technology capabilities are recorded as research and development unless they meet the criteria to be capitalized as internal-use software costs. We expect that our research and development expenses will continue to increase in absolute dollars as we continue to innovate and develop additional products, expand our genomic and medical data management resources and conduct our ongoing and new clinical trials. This expense, though expected to increase in absolute dollars, is expected to decrease modestly as a percentage of revenue in the long term, though it may fluctuate as a percentage of revenue from period to period due to the timing and extent of these expenses. Sales and marketing expense. Our sales and marketing expenses are expensed as incurred and include costs associated with our sales organization, including our direct sales force and sales management, client services, marketing and reimbursement, as well as business development personnel who are focused on our biopharmaceutical customers. These expenses consist primarily of salaries, commissions, bonuses, employee benefits, travel expenses and stock-based compensation, as well as marketing and educational activities and allocated overhead expenses. We expect our sales and marketing expenses to increase in absolute dollars as we expand our sales force, increase our presence within and outside of the United States, and increase our marketing activities to drive further awareness and adoption of our Guardant360 and GuardantOMNI tests and future products. These expenses, though expected to increase in absolute dollars, are expected to decrease modestly as a percentage of revenue in the long term, though they may fluctuate as a percentage of revenue from period to period due to the timing and extent of these expenses. General and administrative expense. Our general and administrative expenses include costs for our executive, accounting and finance, legal and human resources functions. These expenses consist principally of salaries, bonuses, employee benefits, travel expenses and stock-based compensation, as well as professional services fees such as consulting, audit, tax and legal fees, and general corporate costs and allocated overhead expenses. We expect that our general and administrative expenses will continue to increase in absolute dollars, primarily due to increased headcount and costs associated with operating as a public company, including expenses related to legal, accounting, regulatory, maintaining compliance with exchange listing and requirements of the SEC, director and officer insurance premiums and investor relations. These expenses, though expected to increase in absolute dollars, are expected to decrease modestly as a percentage of revenue in the long term, though they may fluctuate as a percentage of revenue from period to period due to the timing and extent of these expenses. Interest income Interest income consists of interest earned on our cash, cash equivalents and marketable securities. Interest expense Interest expense consists primarily of interest from a loan (until it was repaid), capital leases and royalty obligations. Loss on debt extinguishment In June 2017, we repaid a loan prior to maturity which resulted in an extinguishment of the debt for accounting purposes. The difference between the reacquisition price and the net carrying amount of the debt and related royalty liabilities of $5.1 million was recognized as a one-time charge for the year ended December 31, 2017. Other income (expense), net In the first quarter of 2018, we settled a commercial legal dispute. In connection with the settlement, we received a payment of $4.25 million, which was recognized as one-time other income for the year ended December 31, 2018. Other income (expense), net also consists of foreign currency exchange gains and losses. Foreign currency exchange gains and losses relate to transactions and asset and liability balances denominated in currencies other than the U.S. dollar, primarily comprised of a royalty obligation denominated in Euros. We expect our foreign currency gains and losses to continue to fluctuate in the future due to changes in foreign currency exchange rates. Series E convertible preferred stock financing In May 2017 we entered into a Series E convertible preferred stock purchase agreement with SoftBank and certain of our existing stockholders. Pursuant to the purchase agreement, we issued and sold an aggregate of 38,174,246 shares of Series E convertible preferred stock at a purchase price of $8.3936 per share, for an aggregate purchase price of $320.4 million. The purchase agreement also provided that we would issue additional shares of Series E convertible preferred stock to the Series E investors in such an amount as to cause SoftBank’s equity ownership to equal 35% of our outstanding fully-diluted capital stock measured 70 days after the initial closing. This gross-up was intended to maintain SoftBank’s equity ownership at 35% following various repurchases of our equity from existing stockholders. As a result, in July 2017, we repurchased an aggregate of 1,588,065 shares of common stock from certain of our directors and executive officers for a purchase price of $10.23887 per share, which represented a price equal to 90% of the original price per share for the Series E convertible preferred stock, as adjusted to reflect the 0.7378-for-one reverse stock split effected on September 19, 2018. We also engaged in a tender offer pursuant to which we repurchased 131,243 shares of common stock from certain employees at the same per share price paid for the Series E convertible preferred stock, as adjusted to reflect the 0.7378-for-one reverse stock split, and 666,920 shares of Series A convertible preferred stock from existing stockholders at a purchase price of $8.00 per share of Series A convertible preferred stock. Following these repurchases, in October 2017, we issued an additional 796,346 shares of Series E convertible preferred stock to the Series E investors for a purchase price of $0.00001 per share pursuant to the terms of the gross-up provision. In addition, in connection with SoftBank’s purchase of Series E convertible preferred stock, we also agreed to enter into a joint venture agreement with Softbank relating to the commercialization and distribution of our products throughout the JV Territory. Upon the incorporation of the Joint Venture, Guardant Health AMEA, Inc., in May 2018, SoftBank purchased 40,000 shares of common stock of the Joint Venture in exchange for $41.0 million in cash and we purchased 40,000 shares of common stock of the Joint Venture in exchange for $9.0 million in cash. We also entered into various ancillary agreements with the Joint Venture necessary to operate its business. Under the terms of the joint venture agreement, neither we nor SoftBank is obligated to make any further capital contribution, in cash or otherwise, to the Joint Venture. In the event that the Joint Venture requires any additional funding for its operations, the Joint Venture may seek debt financing from financial institutions or additional financing in debt or equity from its major shareholders, which will be on a pro rata basis among such shareholders unless such shareholders agree otherwise. Initial public offering On October 9, 2018, we completed an initial public offering, or the IPO, in which we issued and sold 14,375,000 shares of our common stock at a price of $19.00 per share. We received net proceeds of $249.5 million after deducting underwriting discounts and commissions and offering expenses payable by us. All then-outstanding warrants to purchase our common stock were exercised prior to the completion of the IPO. In addition, in connection with the IPO, all shares of our then-outstanding convertible preferred stock were automatically converted into 58,264,577 shares of our common stock, and all then-outstanding warrants to purchase our convertible preferred stock were automatically converted into warrants to purchase 7,636 shares of our common stock. Results of operations The following table set forth the significant components of our results of operations for the periods presented. (1) Amounts include stock-based compensation expense as follows: (2) Amounts include compensation expenses associated with repurchase of common stock as follows: Comparison of the Years Ended December 31, 2018 and 2017 Revenue Total revenue was $90.6 million for the year ended December 31, 2018 compared to $49.8 million for the year ended December 31, 2017, an increase of $40.8 million, or 82%. Precision oncology testing revenue increased to $78.4 million for the year ended December 31, 2018 from $42.1 million for the year ended December 31, 2017, an increase of $36.3 million, or 86%. This increase in precision oncology testing revenue was primarily due to an increase in tests performed. Precision oncology tests for clinical customers increased to 29,238 for the year ended December 31, 2018 from 23,759 for the year ended December 31, 2017 (excluding 354 and 1,867 tests in 2018 and 2017, respectively, from a customer that in March 2018 began processing tests in-house) mainly due to an increase in the number of physicians ordering our Guardant360 test. Precision oncology revenue from tests for clinical customers, which we have generally recognized as cash payments as received, was $43.7 million for the year ended December 31, 2018 and $24.5 million for the year ended December 31, 2017, respectively. Cash receipts increased due to increases in tests for clinical customers and increases in commercial payer payments that were beneficially affected by the Protecting Access to Medicare Act of 2014. Precision oncology tests for biopharmaceutical customers increased to 10,370 for the year ended December 31, 2018 from 6,286 for the year ended December 31, 2017 due to an increase in the number of biopharmaceutical customers and their contracted projects. The average selling price of precision oncology tests for biopharmaceutical customers increased for the year ended December 31, 2018, compared to the year ended December 31, 2017, due to introduction at the end of 2017 of our GuardantOMNI test, which has a higher selling price than the Guardant360 test. Development services revenue increased to $12.2 million for the year ended December 31, 2018 from $7.8 million for the year ended December 31, 2017, an increase of $4.5 million, or 58%. This increase in development services revenue was due to revenue received from new projects in 2018, mainly new projects related to companion diagnostic development and regulatory approval services to biopharmaceutical customers, and from completion in 2018 of a lab installation project mainly performed in 2017. Costs and operating expenses Cost of precision oncology testing Cost of precision oncology testing revenue was $39.8 million for the year ended December 31, 2018 compared to $28.9 million for the year ended December 31, 2017, an increase of $11.0 million, or 38%. This increase in cost of precision oncology testing was primarily due to a $4.8 million increase in material costs, a $4.7 million increase in labor and manufacturing overhead costs, and a $1.2 million increase in other costs including costs related to freight, royalties and curation of test results for physicians. Cost of development services Cost of development services was $3.4 million for the year ended December 31, 2018 compared to $2.7 million for the year ended December 31, 2017, an increase of $0.6 million, or 23%. Costs include material and labor costs incurred after technological feasibility was achieved on the lab installation and development programs. Research and development expense Research and development expenses were $50.7 million for the year ended December 31, 2018 compared to $25.6 million for the year ended December 31, 2017, an increase of $25.2 million, or 98%. This increase in research and development expense was primarily due to an increase of $9.7 million in personnel-related costs for employees in our research and development group, and an increase of $5.6 million related to allocated facilities and information technology infrastructure costs as we increased our headcount to support continued investment in our technology. This increase is also attributable to an increase of $5.3 million in material costs relating to the development of our LUNAR programs, the preparation of our Guadant360 submission to the FDA, and the continuous improvement in our Guardant360 and GuardantOMNI liquid biopsy panels, and an increase of $2.4 million in development consulting fees. Sales and marketing expense Selling and marketing expenses were $53.5 million for the year ended December 31, 2018 compared to $32.5 million for the year ended December 31, 2017, an increase of $21.0 million, or 65%. This increase was primarily due to an increase of $10.8 million in personnel-related costs associated with the expansion of our commercial organization, an increase of $4.2 million related to allocated facilities and information technology infrastructure costs, an increase of $2.5 million in professional service expenses related to marketing activities, and an increase of $2.0 million in travel expenses. General and administrative expense General and administrative expenses were $36.2 million for the year ended December 31, 2018 compared to $36.8 million for the year ended December 31, 2017, a decrease of $0.6 million, or 2%. This decrease was primarily due to$9.7 million in compensation expenses that we recognized in 2017 in connection with the repurchases of common stock from certain executive officers and employees, compared to compensation expenses of $0.2 million recognized in 2018 related to the repurchase of common stock from an employee. This decrease was largely offset by increases in 2018 of $4.9 million in personnel-related costs as we increased our headcount, and of $3.6 million in professional service expenses related to outside legal, accounting, consulting and IT services. Interest income Interest income was $5.3 million for the year ended December 31, 2018 compared to $2.2 million for the year ended December 31, 2017, an increase of $3.0 million, or 136%. This increase was primarily due to a significant increase in cash, cash equivalents and marketable securities during 2018 primarily as a result of cash received from the IPO in October 2018 and Series E convertible preferred stock financing in May 2017. Interest expense Interest expense was $1.3 million for the year ended December 31, 2018 compared to $2.7 million for the year ended December 31, 2017, a decrease of $1.5 million, or 54%. This decrease was primarily due to the repayment of our debt in June 2017, partially offset by interest incurred on an obligation related to a royalty in connection with a license agreement entered into in January 2017. Loss on debt extinguishment Loss on debt extinguishment was $5.1 million for the year ended December 31, 2017. There was no similar charge for the year ended December 31, 2018. This loss was due to our repayment in June 2017 of the outstanding principal balance and interest on our term loan and buyout of the associated royalty obligation prior to the loan’s maturity. Other income (expense), net * Not meaningful Other income (expense), net included a gain of $4.25 million for settlement of a commercial legal dispute for the year ended December 31, 2018. There was no similar charge or gain for the year ended December 31, 2017. Other income (expense), net also included foreign currency exchange gains of $0.4 million for the year ended December 31, 2018 and foreign currency exchange losses of $1.1 million for the year ended December 31, 2017. This increase was primarily due to an obligation denominated in Euros in connection with a license agreement entered into in January 2017. Provision for income taxes Provision for income taxes was very small for the years ended December 31, 2018 and 2017 due to the losses incurred by us. The net change was insignificant. Comparison of the Years Ended December 31, 2017 and 2016 Revenue Total revenue was $49.8 million for the year ended December 31, 2017 compared to $25.2 million for the year ended December 31, 2016, an increase of $24.6 million, or 97%. Precision oncology testing revenue increased to $42.1 million for the year ended December 31, 2017 from $24.5 million in the year ended December 31, 2016, an increase of $17.6 million, or 72%. This increase in precision oncology testing revenue was primarily due to an increase in tests performed. Precision oncology tests for clinical customers increased to 25,626 for the year ended December 31, 2017 from 18,663 for the year ended December 31, 2016 mainly due to an increase in the number of physicians ordering our Guardant360 test. Precision oncology tests for biopharmaceutical customers increased to 6,286 for the year ended December 31, 2017 from 1,830 for the year ended December 31, 2016 due to an increase in the number of biopharmaceutical customers and their contracted projects. Development service revenue increased to $7.8 million for the year ended December 31, 2017 from $0.8 million in the year ended December 31, 2016, an increase of $7.0 million, or 930%. This increase in development service revenue was due to revenue received from new projects in 2017, mainly new projects related to services to biopharmaceutical customers for development of our GuardantOMNI test and a lab installation project. Costs and operating expenses Cost of precision oncology testing Cost of precision oncology testing revenue was $28.9 million for the year ended December 31, 2017 compared to $22.1 million for the year ended December 31, 2016, an increase of $6.8 million, or 31%. This increase in cost of precision oncology testing was primarily due to a $2.7 million increase in material costs, a $2.5 million increase in production labor and overhead costs, and a $1.6 million increase in other costs including costs related to freight, royalties and curation of test results for physicians. Cost of development services * Not meaningful Cost of development services was $2.7 million for the year ended December 31, 2017 compared to $0.1 million for the year ended December 31, 2016, an increase of $2.7 million. This increase in cost of development services revenue was primarily due to the increase in development services provided to customers. Costs include material and labor costs incurred after technological feasibility was achieved on these development programs. Research and development expense Research and development expenses were $25.6 million for the year ended December 31, 2017 compared to $10.9 million for the year ended December 31, 2016, an increase of $14.7 million, or 135%. This increase in research and development expense was primarily due to an increase of $6.5 million in personnel-related costs for employees in our research and development group as we increased our headcount to support continued investment in our technology. This increase is also attributable to $2.7 million in material costs incurred for the development of the GuardantOMNI liquid biopsy panel and development of technology in connection with a lab installation project prior to achievement of technological feasibility in each project, and an increase of $2.6 million in development consulting fees. Sales and marketing expense Selling and marketing expenses were $32.5 million for the year ended December 31, 2017 compared to $26.2 million for the year ended December 31, 2016, an increase of $6.3 million, or 24%. This increase was primarily due to an increase of $6.3 million in personnel-related costs for expansion of our sales organization and an increase of $0.9 million related to allocated facilities and information technology infrastructure costs, partially offset by a $1.0 million decrease in stock-based compensation expense. General and administrative expense General and administrative expenses were $36.8 million for the year ended December 31, 2017 compared to $9.9 million for the year ended December 31, 2016, an increase of $26.9 million, or 271%. This increase was primarily due to an increase of $9.7 million in compensation expenses as we repurchased common stock from certain executive officers and an increase of $6.3 million in personnel-related costs for our employees, including a $2.7 million increase in stock-based compensation as we increased our headcount. We also had an increase of $8.0 million in legal expenses primarily due to $4.3 million in costs associated with ongoing and recently settled patent lawsuits and a recently settled commercial legal dispute and an increase of $0.9 million related to allocated facilities and information technology infrastructure costs. Interest income Interest income was $2.2 million for the year ended December 31, 2017 compared to $0.7 million for the year ended December 31, 2016, an increase of $1.5 million, or 205%. This increase was primarily due to a significant increase in cash, cash equivalents and marketable securities in 2017 primarily as a result of cash received from our Series E convertible preferred stock financing. Interest expense Interest expense was $2.7 million for the year ended December 31, 2017 compared to $3.0 million for the year ended December 31, 2016, a decrease of $0.3 million, or 10%. This decrease was primarily due to the repayment of our debt in June 2017, partially offset by interest incurred on an obligation related to a royalty in connection with a license agreement entered into in January 2017. Loss on debt extinguishment * Not meaningful Loss on debt extinguishment was $5.1 million for the year ended December 31, 2017. There was no similar charge in 2016. This loss was due to our repayment in June 2017 of the outstanding principal balance and interest on our term loan and buyout of the associated royalty obligation prior to the loan’s maturity. Other income (expense), net * Not meaningful Other income (expense), net included foreign currency exchange losses of $1.0 million for the year ended December 31, 2017. This increase was primarily due to an obligation denominated in Euros in connection with a license agreement entered into in January 2017. Provision for income taxes Provision for income taxes was very small for the years ended December 31, 2017 and 2016 due to the losses incurred by us. The net change was insignificant. Quarterly results of operations The following tables set forth our unaudited quarterly consolidated statements of operations data for each of the eight quarters in the 24-month period ended December 31, 2018. The information for each of these quarters has been prepared in accordance with generally accepted accounting principles in the United States of America and on the same basis as our audited consolidated financial statements included elsewhere in this Annual Report on Form 10-K. In the opinion of management, reflect all adjustments, which include only normal recurring adjustments, necessary for the fair presentation of our results of operations. This data should be read in conjunction with our audited financial statements and related notes included elsewhere in this Annual Report on Form 10-K. These quarterly operating results are not necessarily indicative of our operating results for the full year or any future period. Liquidity and capital resources We have incurred losses and negative cash flows from operations since our inception, and as of December 31, 2018, we had an accumulated deficit of $280.8 million. We expect to incur additional operating losses in the near future and our operating expenses will increase as we continue to expand our sales organization, increase our marketing efforts to drive market adoption of our Guardant360 and GuardantOMNI tests, invest in clinical trials and develop new product offerings from our research programs, including our LUNAR programs. As demand for our Guardant360 and GuardantOMNI tests are expected to continue to increase from physicians and biopharmaceutical companies, we anticipate that our capital expenditure requirements will also increase in order to build additional capacity. We have funded our operations to date principally from the sale of stock and revenue from precision oncology testing and development services. As of December 31, 2018, we had cash and cash equivalents of $140.5 million and marketable securities of $356.0 million. Cash in excess of immediate requirements is invested in accordance with our investment policy, primarily with a view to liquidity and capital preservation. Currently, our funds are held in marketable securities consisting of United States treasury securities and corporate bonds. Based on our current business plan, we believe our current cash, cash equivalents and marketable securities and anticipated cash flow from operations will be sufficient to meet our anticipated cash requirements over at least the next 12 months from the date of this report. We may consider raising additional capital to expand our business, to pursue strategic investments, to take advantage of financing opportunities or for other reasons. As revenue from precision oncology testing and development service is expected to grow, we expect our accounts receivable and inventory balances to increase. Any increase in accounts receivable and inventory may not be completely offset by increases in accounts payable and accrued expenses, which could result in greater working capital requirements. If our available cash, cash equivalents and marketable securities and anticipated cash flow from operations are insufficient to satisfy our liquidity requirements including because of lower demand for our products as a result of lower than currently expected rates of reimbursement from our customers or other risks described in this report, we may seek to sell additional common or preferred equity or convertible debt securities, enter into a credit facility or another form of third-party funding or seek other debt financing. The sale of equity and convertible debt securities may result in dilution to our stockholders and, in the case of preferred equity securities or convertible debt, those securities could provide for rights, preferences or privileges senior to those of our common stock. The terms of debt securities issued or borrowings pursuant to a credit agreement could impose significant restrictions on our operations. If we raise funds through collaborations and licensing arrangements, we might be required to relinquish significant rights to our platform technologies or products or grant licenses on terms that are not favorable to us. Additional capital may not be available to us on reasonable terms, or at all. Cash flows The following table summarizes our cash flows for the periods presented: Operating activities Cash used in operating activities during the year ended December 31, 2018 was $72.2 million, which resulted from a net loss of $84.3 million and net change in our operating assets and liabilities of $1.1 million, partially offset by non-cash charges of $13.2 million. Non-cash charges primarily consisted of $7.1 million of depreciation and amortization and $6.9 million of stock-based compensation, partially offset by $0.4 million of amortization of discount on investment. The net change in our operating assets and liabilities was primarily the result of a $22.9 million increase in accounts receivable driven by higher sales to biopharmaceutical customers, a $3.7 million increase in prepaid expenses and other current assets and a $1.8 million increase in inventory due to higher testing volumes, partially offset by a $13.0 million increase in deferred revenue, an $8.1 million increase in accrued compensation due to increased personnel, a $5.0 million increase in accounts payable and a $1.3 million increase in deferred rent. Cash used in operating activities during the year ended December 31, 2017 was $72.2 million, which resulted from a net loss of $83.2 million and net change in our operating assets and liabilities of $5.0 million, partially offset by non-cash charges of $16.0 million. Non-cash charges primarily consisted of $5.2 million of depreciation and amortization, $5.1 million of loss on debt extinguishment, $3.7 million of stock-based compensation, $1.0 million of unrealized translation losses on a royalty obligation denominated in Euros, $0.7 million of non-cash interest expense and $0.4 million of amortization of premium or discount on marketable securities. The net change in our operating assets and liabilities was primarily the result of a $9.3 million increase in accounts receivable driven by higher sales to biopharmaceutical customers, a $4.5 million increase in inventory due to higher testing volumes and a $0.9 million increase in other assets, partially offset by a $4.7 million increase in accrued expenses and other current liabilities, a $2.3 million increase in accrued compensation due to increased personnel, a $1.3 million increase in accounts payable and a $1.2 million increase in deferred revenue. Cash used in operating activities during the year ended December 31, 2016 was $36.7 million, which resulted from a net loss of $46.1 million, partially offset by non-cash charges of $7.0 million and net change in our operating assets and liabilities of $2.4 million. Non-cash charges primarily consisted of $3.7 million of depreciation and amortization, $2.0 million of stock-based compensation and $1.0 million of non-cash interest expense. The net change in our operating assets and liabilities was primarily the result of a $2.1 million increase in accounts payable, a $1.7 million increase in deferred revenue, a $1.4 million increase in accrued compensation and a $1.0 million increase in accrued expense and deferred rent, partially offset by a $2.8 million increase in accounts receivable and a $0.6 million increase in prepaid and other assets. Investing activities Cash used in investing activities during the year ended December 31, 2018 was $153.0 million, which resulted primarily from purchases of marketable securities of $287.5 million and purchases of property and equipment of $20.2 million, partially offset by maturities of marketable securities of $154.6 million. Cash used in investing activities during the year ended December 31, 2017 was $170.4 million, which resulted primarily from purchases of marketable securities of $236.8 million, purchases of property and equipment of $6.7 million and payment related to a license agreement of $2.3 million, partially offset by maturity of marketable securities of $75.4 million. Cash provided by investing activities during the year ended December 31, 2016 was $26.2 million, which resulted primarily from maturities of marketable securities of $369.4 million, partially offset by purchases of marketable securities of $341.4 million and purchases of property and equipment of $1.8 million. Financing activities Cash provided by financing activities during the year ended December 31, 2018 was $293.2 million, which was primarily due to proceeds from the IPO, net of underwriting discounts and commissions of $254.0 million, and net proceeds from sale of equity interests in noncontrolling interests of $41.0 million. Cash provided by financing activities during the year ended December 31, 2017 was $281.7 million, which was primarily due to proceeds from our issuances of Series E convertible preferred stock, net of issuance costs, of $319.5 million, partially offset by payment related to settlement of debt and buyout of royalty obligations of $25.8 million, repurchases of common stock of $7.2 million and repurchases of preferred stock of $5.3 million. Cash provided by financing activities during the year ended December 31, 2016 was $39.8 million, which was primarily due to proceeds from issuance of Series D convertible preferred stock, net of issuance costs, of $40.0 million. Contractual obligations and commitments Our contractual commitments will have an impact on our future liquidity. The following table summarizes our contractually committed future obligations as of December 31, 2018: (1) We lease our office and laboratory space in Redwood City, California under an operating lease that expires in December 2025. We also have operating leases for manufacturing and office equipment through February 2023. (2) As of December 31, 2018, we had two capital leases for our manufacturing equipment which expire at various dates through April 2021. (3) We have patent license agreements with four parties. Under these agreements, we have made one-time and milestone license fee payments that we have capitalized and are amortizing to expense ratably over the useful life of the applicable underlying patent rights. Under some of these agreements, we are obligated to pay low single-digit percentage running royalties on net sales where the patent right(s) are used in the product or service sold, subject to minimum annual royalties or fees in certain agreements. Net operating loss carryforwards Utilization of the net operating loss, or NOL, carryforwards and credits may be subject to a substantial annual limitation due to the ownership change limitations provided by the Internal Revenue Code of 1986, as amended, or the Internal Revenue Code, and similar state provisions. The annual limitation may result in the expiration of NOL carryforwards and credits before utilization. Current laws impose substantial restrictions on the utilization of NOL carryforwards and credits in the event of an “ownership change” within a three-year period as defined by the Internal Revenue Code Section 382, or Section 382. If there should be an ownership change, our ability to utilize our NOL carryforwards and credits could be limited. We have not performed a Section 382 analysis. Based on the available objective evidence, management determined that it was more likely than not that the net deferred tax assets would not be realizable as of December 31, 2018 and 2017. Accordingly, management applied a full valuation allowance against net deferred tax assets as of December 31, 2018 and 2017. On December 22, 2017, the Tax Cuts and Jobs Act was signed into law. The new legislation decreased the U.S. corporate federal income tax rate from 35% to 21% effective January 1, 2018. The reduction in the tax rate resulted in a $21.3 million reduction in net deferred tax assets. There was no impact on our recorded deferred tax balances as the remeasurement of net deferred tax assets was offset by a change in valuation allowance for the same amount. Under the newly enacted federal income tax law, federal NOL incurred in 2018 and in future years may be carried forward indefinitely, but the deductibility of such NOL is limited. It is uncertain if and to what extent various states will conform to the newly enacted federal income tax law. Off-balance sheet arrangements As of December 31, 2018, we have not had any off-balance sheet arrangements as defined in the rules and regulations of the SEC. Critical accounting policies and estimates We have prepared our financial statements in accordance with accounting principles generally accepted in the United States of America (“GAAP”). Our preparation of these financial statements requires us to make estimates, assumptions and judgments that affect the reported amounts of assets, liabilities, expenses and related disclosures at the date of the financial statements, as well as revenue and expenses recorded during the reporting periods. 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 the carrying value of assets and liabilities that are not readily apparent from other sources. Actual results could therefore differ materially from these estimates under different assumptions or conditions. While our significant accounting policies are described in more detail in Note 2 to our consolidated financial statements included elsewhere in this report, we believe the following accounting policies to be critical to the judgments and estimates used in the preparation of our financial statements. Revenue recognition We recognize revenue when all of the following criteria are met: (i) persuasive evidence of an arrangement exists; (ii) delivery has occurred; (iii) the fee is fixed or determinable; and (iv) collectability is reasonably assured. Criterion (i) is satisfied when we have an arrangement or contract in place. Criterion (ii) is satisfied when we deliver a test report corresponding to each sample, without further commercial obligations. Determination of criteria (iii) and (iv) are based on management’s judgments regarding whether the fee is fixed or determinable, and whether the collectability of the fee is reasonably assured. We recognize revenue from the sale of our precision oncology tests for clinical customers, including certain hospitals, cancer centers, other institutions and patients, at the time results of the test are reported to physicians, if criteria (i) through (iv) above are met. We recognize revenue on a cash basis when we cannot conclude that criteria (iii) and (iv) have been met. Most of precision oncology tests requested by clinical customers are sold without a contracted engagement with a third-party payer; therefore, we experience significant variability in collections and do not have sufficient history to establish a predictable pattern of payment. Because the price is not fixed or determinable and collectability is not reasonably assured, we recognize revenue on a cash basis for sales of our liquid biopsy tests to clinical customers where collection depends on a third-party payer or the individual patient. We use judgment in our assessment of whether the fee is fixed or determinable and whether collectability is reasonably assured in determining when to recognize revenue. In 2018 we began to obtain agreements with certain payers that provided coverage and reimbursement for the testing of most lung cancer patients with our Guardant360 test. We have a limited history of payments under these agreements, including reimbursement by Medicare beginning in October 2018, therefore we recognized revenue on a cash basis for these clinical customers during 2018. Our precision oncology information services are delivered electronically, and as such there are no shipping or handling fees incurred by us or billed to customers. Revenue from sales of our tests to biopharmaceutical customers are based on a negotiated price per test or on the basis of an agreement to provide certain testing volume, data access or biopharmaceutical research and development services over a defined period. We recognize the related revenue upon delivery of the test results, or over the period in which biopharmaceutical research and development services are provided, as appropriate. Multiple-element arrangements Contracts with biopharmaceutical customers can include precision oncology testing as well as various development services. Such contracts are primarily analyzed as multiple-element arrangements given the nature of the service deliverables. For development services performed, we are compensated in various ways, including: (i) through non-refundable regulatory and other developmental milestone payments; and (ii) through royalty and sales milestone payments. We perform development services as part of our normal activities. We record these payments as development services revenue in the statements of operations using a proportional performance model over the period which the unit of accounting is delivered or based on the level of effort expended to date over the total expected effort, whichever is considered the most appropriate measure of performance. For development of new products or services under these arrangements, costs incurred before technological feasibility is assured are included as research and development expenses in our statements of operations, while costs incurred thereafter are recorded as cost of development services. For revenue arrangements with multiple deliverables, we evaluate each deliverable to determine whether it qualifies as a separate unit of accounting. This determination is based on whether the deliverable has stand-alone value to the customer and whether a general right of return exists. In assessing whether an item has standalone value, we consider factors such as the research, development and commercialization capabilities of a third party and the availability of the associated expertise in the general marketplace. In addition, we consider whether the other party in the arrangement can use the other deliverables for their intended purpose without the receipt of the remaining elements, whether the value of the deliverable is dependent on the undelivered items and whether there are other vendors that can provide the undelivered elements. The consideration that is fixed or determinable is then allocated to each separate unit of accounting based on the relative selling price of each deliverable. We allocate the arrangement consideration following a hierarchy to determine the relative selling price to be used for allocating revenue to deliverables: (i) vendor-specific objective evidence of fair value, or VSOE, (ii) third-party evidence of selling price, or TPE, and (iii) best estimate of the selling price, or BESP if neither VSOE nor TPE is available. We typically use BESP to estimate the selling price, since we generally do not have VSOE or TPE of selling price for our units of accounting under multiple-element arrangements. In developing the BESP for a unit of accounting, we consider applicable market conditions and estimated costs. We validate the BESP for units of accounting by evaluating whether changes in the key assumptions used to determine the BESP will have a significant effect on the allocation of arrangement consideration between multiple units of accounting. The consideration allocated to each unit of accounting is recognized as the related goods or services are delivered, limited to the consideration that is not contingent upon future deliverables. We use judgment in identifying the deliverables in our arrangements, assessing whether each deliverable is a separate unit of accounting, and in determining the best estimate of selling price for certain deliverables. We also use judgment in determining the period over which the deliverables are recognized in certain of our arrangements. Any amounts received that do not meet the criteria for revenue recognition are recorded as deferred revenue until such criteria are met. We performed laboratory installation and maintenance services for one of our customers as part of a multiple-element arrangement entered into in 2017. We recognized certain revenue from our construction service deliverables in a multiple-element collaboration arrangement based on the completed-contract method. This method was used as we determined that we did not have the basis for estimating performance under the contract. Other construction service deliverables under that contract were recognized under the percentage-of-completion method due to our ability to make reasonably dependable estimates of the extent of progress toward contract completion. All construction services under this arrangement were completed in March 2018. Milestones We recognize payments that are contingent upon achievement of a substantive milestone in their entirety in the period in which the milestone is achieved. Milestones are defined as events that can only be achieved based on our performance and there is substantive uncertainty about whether the event will be achieved at the inception of the arrangement. Events that are contingent only on the passage of time or only on counterparty performance are not considered substantive milestones. Further, the amounts received must relate solely to prior performance, be reasonable relative to all of the deliverables and payment terms within the agreement and commensurate with our performance to achieve the milestone after commencement of the agreement. Any contingent payment that becomes payable upon achievement of events that are not considered substantive milestones are allocated to the units of accounting previously identified at the inception of an arrangement when the contingent payment is received, and revenue is recognized based on the revenue recognition criteria for each unit of accounting. Revenue from commercial milestone payments are recorded as revenue upon achievement of the milestone, assuming all other revenue recognition criteria are met. Variable interest entity We review agreements we enter into with third party entities, pursuant to which we may have a variable interest in the entity, in order to determine if the entity is a variable interest entity, or VIE. If the entity is a VIE, we assess whether or not we are the primary beneficiary of that entity. In determining whether we are the primary beneficiary of an entity, we apply a qualitative approach that determines whether we have both (1) the power to direct the economically significant activities of the entity and (2) the obligation to absorb losses of, or the right to receive benefits from, the entity that could potentially be significant to that entity. If we determine we are the primary beneficiary of a VIE, we consolidate the statements of operations and financial condition of the VIE into our consolidated financial statements. Accounting for the consolidation is based on our determination if the VIE meets the definition of a business or and asset. Assets, liabilities and noncotnrolling interests, excluding goodwill, of VIEs that are not determined to be businesses are recorded at fair value in our financial statements upon consolidation. Assets and liabilities that we have transferred to a VIE, after, or shortly before the date we became the primary beneficiary are recorded at the same amount at which the assets and liabilities would have been measured if they had not been transferred. Our determination about whether we should consolidate such VIEs is made continuously as changes to existing relationships or future transactions may result in a consolidation or deconsolidation event. In connection with SoftBank’s purchase of our Series E convertible preferred stock, we entered into a joint venture agreement with an entity affiliated with SoftBank. In May 2018, we and SoftBank formed and capitalized the Joint Venture for the sale, marketing and distribution of our tests in the JV Territory. We expect to rely on the Joint Venture to accelerate commercialization of our products in Asia, the Middle East and Africa, with an initial focus on Japan. As of December 31, 2018, the Joint Venture is deemed to be a VIE and we are identified as the primary beneficiary of the VIE. Consequently, we have consolidated the financial position, results of operations and cash flows of the Joint Venture in our financial statements and all intercompany balances have been eliminated in consolidation. The joint venture agreement also includes a put-call arrangement with respect to the shares of the Joint Venture held by SoftBank and its affiliates. Under certain specified circumstances and on terms specified in the joint venture agreement, SoftBank will have a put right to cause us to purchase all shares of the Joint Venture held by SoftBank and its affiliates, and we will have a call right to purchase all such shares. The noncontrolling interest held by SoftBank contains embedded put-call redemption features that are not solely within our control and has been classified outside of permanent equity in our consolidated balance sheets. The put-call feature embedded in the redeemable noncontrolling interest do not currently require bifurcation as it does not meet the definition of a derivative and is considered to be clearly and closely related to the redeemable noncontrolling interest. The noncontrolling interest is considered probable of becoming redeemable as SoftBank has the option to exercise its put right to sell its equity ownership in the Joint Venture to us on or after the seventh anniversary of the formation of the Joint Venture, on each subsequent anniversary of the IPO and under certain other circumstances. We elected to recognize the change in redemption value immediately as they occur as if the put-call redemption feature were exercisable at the end of the reporting period. The carrying value of the redeemable noncontrolling interest is first adjusted for the earnings or losses attributable to the redeemable noncontrolling interest based on the percentage of the economic or ownership interest retained in the consolidated VIE by the noncontrolling parties, and then adjusted to equal to its redemption amount, or the fair value of the noncontrolling interest held by SoftBank, as if the redemption were to occur at the end of the reporting date. Stock-based compensation We measure stock-based compensation expense for stock options granted to our employees and directors on the date of grant and recognize the corresponding compensation expense of those awards over the requisite service period, which is generally the vesting period of the respective award. We account for stock-based compensation arrangements with non-employee consultants using a fair value approach. The estimated fair value of unvested options granted to non-employee consultants is remeasured at each reporting date through the date of final vesting. As a result, the noncash charge to operations for non-employee options with vesting conditions is affected in each reporting period by changes in the estimated fair value of our common stock. We estimate the fair value of stock options granted to our employees and directors on the grant date, and the resulting stock-based compensation expense, using the Black-Scholes option-pricing model. The Black-Scholes option-pricing model requires the use of assumptions regarding a number of variables that are complex, subjective and generally require significant judgment to determine. The assumptions used to calculate the fair value of our stock options were: Fair value of common stock Prior to the IPO, the fair value of the common stock underlying the stock options was determined by our board of directors, with input from management and independent third-party valuations. The grant date fair value of our common stock was determined using valuation methodologies which utilizes certain assumptions including probability weighting of events, volatility, time to liquidation, a risk-free interest rate and an assumption for a discount for lack of marketability. In determining the fair value of our common stock, the methodologies used to estimate our enterprise value were performed using methodologies, approaches, and assumptions consistent with the American Institute of Certified Public Accountants Accounting and Valuation Guide, Valuation of Privately-Held-Company Equity Securities Issued as Compensation. Subsequent to the IPO, the fair value of our common stock is determined by the closing price, on the date of grant, of our common stock, which is traded on the Nasdaq Global Select Market. Expected term Our expected term represents the period that our stock options are expected to be outstanding and is determined using a simplified method (based on the midpoint between the vesting date and the end of the contractual term), as we do not have sufficient historical data to use any other method to estimate expected term. Expected volatility Prior to the commencement of trading of our common stock on the Nasdaq Global Select Market on October 4, 2018 in connection with the IPO, there was no active trading market for our common stock. Due to limited historical data for the trading of our common stock, expected volatility is estimated based on the average volatility for comparable publicly traded peer group companies in the same industry over a period equal to the expected term of the stock option grants. The comparable companies are chosen based on their similar size, stage in the life cycle or area of specialty. Risk-free interest rate The risk-free interest rate is based on the U.S. treasury zero coupon issues in effect at the time of grant for periods corresponding with the expected term of the stock option grants. Expected dividend yield We have never paid dividends on our common stock and have no plans to pay dividends on our common stock. Therefore, we use an expected dividend yield of zero. Black-Scholes assumptions The weighted-average assumptions used in our Black-Scholes option-pricing model were as follows for stock option granted to our employees for the periods presented: We recognize stock-based compensation expense net of forfeitures as they occur in accordance with Accounting Standards Update 2016-09, Compensation - Stock Compensation (Topic 718). We will continue to use judgment in evaluating the assumptions related to our stock-based compensation on a prospective basis. As we continue to accumulate additional data related to our common stock, we may have refinements to our estimates, which could materially impact our future stock-based compensation expense. As of December 31, 2018, we had unrecognized stock-based compensation of 17.5 million related to unvested stock options which is expected to be recognized over a weighted-average period of 2.7 years. JOBS Act accounting election We are an “emerging growth company,” or EGC, within the meaning of the Jumpstart Our Business Act of 2012, or JOBS Act. Section 107(b) of the JOBS Act provides that an EGC can leverage the extended transition period, provided in Section 102(b) of the JOBS Act, for complying with new or revised accounting standards. Thus, an EGC can delay the adoption of new or revised accounting standards that have different effective dates for public and private companies until those standards apply to private companies. We have elected to use this extended transition period and, as a result, our financial statements may not be comparable to companies that comply with public company effective dates. We also intend to rely on other exemptions provided by the JOBS Act, including without limitation, not being required to comply with the auditor attestation requirements of Section 404(b) of the Sarbanes-Oxley Act of 2002. We will remain an EGC until the earliest of (1) the last day of the fiscal year following the fifth anniversary of the consummation of the IPO, (2) the last day of the fiscal year in which we have total annual gross revenue of at least $1.07 billion, (3) the last day of the fiscal year in which we are deemed to be a “large accelerated filer” as defined in Rule 12b-2 under the Exchange Act, which would occur if the market value of our common stock held by non-affiliates exceeded $700.0 million as of the last business day of the second fiscal quarter of such year or (4) the date on which we have issued more than $1.0 billion in non-convertible debt securities during the prior three-year period. While we may otherwise remain an EGC until as late as December 31, 2023, if the market value of our common stock that is held by non-affiliates exceeds $700 million as of June 30, 2019, we expect that we will cease to be an EGC and will need to comply with additional legal, financial and accounting requirements as of December 31, 2019, which could result in substantial costs and additional risks for us and divert management’s attention. Recent accounting pronouncements See Note 2 to our consolidated financial statements included elsewhere in this report for more information.

<s>[INST] Overview We are a leading precision oncology company focused on helping conquer cancer globally through use of our proprietary blood tests, vast data sets and advanced analytics. We believe that the key to conquering cancer is unprecedented access to its molecular information throughout all stages of the disease, which we intend to enable by a routine blood draw, or liquid biopsy. Our Guardant Health Oncology Platform is designed to leverage our capabilities in technology, clinical development, regulatory and reimbursement to drive commercial adoption, improve patient clinical outcomes and lower healthcare costs. In pursuit of our goal to manage cancer across all stages of the disease, we launched our Guardant360 and GuardantOMNI liquid biopsybased tests for advanced stage cancer. Our Guardant360 test, launched in 2014, has been used by more than 6,000 oncologists, over 50 biopharmaceutical companies and all 28 National Comprehensive Cancer Network, or NCCN, Centers. Our GuardantOMNI test, launched in 2017, is specifically built for our biopharmaceutical customers as a comprehensive genomic profiling tool to help accelerate clinical development programs in both immunooncology and targeted therapy. Our LUNAR1 and LUNAR2 programs are developing tests for minimal residual disease and recurrence monitoring and for early detection screening, respectively. In late 2018 we launched our LUNAR assay for research use by biopharmaceutical and academic researchers. Since our inception, we have devoted substantially all of our resources to research and development activities related to our Guardant360 and GuardantOMNI tests and our LUNAR programs, including clinical and regulatory initiatives to obtain approval by the FDA, as well as sales and marketing activities. We have over 40 approved, completed or active clinical outcomes studies, more than 100 peerreviewed publications and more than 300 scientific abstracts. We are pioneering the clinical comprehensive liquid biopsy market with our Guardant360 and GuardantOMNI tests, both of which analyze circulating tumor DNA in blood. Our Guardant360 test is a molecular diagnostic test measuring 73 cancerrelated genes and has been used by clinicians to help inform which therapy may be effective for advanced stage cancer patients with solid tumors and by biopharmaceutical companies for a range of applications, including identifying target patient populations to accelerate translational science research, clinical trial enrollment, and drug development, and postapproval commercialization. Our GuardantOMNI test has a broader 500gene panel, including genes associated with homologous recombination repair deficiency and biomarkers for immunooncology applications, such as tumor mutational burden and microsatellite instability, and has achieved comparable analytical performance in clinical studies, including for translational science applications in collaboration with several biopharmaceutical companies, including Merck MSD, Merck KGaA, Pfizer, AstraZeneca and BristolMyers Squibb. The FDA granted designation as a breakthrough device for our Guardant360 test in January 2018 and for our GuardantOMNI test in December 2018. An expedited access pathway and potentially faster review are provided for breakthrough medical devices that address unmet medical needs. Our Guardant360 and GuardantOMNI tests are both being developed as companion diagnostics under collaborations with biopharmaceutical companies. We perform our Guardant360, GuardantOMNI and other tests in our clinical laboratory located in Redwood City, California. Our laboratory is accredited by the Clinical Laboratory Improvement Amendments of 1988, or CLIA, permitted by the New York State Department of Health, or NYSDOH, and licensed in California and four other states. The analytical and clinical data that we have generated in our efforts to establish clinical utility, combined with the support we have developed with key opinion leaders, or KOLs, in the oncology space have led to positive coverage decisions by a number of commercial payers. Our Guardant360 test is currently covered by Cigna, Priority Health and multiple Blue Cross Blue Shield plans, which have adopted reimbursement policies that specifically cover Guardant360 test for nonsmall [/INST] Negative. </s>

Guardant Health, Inc.

2020-03-02

2019-12-31

Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations You should read the following discussion and analysis of financial condition and results of operations together with the consolidated financial statements and related notes included elsewhere in this Annual Report on Form 10-K. This discussion and other parts of this Annual Report on Form 10-K contain forward-looking statements that involve risk and uncertainties, such as statements of our plans, objectives, expectations and intentions. Our actual results could differ materially from those discussed in these forward-looking statements. Factors that could cause or contribute to such differences include, but are not limited to, those discussed in Part I, Item 1A“Risk Factors,” of this Annual Report on Form 10-K. The following generally compares our results of operations for the years ended December 31, 2019 and 2018. A detailed discussion comparing our results of operations for the years ended December 31, 2018 and 2017 can be found in Part II, Item 7, “Management’s Discussion and Analysis of Financial Condition and Results of Operations,” of our Annual Report on Form 10-K for the year ended December 31, 2018. Overview We are a leading precision oncology company focused on helping conquer cancer globally through use of our proprietary blood tests, vast data sets and advanced analytics. We believe that the key to conquering cancer is unprecedented access to its molecular information throughout all stages of the disease, which we intend to enable by a routine blood draw, or liquid biopsy. Our Guardant Health Oncology Platform is designed to leverage our capabilities in technology, clinical development, regulatory and reimbursement to drive commercial adoption, accelerate drug development, improve patient clinical outcomes and lower healthcare costs. In pursuit of our goal to manage cancer across all stages of the disease, we launched our Guardant360 and GuardantOMNI liquid biopsy-based tests for advanced stage cancer. Our Guardant360 test, launched in 2014, has been used by more than 7,000 oncologists, over 50 biopharmaceutical companies and all 28 National Comprehensive Cancer Network, or NCCN, Centers. Our GuardantOMNI test, launched in 2017, has been used by our biopharmaceutical customers as a comprehensive genomic profiling tool to help accelerate clinical development programs in both immuno-oncology and targeted therapy. These tests fuel development of our LUNAR program, which aims to address the needs of early stage cancer patients with neoadjuvant and adjuvant treatment selection, cancer survivors with surveillance, asymptomatic individuals eligible for cancer screening and individuals at a higher risk for developing cancer with early detection. Our LUNAR-1 assay was launched in 2018 for research use and in late 2019 for investigational use. Since our inception, we have devoted substantially all of our resources to research and development activities related to our Guardant360 and GuardantOMNI tests and our LUNAR program, including clinical and regulatory initiatives to obtain approval by the U.S. Food and Drug Administration, or the FDA, as well as sales and marketing activities. We have over 50 approved, completed or active clinical outcomes studies, more than 150 peer-reviewed publications and more than 400 scientific abstracts. We are pioneering the clinical comprehensive liquid biopsy market with our Guardant360 and GuardantOMNI tests, both of which analyze circulating tumor DNA in blood. Our Guardant360 test is a molecular diagnostic test measuring 74 cancer-related genes and has been used by clinicians to help inform which therapy may be effective for advanced stage cancer patients with solid tumors and by biopharmaceutical companies for a range of applications, including identifying target patient populations to accelerate translational science research, clinical trial enrollment, and drug development, and post-approval commercialization. Our GuardantOMNI test has a broader 500-gene panel, including genes associated with homologous recombination repair deficiency and biomarkers for immuno-oncology applications, such as tumor mutational burden and microsatellite instability, and has achieved comparable analytical performance in clinical studies, including for translational science applications in collaboration with several biopharmaceutical companies, including AstraZeneca, Bristol-Myers Squibb, Merck MSD, Merck KGaA of Darmstadt, Germany and Pfizer. Our Guardant360 and GuardantOMNI tests have each been designated by the FDA as a breakthrough device for use as a companion diagnostic in connection with certain specified therapeutic products of our biopharmaceutical customers. Among other things, designation as a breakthrough device provides for priority review by the FDA and more interactive communication with the FDA during the development process. Our Guardant360 and GuardantOMNI tests are both being developed as companion diagnostics under collaborations with biopharmaceutical companies, including AstraZeneca and Amgen. We perform our Guardant360, GuardantOMNI and other tests in our clinical laboratory located in Redwood City, California. Our laboratory is certified pursuant to the Clinical Laboratory Improvement Amendments of 1988, or CLIA, accredited by the College of American Pathologists, or CAP, permitted by the New York State Department of Health, or NYSDOH, and licensed in California and four other states. The analytical and clinical data that we have generated in our efforts to establish clinical utility, combined with the support we have developed with key opinion leaders, or KOLs, in the oncology space have led to positive coverage decisions by a number of commercial payers. Our Guardant360 test is currently covered by Cigna, Priority Health, multiple Blue Cross Blue Shield plans as well as the health plans associated with eviCore, which have adopted policies that specifically cover Guardant360 test for non-small cell lung cancer, or NSCLC, which we believe gives us a competitive advantage with these payers. In July 2018, Palmetto GBA, the Medicare Administrative Contractor, or MAC, responsible for administering Medicare’s Molecular Diagnostic Services Program, or MolDx, issued a local coverage determination, or LCD, for our Guardant360 test for NSCLC patients who meet certain clinical criteria. We worked with Palmetto GBA to obtain this positive coverage decision through the submission of a detailed dossier of analytical and clinical data to substantiate that the test meets Medicare’s medical necessity requirements. Subsequently in 2018, Noridian Healthcare Solutions, the MAC responsible for adjudicating claims in California, where our laboratory is located, and a participant in MolDx, also finalized its LCD for Guardant360 test. Pursuant to this Noridian LCD, in September 2018, we began to submit claims for reimbursement for Guardant360 clinical testing performed for NSCLC patients covered under the LCD who meet certain clinical criteria, and in October 2018, we began to receive payments for these services from Medicare. We estimate that approximately 75% of Medicare patients tested for NSCLC are covered by the LCDs for NSCLC patients. For the years ended December 31, 2019 and 2018, respectively, approximately 44% and 46% of our U.S. clinical tests were for patients tested for NSCLC. In December 2019, replacing its prior NSCLC patient LCD, Palmetto GBA finalized a new LCD for our Guardant360 test that provides limited Medicare coverage for the Guardant360 test in patients diagnosed with solid cancers of non-central nervous system origin. The new LCD requires that patients are recurrent, relapsed, refractory, metastatic, or advanced cancer patients who are seeking further treatment and are potential candidates for an FDA-approved or NCCN-recommended (for Category 1 or 2A level of evidence) biomarker targeted therapy. Additionally, the patient must not have had a previous Guardant360 testing and must be untreated or not responding on the patient’s current therapy. A patient who has previously been tested with the Guardant360 test and has progressed with new malignant growth since the patient’s prior test is considered to have a new primary cancer diagnosis and thus is eligible to have another test. Finally, for qualifying cancers other than NSCLC, tissue-based comprehensive genomic profiling must be infeasible for coverage. NSCLC patients would be eligible for coverage if tissue-based testing is infeasible or if previous tissue-based comprehensive genomic profiling returned no actionable results. The new LCD covers our Guardant360 test for fee-for-service Medicare patients with advanced cancers who meet its clinical criteria for complete genomic profiling with next-generation sequencing, or NGS, of tumor tissue to optimize treatment selection decisions but have insufficient or unavailable tissue for molecular profiling. The expanded Medicare coverage decision is in line with FDA approvals of several tumor-agnostic drugs that are based on a single genomic biomarker across all cancers or that are targetable across multiple cancer types. We expect Noridian Healthcare Solutions to issue a new LCD for our Guardant360 test equivalent to the new LCD issued by Palmetto GBA, though the timing and scope of the Noridian LCD are uncertain. Based on historic physician ordering patterns, we believe the new Noridian LCD, if issued, would significantly expand coverage for use of the Guardant360 test for Medicare patients. We also anticipate approval by the FDA, if obtained, may support further improvements in coverage and reimbursement for our Guardant360 test. In the United States, we market our tests to clinical customers through our sales organization, which is engaged in sales efforts and promotional activities primarily targeting oncologists and cancer centers. Outside the United States, we market our tests to clinical customers through distributors and direct contracts with healthcare institutions. We also market our tests to biopharmaceutical customers globally through our business development team, which promotes the broad utility of our tests throughout drug development and commercialization. Additionally, we have established a joint venture with SoftBank to accelerate commercialization of our products including in Asia, the Middle East and Africa, with our initial focus being on Japan. Our products are currently marketed in approximately 40 countries. We generated total revenue of $214.4 million, $90.6 million and $49.8 million for the years ended December 31, 2019, 2018 and 2017, respectively. We also incurred net losses of $67.9 million, $84.3 million and $83.2 million in the years ended December 31, 2019, 2018 and 2017, respectively. We have funded our operations to date principally from the sale of our stock and revenue from our precision oncology testing and development services. In 2017, we raised $320.4 million through the sale of our Series E convertible preferred stock. In October 2018, we completed our initial public offering, or the IPO, selling 14,375,000 shares of our common stock and raising $249.5 million net of underwriting discounts and commissions and other expenses payable by us. In May 2019, we completed an underwritten public offering of a total of 5,175,000 shares of our common stock, through which we received net proceeds of approximately $349.7 million after deducting underwriting discounts and commissions and offering expenses payable by us. As of December 31, 2019, we had cash, cash equivalents and marketable securities of $791.6 million. Factors affecting our performance We believe there are several important factors that have impacted and that we expect will impact our operating performance and results of operations, including: • Testing volume, pricing and customer mix. Our revenue and costs are affected by the volume of testing and mix of customers from period to period. We evaluate both the volume of tests that we perform for patients on behalf of clinicians and the number of tests we perform for biopharmaceutical companies. Our performance depends on our ability to retain and broaden adoption with existing customers, as well as attract new customers. We believe that the test volume we receive from clinicians and biopharmaceutical companies are indicators of growth in each of these customer verticals. Customer mix for our tests has the potential to significantly affect our results of operations, as the average selling price for biopharmaceutical sample testing is currently higher than our average selling price for clinical tests because we are not a contracted provider for, or our tests are not covered by clinical patients’ insurance for, the majority of the tests that we perform for patients on behalf of clinicians. Approximately 38% of our U.S. clinical tests for the years ended December 31, 2019 and 2018 were for Medicare beneficiaries. Prior to the third quarter of 2018, Medicare did not cover our tests and we did not submit claims for reimbursement. In September 2018, we began to submit claims to Medicare for reimbursement for Guardant360 clinical tests for NSCLC patients covered under MolDx who meet certain clinical criteria, and in October 2018, we began to receive payments from Medicare for these clinical tests. In December 2019, Palmetto GBA expanded its LCD for our Guardant360 test to provide limited Medicare coverage for use of Guardant360 for qualifying patients diagnosed with solid tumor cancers of non-central nervous system origin. Noridian Healthcare Solutions, or Noridian, is the MAC responsible for adjudicating claims in California where our laboratory is located. Noridian is a participant in MolDx and recently issued a draft LCD for the Guardant360 test modeled on the expanded Palmetto LCD. We may not be able to obtain reimbursement under the expanded Noridian LCD until it is finalized and Noridian completes certain administrative steps. • Regulatory approval. Our Guardant360 test was the first comprehensive liquid biopsy test approved by NYSDOH. In addition, we believe our facility was the first comprehensive liquid biopsy laboratory to be CLIA-certified, CAP-accredited and NYSDOH-permitted. In the fourth quarter of 2019, we submitted a premarket approval, or PMA, application to seek the FDA’s approval of our Guardant360 test to be used as a companion diagnostic, initially in connection with one therapeutic product of a biopharmaceutical customer, and to provide tumor mutation profiling for cancer patients with solid tumors. In February 2020, we submitted an additional module of the PMA application for our Guardant360 test to the FDA. Medicare’s National Coverage Determination for Next Generation Sequencing established in 2018 and subsequently updated in 2020 provides coverage for molecular diagnostic tests such as our Guardant360 test, if, among other criteria, such tests are offered within their FDA-approved companion diagnostic labeling. We believe that this establishes a competitive advantage for tests receiving FDA approval and that FDA approval will be increasingly necessary for diagnostic tests to gain adoption, both in the United States and abroad. We believe FDA approval, if obtained, will help increase adoption of our tests and facilitate favorable reimbursement decisions by Medicare and commercial payers. We also intend to pursue regulatory approvals in specific markets outside of the United States, including in Europe, Japan and China. Any negative regulatory decisions or changes in regulatory requirements affecting our business could adversely impact our operations and financial results. • Payer coverage and reimbursement. Our revenue depends on achieving broad coverage and reimbursement for our tests from third-party payers, including both commercial and government payers. Payment from commercial payers can vary depending on whether we have entered into a contract with the payers as a “participating provider” or do not have a contract and are considered a “non-participating provider.” Payers often reimburse non-participating providers, if at all, at a lower amount than participating providers. We have received a substantial portion of our revenue from a limited number of commercial payers, most of which have not contracted with us to be a participating provider. We have received reimbursement for tests of patients with a variety of cancers, though for amounts that on average are significantly lower than for participating providers. We have experienced situations where commercial payers proactively reduced the amounts they were willing to reimburse for our tests, and in other situations, commercial payers have determined that the amounts they previously paid were too high and have sought to recover those perceived excess payments by deducting such amounts from payments otherwise being made. When we contract with a payer to serve as a participating provider, reimbursements by the payer are generally made pursuant to a negotiated fee schedule and are limited to only covered indications or where prior approval has been obtained. Becoming a participating provider can result in higher reimbursement amounts for covered uses of our test and, potentially, no reimbursement for non-covered uses identified under the payer’s policies or the contract. As a result, the potential for more favorable reimbursement associated with becoming a participating provider may be offset by a potential loss of reimbursement for non-covered uses of our tests. Current Procedural Terminology, or CPT, coding plays a significant role in how our Guardant360 test is reimbursed both from commercial and governmental payers. Changes to the codes used to report the Guardant360 test to payers may result in significant changes in its reimbursement. If our Guardant360 test receives approval from the FDA, we may be required to obtain a new code to report the Guardant360 test on claims submitted to U.S. payers. If a coding change were to occur, payments for certain uses of the Guardant360 test could be reduced or eliminated by such payers. Cigna, Priority Health, multiple Blue Cross Blue Shield plans as well as the health plans associated with eviCore adopted policies that cover our Guardant360 test for the majority of NSCLC patients we test. If their policies were to change in the future to cover additional cancer indications, we anticipate that our total reimbursement would increase. In September 2018, we began to submit claims for reimbursement with respect to Guardant360 clinical testing performed for NSCLC patients covered under the LCD who meet certain clinical criteria, and in October 2018, we began to receive payments from Medicare. We estimate total coverage in the United States for the Guardant360 test to be more than 170 million lives, including Medicare beneficiaries and members of several commercial health plans. If we fail to obtain or maintain coverage and adequate reimbursement from third-party payers, we may be unable to increase our testing volume and revenue as expected. Retrospective reimbursement adjustments, such as deductions from further payments and clawbacks, can also negatively impact our revenue and cause our financial results to fluctuate. Due to the inherent variability of the insurance landscape, historic success of, and payments from, appeals of reimbursement denials by payers are not indicative of future success of and payments from such appeals. • Biopharmaceutical customers. Our revenue also depends on our ability to attract new, and to maintain and expand relationships with existing, biopharmaceutical customers, and we expect to increase our sales and marketing expense in furtherance of this goal. As we continue to develop these relationships, we expect to support a growing number of clinical trials both in the United States and internationally. If our relationships expand with biopharmaceutical customers, we believe we may continue to have opportunities to offer our platform to such customers for companion diagnostic development, novel target discovery and validation as well as clinical trial enrollment, and to grow into other business opportunities. For example, we believe that our genomic data, in combination with clinical outcomes or claims data, has revenue-generating potential, supporting novel drug development and companion diagnostic development. • Research and development. A significant aspect of our business is our investment in research and development, including the development of new products, such as those being developed as part of our LUNAR program. In particular, we have invested heavily in clinical studies, including more than 50 clinical outcomes studies, the largest-ever liquid-to-tissue concordance study, and a prospective interventional clinical utility study demonstrating clinical overall response rates in line with tissue biopsy approaches. Our clinical research has resulted in over 150 peer-reviewed publications. With respect to our LUNAR program, we initiated a prospective screening study, which we refer to as the ECLIPSE trial, to recruit approximately 10,000 patients and evaluate the performance of our LUNAR-2 assay in detecting colorectal cancer in average-risk adults, and in collaboration with a National Clinical Trials Network group, initiated a prospective multi-center randomized controlled trial, which we refer to as the COBRA study, in approximately 1,400 patients with resected stage II colon cancer to use our LUNAR-1 assay to evaluate recurrence-free survival in patients who receive ctDNA-directed therapy as compared to the current standard-of-care active surveillance. Furthermore, we are collaborating with investigators from multiple academic cancer centers, including MD Anderson Cancer Center, the University of Colorado, Memorial Sloan Kettering Cancer Center, Massachusetts General Cancer Center, Wake Forest Cancer Center and the University of California San Francisco, as well as several international institutions. We believe these studies are critical to gaining physician adoption and driving favorable coverage decisions by payers, and expect our investments in clinical studies to increase. We expect to increase our research and development expense with the goal of fueling further innovation. • International expansion. A component of our long-term growth strategy is to expand our commercial footprint internationally, and we expect to increase our sales and marketing expense to execute on this strategy. We currently offer our tests in countries outside the United States primarily through distributor relationships or direct contracts with hospitals. In May 2018, we formed and capitalized a joint venture, Guardant Health AMEA, Inc., which we refer to as the Joint Venture, with SoftBank, relating to the sale, marketing and distribution of our tests generally outside the Americas and Europe. We expect to rely on the Joint Venture to accelerate commercialization of our products in Asia, the Middle East and Africa, with our initial focus being on Japan. The recent outbreak of novel coronavirus may disrupt operations for the Joint Venture and make it more difficult to sell our tests in the affected countries or regions, many of which are in the JV Territory. While the impact of this outbreak on the Joint Venture’s business is still uncertain and depends on many factors, including how long the outbreak goes uncontained, the Joint Venture’s revenue and results of operations could be adversely affected. While each of these areas presents significant opportunities for us, they also pose significant risks and challenges that we must address. See Part I, Item 1A, “Risk Factors” of this Annual Report on Form 10-K for more information. Components of results of operations Revenue We derive our revenue from two sources: (i) precision oncology testing and (ii) development services. Effective January 1, 2019, we adopted a new revenue recognition standard FASB ASC Topic 606, Revenue from Contracts with Customers, or ASC 606, which primarily impacted our recognition of revenue related to patient claims paid by third-party commercial and governmental payors. We adopted ASC 606 using the modified retrospective method, which means that the cumulative effect of applying ASC 606 has been recognized to beginning accumulated deficit at January 1, 2019, the date of adoption of ASC 606, and prior comparative periods were not recast to reflect ASC 606. As a result, revenue for the year ended December 31, 2018 is presented in accordance with FASB ASC Topic 605, Revenue Recognition, or ASC 605, whereas revenue for the year ended December 31, 2019 is presented under ASC 606. ASC 606 provides a five-step model for recognizing revenue that includes identifying the contract with a customer, identifying the performance obligations in the contract, determining the transaction price, allocating the transaction price to the performance obligations, and recognizing revenue when, or as, an entity satisfies a performance obligation. Precision oncology testing. Precision oncology testing revenue is generated from sales of our Guardant 360 and GuardantOMNI tests to clinical and biopharmaceutical customers. In the United States, through December 31, 2019, we generally performed tests as an out-of-network service provider without contracts with health insurance companies. We submit claims for payment for tests performed for patients covered by U.S. private payers. Prior to the third quarter of 2018, Medicare did not cover our tests and we did not submit claims for reimbursement for these tests. In September 2018, we began to submit claims to Medicare for reimbursement for Guardant360 clinical testing performed for NSCLC patients covered under Medicare’s Molecular Diagnostic Services Program who meet certain clinical criteria. Tests for patients covered by Medicare represented approximately 38% of our U.S. clinical tests in both 2019 and 2018. Due to the historical general lack of contracts with U.S. private payers and variability in payments received for claims submitted to them, as well as the limited claims experience to date with Medicare, from our inception through the end of 2018 revenue had not been recognized by us at the time the service was performed as the price of the transaction was not fixed or determinable and collectability was not reasonably assured. As we provide precision oncology testing to biopharmaceutical customers under contracts for which all recognition criteria are met, we have recognized revenue on an accrual basis for those services. Development services. Development services revenue represents services, other than precision oncology testing, that we provide to biopharmaceutical companies and large medical institutions. It includes companion diagnostic development and regulatory approval services, clinical trial referrals and liquid biopsy testing development and support. We collaborate with biopharmaceutical companies in the development and clinical trials of new drugs. As part of these collaborations, we provide services related to regulatory filings with the FDA to support companion diagnostic device submissions for our liquid biopsy panels. Under these arrangements, we generate revenue from progression of our collaboration efforts, as well as from provision of on-going support. Development services revenue can vary over time as different projects start and complete. Costs and operating expenses Cost of precision oncology testing. Cost of precision oncology testing generally consists of cost of materials, direct labor, including bonus, benefit and stock-based compensation; equipment and infrastructure expenses associated with processing liquid biopsy test samples, including sample accessioning, library preparation, sequencing, quality control analyses and shipping charges to transport blood samples; freight; curation of test results for physicians; and license fees due to third parties. Infrastructure expenses include depreciation of laboratory equipment, rent costs, amortization of leasehold improvements and information technology costs. Costs associated with performing our tests are recorded as the tests are performed regardless of whether revenue was recognized with respect to the tests. Royalties for licensed technology are calculated as a percentage of revenues generated using the associated technology and recorded as expense at the time the related revenue is recognized. One-time royalty payments related to signing of license agreements or other milestones, such as issuance of new patents, are amortized to expense over the expected useful life of the patents. While we do not believe the technologies underlying these licenses are necessary to permit us to provide our tests, we do believe these technologies are potentially valuable and of possible strategic importance to us or our competitors. Cost of precision oncology testing revenue included royalty expense of $4.4 million and $1.4 million for the years ended December 31, 2019 and 2018, respectively. We expect the cost of precision oncology testing to generally increase in line with the increase in the number of tests we perform, but the cost per test to decrease modestly over time due to the efficiencies we may gain as test volume increases, and from automation and other cost reductions. Cost of development services. Cost of development services includes costs incurred for the performance of development services requested by our customers. For development of new products, costs incurred before technological feasibility has been achieved are reported as research and development expenses, while costs incurred thereafter are reported as cost of revenue. Cost of development services will vary depending on the nature, timing and scope of customer projects. Research and development expense. Research and development expenses consist of costs incurred to develop technology and include salaries and benefits, reagents and supplies used in research and development laboratory work, infrastructure expenses, including allocated facility occupancy and information technology costs, contract services, other outside costs and costs to develop our technology capabilities. Research and development expenses also include costs related to activities performed under contracts with biopharmaceutical companies before technological feasibility has been achieved. Research and development costs are expensed as incurred. Payments made prior to the receipt of goods or services to be used in research and development are deferred and recognized as expense in the period in which the related goods are received or services are rendered. Costs to develop our technology capabilities are recorded as research and development unless they meet the criteria to be capitalized as internal-use software costs. We expect that our research and development expenses will continue to increase in absolute dollars as we continue to innovate and develop additional products, expand our genomic and medical data management resources and conduct our ongoing and new clinical trials, with a particular focus on our LUNAR program. Sales and marketing expense. Our sales and marketing expenses are expensed as incurred and include costs associated with our sales organization, including our direct sales force and sales management, client services, marketing and reimbursement, medical affairs, as well as business development personnel who are focused on our biopharmaceutical customers. These expenses consist primarily of salaries, commissions, bonuses, employee benefits, travel expenses and stock-based compensation, as well as marketing and educational activities and allocated overhead expenses. We expect our sales and marketing expenses to increase in absolute dollars as we expand our sales force, increase our presence within and outside of the United States, and increase our marketing activities to drive further awareness and adoption of our Guardant360 and GuardantOMNI tests. General and administrative expense. Our general and administrative expenses include costs for our executive, accounting and finance, legal and human resources functions. These expenses consist principally of salaries, bonuses, employee benefits, travel expenses and stock-based compensation, as well as professional services fees such as consulting, audit, tax and legal fees, and general corporate costs and allocated overhead expenses. We expect that our general and administrative expenses will continue to increase in absolute dollars, primarily due to increased headcount and costs associated with operating as a public company, including expenses related to legal, accounting, regulatory, maintaining compliance with exchange listing and requirements of the SEC, director and officer insurance premiums and investor relations. These expenses, though expected to increase in absolute dollars, are expected to decrease modestly as a percentage of revenue in the long term, though they may fluctuate as a percentage of revenue from period to period due to the timing and extent of these expenses. Interest income Interest income consists of interest earned on our cash, cash equivalents and marketable securities. Interest expense Interest expense consists primarily of interest from finance leases or capital leases and royalty obligations. Other income (expense), net In the first quarter of 2018, we settled a commercial legal dispute. In connection with the settlement, we received a payment of $4.25 million, which was recognized as one-time other income (expense), net for the year ended December 31, 2018. Other income (expense), net also consists of foreign currency exchange gains and losses. We expect our foreign currency gains and losses to continue to fluctuate in the future due to changes in foreign currency exchange rates. Provision for (Benefit from) income tax Income taxes are recorded using an asset and liability approach. Deferred tax assets and liabilities are recognized for the future tax consequences attributable to differences between the financial statement carrying amounts of existing assets and liabilities and their respective tax bases using enacted tax rates in effect for the year in which the differences are expected to affect taxable income. Tax benefits are recognized when it is more likely than not that a tax position will be sustained during an audit. Deferred tax assets are reduced by a valuation allowance if current evidence indicates that it is considered more likely than not that these benefits will not be realized. Our tax positions are subject to income tax audits. We recognize the tax benefit of an uncertain tax position only if it is more likely than not that the position is sustainable upon examination by the taxing authority, based on the technical merits. The tax benefit recognized is measured as the largest amount of benefit which is more likely than not to be realized upon settlement with the taxing authority. We recognize interest accrued and penalties related to unrecognized tax benefits in its tax provision. We evaluate uncertain tax positions on a regular basis. The evaluations are based on a number of factors, including changes in facts and circumstances, changes in tax law, correspondence with tax authorities during the course of the audit, and effective settlement of audit issues. The provision for (benefit from) income taxes includes the effects of any accruals that we believe are appropriate, as well as the related net interest and penalties. Results of operations The following table sets forth the significant components of our results of operations for the periods presented. (1) Fiscal year 2018 results do not reflect the impact of the adoption of the new revenue accounting standard in fiscal year 2019. (2) Amounts include stock-based compensation expense as follows: (3) Amounts include $157,000 of compensation expenses associated with repurchase of common stock for the year ended December 31, 2018. Comparison of the Years Ended December 31, 2019 and 2018 Revenue Total revenue was $214.4 million for the year ended December 31, 2019 compared to $90.6 million for the year ended December 31, 2018, an increase of $123.7 million, or 137%. Precision oncology testing revenue increased to $180.5 million for the year ended December 31, 2019 from $78.4 million for the year ended December 31, 2018, an increase of $102.1 million, or 130%. Precision oncology revenue from tests for clinical customers was $101.0 million for the year ended December 31, 2019, up 131.1% from $43.7 million for the year ended December 31, 2018. This increase in clinical testing revenue was driven primarily by increases in test volume plus higher average revenue per test. Precision oncology revenue for the year ended December 31, 2019 included $6.8 million of payments received during that year from successful appeals of payers’ denials of reimbursement for samples processed in 2018. Given the age of the samples associated with these successful appeals, we do not believe this appeals revenue is indicative of results in the ordinary course of our operations. Precision oncology tests for clinical customers increased to 49,926 for the year ended December 31, 2019 from 29,238 for the year ended December 31, 2018 (excluding 354 tests in 2018 from a customer that in March 2018 began processing tests in-house). We believe this volume increase is due to a number of factors including increases in our commercial programs, additional clinical data including from the NILE study, and new drugs which continue to expand the need for comprehensive genomic profiling. Average revenue per test increased due to reimbursement for testing of most Medicare lung cancer patients starting in the fourth quarter of 2018, increases in commercial payer payments that we believe were beneficially affected by the Protecting Access to Medicare Act of 2014 (“PAMA”), and the $6.8 million from appeals of samples tested in 2018. Precision oncology revenue from tests for biopharmaceutical customers was $79.5 million for the year ended December 31, 2019, up 129.1% from $34.7 million for the year ended December 31, 2018. Precision oncology tests for biopharmaceutical customers increased to 20,643 for the year ended December 31, 2019 from 10,370 for the year ended December 31, 2018 due to an increase in the number of biopharmaceutical customers and their contracted projects. The average selling price of precision oncology tests for biopharmaceutical customers was $3,850 for the year ended December 31, 2019, up from $3,347 the year ended December 31, 2018, due to a greater number of such tests being GuardantOMNI test, which has a higher selling price than the Guardant360 test. The change to accounting for revenue under ASC 606 increased precision oncology revenue from tests for pharmaceutical customers by $1.0 million since revenue under ASC 605 for precision oncology revenue from tests for pharmaceutical customers for the year ended December 31, 2019 would have been approximately $78.5 million. Development services revenue increased to $33.9 million for the year ended December 31, 2019 from $12.2 million for the year ended December 31, 2018, an increase of $21.7 million, or 177%. This increase in development services revenue was due to revenue received from new projects in 2019 and was mainly received from biopharmaceutical customers related to companion diagnostic development and regulatory approval services. Costs and operating expenses Cost of precision oncology testing Cost of precision oncology testing revenue was $62.3 million for the year ended December 31, 2019 compared to $39.8 million for the year ended December 31, 2018, an increase of $22.4 million, or 56%. This increase in cost of precision oncology testing was primarily due to a $11.2 million increase in material costs, a $5.2 million increase in labor and manufacturing overhead costs, and a $2.9 million increase in royalties and $3.2 million increase in other costs including costs related to freight, curation of test results for physicians. Cost of development services Cost of development services was $8.5 million for the year ended December 31, 2019 compared to $3.4 million for the year ended December 31, 2018, an increase of $5.1 million, or 152%. This increase in cost of development services was primarily due to an increase in labor costs related to companion diagnostic development and regulatory approval service contracts. Research and development expense Research and development expenses were $86.3 million for the year ended December 31, 2019 compared to $50.7 million for the year ended December 31, 2018, an increase of $35.6 million, or 70%. This increase in research and development expense was primarily due to an increase of $14.9 million in personnel-related costs, an increase of $4.2 million in noncash stock-based compensation for employees in our research and development group, an increase of $2.2 million related to allocated facilities and information technology infrastructure costs, and a $0.9 million increase in office administrative costs as we increased our headcount to support continued investment in our technology. The increase is also attributable to an increase of $7.9 million in material costs relating to the development of our LUNAR programs and the continuous improvement in our Guardant360 and GuardantOMNI liquid biopsy panels, and an increase of $4.9 million in development consulting fees. Sales and marketing expense Selling and marketing expenses were $78.3 million for the year ended December 31, 2019 compared to $53.5 million for the year ended December 31, 2018, an increase of $24.9 million, or 47%. This increase was primarily due to an increase of $15.6 million in personnel-related costs and an increase of $3.0 million in noncash stock-based compensation associated with the expansion of our commercial organization, an increase of $2.9 million related to office administrative costs, an increase of $2.3 million in travel expenses, an increase of $0.5 million related to allocated facilities and information technology infrastructure costs, and an increase of $0.6 million in professional service expenses related to marketing activities. General and administrative expense General and administrative expenses were $61.4 million for the year ended December 31, 2019 compared to $36.2 million for the year ended December 31, 2018, an increase of $25.2 million, or 70%. This increase was primarily due to an increase of $15.6 million in personnel-related costs including an increase of $2.5 million in noncash stock-based compensation expense and an increase of $1.2 million in administration expenses as we increased our headcount, and an increase of $11.9 million in professional service expenses related to outside legal, accounting, consulting and IT services. This increase was offset by a $3.0 million reduction in legal costs due to settlements of a patent lawsuits and commercial legal disputes that were finalized and incurred in 2018. Interest income Interest income was $13.7 million for the year ended December 31, 2019 compared to $5.3 million for the year ended December 31, 2018, an increase of $8.5 million, or 161%. The increase was primarily due to a higher cash, cash equivalents and marketable securities average balance year over year due to the timing of receipt of cash proceeds from our initial public offering and the follow-on offering that was completed in May 2019. Interest expense Interest expense was $1.2 million for the year ended December 31, 2019 compared to $1.3 million for the year ended December 31, 2018, a decrease of $0.1 million, or 6%. This decrease was primarily due to reduced outstanding balance of an obligation related to a royalty in connection with a patent license agreement entered into in January 2017. Other income (expense), net * Not meaningful Other income (expense), net included a gain of $4.3 million for settlement of a commercial legal dispute for the year ended December 31, 2018. There was no similar charge or gain for the year ended December 31, 2019. Other income (expense), net also included foreign currency exchange gains of $0.4 million for the year ended December 31, 2018. Foreign currency exchange gains/losses for the year ended December 31, 2019 was immaterial. Provision for (benefit from) income taxes Benefit from income taxes of $1.9 million for the year ended December 31, 2019 compared to an expense of $38,000 for the year ended December 31, 2018 was primarily due to the release of valuation allowance of $1.6 million associated with nondeductible intangible assets recorded as part of the Bellwether Bio acquisition. Additionally, there was a benefit of $0.4 million associated with the utilization of tax losses from continuing operations against other comprehensive income gains. Quarterly results of operations The following tables set forth our unaudited quarterly consolidated statements of operations data for each of the eight quarters in the 24-month period ended December 31, 2019. The information for each of these quarters has been prepared in accordance with generally accepted accounting principles in the United States of America and on the same basis as our audited consolidated financial statements included elsewhere in this Annual Report on Form 10-K. In the opinion of management, reflect all adjustments, which include only normal recurring adjustments, necessary for the fair presentation of our results of operations. This data should be read in conjunction with our audited financial statements and related notes included elsewhere in this Annual Report on Form 10-K. These quarterly operating results are not necessarily indicative of our operating results for the full year or any future period. (1) Quarterly periods in 2018 do not reflect the adoption of the new revenue accounting standards in 2019. Liquidity and capital resources We have incurred losses and negative cash flows from operations since our inception, and as of December 31, 2019, we had an accumulated deficit of $352.8 million. We expect to incur additional operating losses in the near future and our operating expenses will increase as we continue to invest in clinical trials and develop new product offerings from our research programs, including our LUNAR program, expand our sales organization, and increase our marketing efforts to drive market adoption of our Guardant360 and GuardantOMNI tests. As demand for our Guardant360 and GuardantOMNI tests are expected to continue to increase from physicians and biopharmaceutical companies, we anticipate that our capital expenditure requirements will also increase in order to build additional capacity. We have funded our operations to date principally from the sale of stock and revenue from precision oncology testing and development services. As of December 31, 2019, we had cash and cash equivalents of $143.2 million and marketable securities of $648.4 million. Cash in excess of immediate requirements is invested in accordance with our investment policy, primarily with a view to liquidity and capital preservation. Currently, our funds are held in marketable securities consisting of United States treasury securities and corporate bonds. Based on our current business plan, we believe our current cash, cash equivalents and marketable securities and anticipated cash flow from operations will be sufficient to meet our anticipated cash requirements over at least the next 12 months from the date of this Annual Report on Form 10-K. We may consider raising additional capital to expand our business, to pursue strategic investments, to take advantage of financing opportunities or for other reasons. As revenue from precision oncology testing and development service is expected to grow, we expect our accounts receivable and inventory balances to increase. Any increase in accounts receivable and inventory may not be completely offset by increases in accounts payable and accrued expenses, which could result in greater working capital requirements. If our available cash, cash equivalents and marketable securities and anticipated cash flow from operations are insufficient to satisfy our liquidity requirements including because of lower demand for our products as a result of lower than currently expected rates of reimbursement from our customers or other risks described in this Annual Report on Form 10-K, we may seek to sell additional common or preferred equity or convertible debt securities, enter into a credit facility or another form of third-party funding or seek other debt financing. The sale of equity and convertible debt securities may result in dilution to our stockholders and, in the case of preferred equity securities or convertible debt, those securities could provide for rights, preferences or privileges senior to those of our common stock. The terms of debt securities issued or borrowings pursuant to a credit agreement could impose significant restrictions on our operations. If we raise funds through collaborations and licensing arrangements, we might be required to relinquish significant rights to our platform technologies or products or grant licenses on terms that are not favorable to us. Additional capital may not be available to us on reasonable terms, or at all. Cash flows The following table summarizes our cash flows for the periods presented: Operating activities Cash used in operating activities during the year ended December 31, 2019 was $47.1 million, which resulted from a net loss of $67.9 million and net change in our operating assets and liabilities of $6.1 million, partially offset by non-cash charges of $26.8 million. Non-cash charges primarily consisted of $11.4 million of depreciation and amortization and $17.0 million of stock-based compensation, partially offset by $2.3 million of amortization of discount on investment. The net change in our operating assets and liabilities was primarily the result of a $7.4 million increase in accounts receivable driven by higher sales to biopharmaceutical customers and adoption of ASC 606, a $6.2 million increase in prepaid expenses and other current assets, a $6.0 million increase in inventory to support testing volumes, a $2.9 million increase in other assets for security deposits relating to new leases entered into in 2019 and a $3.9 million decrease in deferred revenue partially offset by a $9.2 million increase in accrued expenses and other current liabilities, a $5.6 million increase in accrued compensation due to increased personnel, a $4.3 million increase in accounts payable and a $1.0 million increase in operating lease liabilities as a result of the adoption of ASC 842. Cash used in operating activities during the year ended December 31, 2018 was $72.2 million, which resulted from a net loss of $84.3 million and net change in our operating assets and liabilities of $1.1 million, partially offset by non-cash charges of $13.2 million. Non-cash charges primarily consisted of $7.1 million of depreciation and amortization and $6.9 million of stock-based compensation, partially offset by $0.4 million of amortization of discount on investment. The net change in our operating assets and liabilities was primarily the result of a $22.9 million increase in accounts receivable driven by higher sales to biopharmaceutical customers, a $3.7 million increase in prepaid expenses and other current assets and a $1.8 million increase in inventory due to higher testing volumes, partially offset by a $13.0 million increase in deferred revenue, an $8.1 million increase in accrued compensation due to increased personnel, a $5.0 million increase in accounts payable and a $1.3 million increase in deferred rent. Investing activities Cash used in investing activities during the year ended December 31, 2019 was $317.6 million, which resulted primarily from purchases of marketable securities of $614.3 million, purchases of property and equipment of $18.7 million purchase of business of $7.3 million and purchase of intangible assets of $2.5 million, partially offset by our proceeds from the maturities of marketable securities of $325.3 million. Cash used in investing activities during the year ended December 31, 2018 was $153.0 million, which resulted primarily from purchases of marketable securities of $287.5 million and purchases of property and equipment of $20.2 million, partially offset by our proceeds from the maturities of marketable securities of $154.6 million. Financing activities Cash provided by financing activities during the year ended December 31, 2019 was $367.3 million which was primarily due to proceeds of $350.4 million from the follow-on offering completed in May 2019, and receipt of proceeds of $18.0 million from issuance of common stock upon exercise of stock options and issuance of shares under our ESPP. Cash provided by financing activities during the year ended December 31, 2018 was $293.2 million, which was primarily due to proceeds from the IPO of $254.0 million, net of underwriting discounts and commissions, and net proceeds from sale of equity interests in noncontrolling interests of $41.0 million. Contractual obligations and commitments Our contractual commitments will have an impact on our future liquidity. The following table summarizes our contractually committed future obligations as of December 31, 2019: (1) We lease our office and laboratory space in Redwood City, California, and office space in Spring City, Texas and Seattle, Washington under operating leases that expire between January 2021 - November 2027. We also have operating leases for manufacturing and office equipment through March 2023. (2) Includes payments relating to a facility agreement entered into as of December 31, 2019 for a lease commencing in 2020 net of sublease income of $0.1 million. (3) We have patent license agreements with four parties. Under these agreements, we have made one-time and milestone license fee payments that we have capitalized and are amortizing to expense ratably over the useful life of the applicable underlying patent rights. Under some of these agreements, we are obligated to pay low single-digit percentage running royalties on net sales where the patent right(s) are used in the product or service sold, subject to minimum annual royalties or fees in certain agreements. Off-balance sheet arrangements As of December 31, 2019, we have not had any off-balance sheet arrangements as defined in the rules and regulations of the SEC. Critical accounting policies and estimates We have prepared our financial statements in accordance with accounting principles generally accepted in the United States of America (“GAAP”). Our preparation of these financial statements requires us to make estimates, assumptions and judgments that affect the reported amounts of assets, liabilities, expenses and related disclosures at the date of the financial statements, as well as revenue and expenses recorded during the reporting periods. 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 the carrying value of assets and liabilities that are not readily apparent from other sources. Actual results could therefore differ materially from these estimates under different assumptions or conditions. While our significant accounting policies are described in more detail in Note 2 to our consolidated financial statements included elsewhere in this Annual Report on Form 10-K, we believe the following accounting policies to be critical to the judgments and estimates used in the preparation of our financial statements. Revenue recognition We derive revenue from the provision of precision oncology testing services provided to our ordering physicians and biopharmaceutical customers, as well as from biopharmaceutical research and development services provided to our biopharmaceutical customers. Precision oncology services include genomic profiling and the delivery of other genomic information derived from our platform. Development services include companion diagnostic development, information solutions and laboratory services. We currently receive payments from commercial third-party payors, certain hospitals and oncology centers and individual patients, as well as biopharmaceutical companies and research institutes. Effective January 1, 2019, we began recognizing revenue in accordance with ASC Topic 606, Revenue from Contracts with Customers, or ASC 606. Revenues are recognized when control of services is transferred to customers, in an amount that reflects the consideration we expect to be entitled to in exchange for those services. ASC 606 provides for a five-step model that includes identifying the contract with a customer, identifying the performance obligations in the contract, determining the transaction price, allocating the transaction price to the performance obligations, and recognizing revenue when, or as, an entity satisfies a performance obligation. Precision oncology testing We recognize revenue from the sale of our precision oncology tests for clinical customers, including certain hospitals, cancer centers, other institutions and patients, at the time results of the test are reported to physicians. Most precision oncology tests requested by clinical customers are sold without a written agreement; however, we determine an implied contract exists with our clinical customers. We identify each sale of our liquid biopsy test to clinical customer as a single performance obligation. With the exception of certain limited contracted arrangements with insurance carriers and other institutions where the transaction price is fixed, a stated contract price does not exist and the transaction price for each implied contract with our clinical customers represents variable consideration. We estimate the variable consideration under the portfolio approach and consider the historical reimbursement data from third-party payers and patients, as well as known current or anticipated reimbursement trends not reflected in the historical data. We monitor the estimated amount to be collected in the portfolio at each reporting period based on actual cash collections in order to assess whether a revision to the estimate is required. Both the estimate and any subsequent revision contain uncertainty and require the use of judgment in the estimation of the variable consideration and application of the constraint for such variable consideration. Revenue from sales of precision oncology tests to biopharmaceutical customers are based on a negotiated price per test or on the basis of an agreement to provide certain testing volume over a defined period. We identify our promise to transfer a series of distinct liquid biopsy tests to biopharmaceutical customers as a single performance obligation. Precision oncology tests to biopharmaceutical customers are generally billed at a fixed price for each test performed. For agreements involving testing volume to be satisfied over a defined period, revenue is recognized over time based on the number of tests performed as the performance obligation is satisfied over time. Results of our precision oncology services are delivered electronically, and as such there are no shipping or handling fees incurred by us or billed to customers. Development services We perform development services for our biopharmaceutical customers utilizing our precision oncology information platform. Development services typically represent a single performance obligation as we perform a significant integration service, such as analytical validation and regulatory submissions. The individual promises are not separately identifiable from other promises in the contracts and, therefore, are not distinct. However, under certain contracts, a biopharmaceutical customer may engage us for multiple distinct development services which are both capable of being distinct and separately identifiable from other promises in the contracts and, therefore, distinct performance obligations. We collaborate with pharmaceutical companies in the development and clinical trials of new drugs. As part of these collaborations, we provide services related to regulatory filings with the FDA to support companion diagnostic device submissions for our liquid biopsy panels. Under these collaborations, we generate revenue from achievement of milestones, as well as provision of on-going support. These collaboration arrangements include no royalty obligations. For development services performed, we are compensated through a combination of an upfront fee and performance-based non-refundable regulatory and other developmental milestone payments. The transaction price of our development services contracts typically represents variable consideration. Application of the constraint for variable consideration to milestone payments is an area that requires significant judgment. We evaluate factors such as the scientific, clinical, regulatory, commercial, and other risks that must be managed to achieve the respective milestone and the level of effort and investment required to achieve the respective milestone. In making this assessment, we consider our historical experience with similar milestones, the degree of complexity and uncertainty associated with each milestone, and whether achievement of the milestone is dependent on parties other than us. The constraint for variable consideration is applied such that it is probable a significant reversal of revenue will not occur when the uncertainty associated with the contingency is resolved. Application of the constraint for variable consideration is updated at each reporting period as a revision to the estimated transaction price. We recognize development services revenue over the period in which biopharmaceutical research and development services are provided. Specifically, we recognize revenue using an input method to measure progress, utilizing costs incurred to-date relative to total expected costs as its measure of progress. For development of new products or services under these arrangements, costs incurred before technological feasibility is reached are included as research and development expenses in our consolidated statements of operations, while costs incurred thereafter are recorded as cost of development services. Contracts with multiple performance obligations Contracts with biopharmaceutical customers may include multiple distinct performance obligations, such as provision of precision oncology testing, biopharmaceutical research and development services, and clinical trial enrollment assistance, among others. We evaluate the terms and conditions included within our contracts with biopharmaceutical customers to ensure appropriate revenue recognition, including whether services are considered distinct performance obligations that should be accounted for separately versus together. We first identify material promises, in contrast to immaterial promises or administrative tasks, under the contract and then evaluates whether these promises are both capable of being distinct and distinct within the context of the contract. In assessing whether a promised service is capable of being distinct, we consider whether the customer could benefit from the service either on its own or together with other resources that are readily available to the customer, including factors such as the research, development, and commercialization capabilities of a third party and the availability of the associated expertise in the general marketplace. In assessing whether a promised service is distinct within the context of the contract, we consider whether we provide a significant integration of the services, whether the services significantly modify or customize one another, or whether the services are highly interdependent or interrelated. For contracts with multiple performance obligations, the transaction price is allocated to the separate performance obligations on a relative standalone selling price basis. We determine standalone selling price by considering the historical selling price of these performance obligations in similar transactions as well as other factors, including, but not limited to, the price that customers in the market would be willing to pay, competitive pricing of other vendors, industry publications and current pricing practices, and expected costs of satisfying each performance obligation plus appropriate margin. Variable interest entity We review agreements we enter into with third party entities, pursuant to which we may have a variable interest in the entity, in order to determine if the entity is a variable interest entity, or VIE. If the entity is a VIE, we assess whether or not we are the primary beneficiary of that entity. In determining whether we are the primary beneficiary of an entity, we apply a qualitative approach that determines whether we have both (1) the power to direct the economically significant activities of the entity and (2) the obligation to absorb losses of, or the right to receive benefits from, the entity that could potentially be significant to that entity. If we determine we are the primary beneficiary of a VIE, we consolidate the statements of operations and financial condition of the VIE into our consolidated financial statements. Accounting for the consolidation is based on our determination if the VIE meets the definition of a business or and asset. Assets, liabilities and noncontrolling interests, excluding goodwill, of VIEs that are not determined to be businesses are recorded at fair value in our financial statements upon consolidation. Assets and liabilities that we have transferred to a VIE, after, or shortly before the date we became the primary beneficiary are recorded at the same amount at which the assets and liabilities would have been measured if they had not been transferred. Our determination about whether we should consolidate such VIEs is made continuously as changes to existing relationships or future transactions may result in a consolidation or deconsolidation event. In May 2018, we and SoftBank formed and capitalized the Joint Venture for the sale, marketing and distribution of our tests in the JV Territory. We expect to rely on the Joint Venture to accelerate commercialization of our products in Asia, the Middle East and Africa, with an initial focus on Japan. As of March 31, 2018, the Joint Venture is deemed to be a VIE and we are identified as the primary beneficiary of the VIE. Consequently, we have consolidated the financial position, results of operations and cash flows of the Joint Venture in our financial statements and all intercompany balances have been eliminated in consolidation. The joint venture agreement also includes a put-call arrangement with respect to the shares of the Joint Venture held by SoftBank and its affiliates. SoftBank will have a put right to cause us to purchase all shares of the Joint Venture held by SoftBank and its affiliates, and we will have a call right to purchase all such shares in the event of (i) certain material disagreement relating to the Joint Venture or its business that may seriously affect the ability of the Joint Venture to perform its obligations under the joint venture agreement or may otherwise seriously impair the ability of the Joint Venture to conduct its business in an effective matter, other than one relating to the Joint Venture’s business plan or to factual matters that may be capable of expert determination; (ii) the effectiveness of our initial public offering, a change in control, the seventh anniversary of the formation of the Joint Venture, or each subsequent anniversary of each of the foregoing events; or (iii) a material breach of the joint venture agreement by the other party that goes unremedied within 20 business days. Unless the shares of the Joint Venture are publicly traded and listed on a nationally recognized stock exchange, the purchase price per share of the Joint Venture in these situations will be determined by a third-party valuation firm on the assumption that the sale is on an arm’s-length basis on the date of the put or call notice. The third-party valuation firm may evaluate a range of factors and employ assumptions that are subjective in nature, which could result in the fair value of SoftBank’s interest in the Joint Venture being determined to be materially different from what has been recorded in our consolidated financial statements, including those included elsewhere in this Annual Report on Form 10-K. In the event we exercise our call right, the fair value of the Joint Venture will be deemed to be no less than an amount that yields a 20% internal rate of return on each tranche of capital invested by SoftBank and its affiliates in the Joint Venture, taking into account all proceeds received by SoftBank and its affiliates arising from their shares through such date. In the event SoftBank exercises its put right and the fair value of the Joint Venture is determined to be greater than 40% of our fair value, we will only be required to purchase the number of shares of the Joint Venture held by SoftBank and its affiliates having an aggregate value equal to the product of 40% of our fair value and the pro rata portion of the outstanding shares of the Joint Venture held by SoftBank and its affiliates. We may pay the purchase price for the shares of the Joint Venture in cash, in shares of our common stock, or in a combination thereof. In the event we exercise the call right, SoftBank will choose the form of consideration. In the event SoftBank exercises the put right, we will choose the form of consideration. The noncontrolling interest held by SoftBank contains embedded put-call redemption features that are not solely within our control and has been classified outside of permanent equity in our consolidated balance sheets. The put-call feature embedded in the redeemable noncontrolling interest do not currently require bifurcation as it does not meet the definition of a derivative and is considered to be clearly and closely related to the redeemable noncontrolling interest. The noncontrolling interest is considered probable of becoming redeemable as SoftBank has the option to exercise its put right to sell its equity ownership in the Joint Venture to us on or after the seventh anniversary of the formation of the Joint Venture, on each subsequent anniversary of the IPO and under certain other circumstances. We elected to recognize the change in redemption value immediately as they occur as if the put-call redemption feature were exercisable at the end of the reporting period. Stock-based compensation After the adoption of Accounting Standards Update 2018-07, Compensation-Stock Compensation (Topic 718): Improvements to Nonemployee Share-Based Payment Accounting on January 1, 2019, we measure stock-based compensation expense for stock options granted to our employees, directors, and nonemployee consultants on the date of grant and recognize the corresponding compensation expense of those awards over the period that the related services are rendered, which is generally the vesting period of the respective award. Compensation expense for stock options with performance metrics is calculated based upon expected achievement of the metrics specified in the grant. We estimate the fair value of stock options granted to our employees, directors, nonemployee consultants and purchase rights under our 2018 Employee Stock Purchase Plan on the grant date using the Black-Scholes option-pricing model. The Black-Scholes option-pricing model requires the use of assumptions regarding a number of variables that are complex, subjective and generally require significant judgment to determine. The assumptions used to calculate the fair value of our stock options were: Expected term Our expected term represents the period that our stock options are expected to be outstanding. After the adoption of Accounting Standards Update 2018-07, Compensation-Stock Compensation (Topic 718): Improvements to Nonemployee Share-Based Payment Accounting on January 1, 2019, the expected term of stock options issued to employees and nonemployee consultants is determined using the simplified method (based on the mid-point between the vesting date and the end of the contractual term), as we do not have sufficient historical data to use any other method to estimate expected term. Expected volatility Prior to the commencement of trading of our common stock on the Nasdaq Global Select Market on October 4, 2018 in connection with the IPO, there was no active trading market for our common stock. Due to limited historical data for the trading of our common stock, expected volatility is estimated based on the average volatility for comparable publicly traded peer group companies in the same industry plus our expected volatility for the available periods. The comparable companies are chosen based on their similar size, stage in the life cycle or area of specialty. Risk-free interest rate The risk-free interest rate is based on the U.S. treasury zero coupon issues in effect at the time of grant for periods corresponding with the expected term of the stock option grants. Expected dividend yield We have never paid dividends on our common stock and have no plans to pay dividends on our common stock. Therefore, we use an expected dividend yield of zero. Black-Scholes assumptions The weighted-average assumptions used in our Black-Scholes option-pricing model were as follows for stock option granted to our employees, directors and nonemployees for the periods presented: We recognize stock-based compensation expense net of forfeitures as they occur in accordance with Accounting Standards Update 2016-09, Compensation - Stock Compensation (Topic 718). We will continue to use judgment in evaluating the assumptions related to our stock-based compensation on a prospective basis. As we continue to accumulate additional data related to our common stock, we may have refinements to our estimates, which could materially impact our future stock-based compensation expense. Recent accounting pronouncements See Note 2, Summary of Significant Accounting Policies, to our consolidated financial statements included elsewhere in this Annual Report on Form 10-K for more information.

<s>[INST] The following generally compares our results of operations for the years ended December 31, 2019 and 2018. A detailed discussion comparing our results of operations for the years ended December 31, 2018 and 2017 can be found in Part II, Item 7, “Management’s Discussion and Analysis of Financial Condition and Results of Operations,” of our Annual Report on Form 10K for the year ended December 31, 2018. Overview We are a leading precision oncology company focused on helping conquer cancer globally through use of our proprietary blood tests, vast data sets and advanced analytics. We believe that the key to conquering cancer is unprecedented access to its molecular information throughout all stages of the disease, which we intend to enable by a routine blood draw, or liquid biopsy. Our Guardant Health Oncology Platform is designed to leverage our capabilities in technology, clinical development, regulatory and reimbursement to drive commercial adoption, accelerate drug development, improve patient clinical outcomes and lower healthcare costs. In pursuit of our goal to manage cancer across all stages of the disease, we launched our Guardant360 and GuardantOMNI liquid biopsybased tests for advanced stage cancer. Our Guardant360 test, launched in 2014, has been used by more than 7,000 oncologists, over 50 biopharmaceutical companies and all 28 National Comprehensive Cancer Network, or NCCN, Centers. Our GuardantOMNI test, launched in 2017, has been used by our biopharmaceutical customers as a comprehensive genomic profiling tool to help accelerate clinical development programs in both immunooncology and targeted therapy. These tests fuel development of our LUNAR program, which aims to address the needs of early stage cancer patients with neoadjuvant and adjuvant treatment selection, cancer survivors with surveillance, asymptomatic individuals eligible for cancer screening and individuals at a higher risk for developing cancer with early detection. Our LUNAR1 assay was launched in 2018 for research use and in late 2019 for investigational use. Since our inception, we have devoted substantially all of our resources to research and development activities related to our Guardant360 and GuardantOMNI tests and our LUNAR program, including clinical and regulatory initiatives to obtain approval by the U.S. Food and Drug Administration, or the FDA, as well as sales and marketing activities. We have over 50 approved, completed or active clinical outcomes studies, more than 150 peerreviewed publications and more than 400 scientific abstracts. We are pioneering the clinical comprehensive liquid biopsy market with our Guardant360 and GuardantOMNI tests, both of which analyze circulating tumor DNA in blood. Our Guardant360 test is a molecular diagnostic test measuring 74 cancerrelated genes and has been used by clinicians to help inform which therapy may be effective for advanced stage cancer patients with solid tumors and by biopharmaceutical companies for a range of applications, including identifying target patient populations to accelerate translational science research, clinical trial enrollment, and drug development, and postapproval commercialization. Our GuardantOMNI test has a broader 500gene panel, including genes associated with homologous recombination repair deficiency and biomarkers for immunooncology applications, such as tumor mutational burden and microsatellite instability, and has achieved comparable analytical performance in clinical studies, including for translational science applications in collaboration with several biopharmaceutical companies, including AstraZeneca, BristolMyers Squibb, Merck MSD, Merck KGaA of Darmstadt, Germany and Pfizer. Our Guardant360 and GuardantOMNI tests have each been designated by the FDA as a breakthrough device for use as a companion diagnostic in connection with certain specified therapeutic products of our biopharmaceutical customers. Among other things, designation as a breakthrough device provides for priority review by the FDA and more interactive communication with the FDA during the development process. Our Guardant360 and GuardantOMNI tests are both being developed as companion diagnostics under collaborations with biopharmaceut [/INST] Negative. </s>

RESIDEO TECHNOLOGIES, INC.

2019-03-18

2018-12-31

Item 7.Management’s Discussion and Analysis of Financial Condition and Results of Operations (Dollars in millions, except per share amounts) The following Management’s Discussion and Analysis of Financial Condition and Results of Operations is intended to help you understand the results of operations and financial condition of Resideo Technologies, Inc. and its consolidated subsidiaries (“Resideo” or “the Company”, “we”, “us” or “our”) for the three years ended December 31, 2018 and should be read in conjunction with the Consolidated and Combined Financial Statements and the notes thereto contained elsewhere in this Form 10-K. Overview and Business Trends We are a leading global provider of critical comfort, residential and thermal solutions and security solutions primarily in residential environments. Our products consist of solutions in Comfort, Residential Thermal Solutions and Security categories and include temperature and humidity control, thermal, water and air solutions and remote patient monitoring software solutions as well as security panels, sensors, peripherals, wire and cable, communications devices, video cameras, awareness solutions, cloud infrastructure, installation and maintenance tools and related software. Our ADI Global Distribution business is the leading wholesale distributor of security and low voltage electronic products which include video surveillance, intrusion, access control, fire and life safety, wire, networking and professional audio visual systems. We manage our business operations through two segments, Products and Solutions and Global Distribution. The Products and Solutions segment offerings include our Comfort, Residential Thermal Solutions and Security products, which, consistent with our industry, has a higher gross and operating margin profile in comparison to the Global Distribution segment. Our financial performance over the last three years has been supported by several macro trends. Steady growth in residential and non-residential construction and growth in renovation and remodeling in the United States has had a positive impact on the growth of our Products and Solutions and Global Distribution businesses. The financial performance of our Products and Solutions business has further benefited from increasing penetration of wireless connectivity and the proliferation of connected devices. The financial performance of our Global Distribution business has been further aided by increasing contractor needs for training and technical expertise, and increasing demand for same day order fulfilment. Recent Developments Separation from Honeywell The Company was incorporated in Delaware on April 24, 2018. We separated from Honeywell International Inc. (“Honeywell”) on October 29, 2018 (the “Distribution Date”), becoming an independent publicly traded company as a result of a pro rata distribution of our common stock to shareholders of Honeywell (the “Spin-Off”). On October 29, 2018, Honeywell’s shareholders of record as of October 16, 2018 (the “Record Date”) received one share of our common stock, par value $0.001 per share, for every six shares of Honeywell’s common stock, par value $1.00 per share, held as of the Record Date. We began trading “regular way” under the ticker symbol “REZI” on the New York Stock Exchange on October 29, 2018. In connection with the Spin-Off, we entered into certain agreements with Honeywell, such as the Honeywell Reimbursement Agreement, the Trademark License Agreement, Tax Matters Agreement, Employee Matters Agreement, Patent Cross-License Agreement and Transition Services Agreement, which will cause us to incur new costs. See Note 21. Commitments and Contingencies of Notes to Consolidated and Combined Financial Statements for a description of the material terms thereof. Basis of Presentation Our Consolidated Balance Sheet as of December 31, 2018 consists of the consolidated balances of Resideo as prepared on a stand-alone basis. Our Combined Balance Sheet as of December 31, 2017, and Consolidated and Combined Statements of Operations, Comprehensive Income (Loss), Equity, and Cash Flows for the years ended December 31, 2018, 2017 and 2016, have been prepared on a “carve-out” basis for the periods and dates prior to the Spin-Off and include stand-alone results for the period subsequent to the date of Spin-Off. Prior to the separation, RESIDEO TECHNOLOGIES, INC. these Consolidated and Combined Financial Statements were derived from the consolidated financial statements and accounting records of Honeywell. These Consolidated and Combined Financial Statements reflect our consolidated historical financial position, results of operations and cash flows as the business was historically managed in conformity with Generally Accepted Accounting Principles in the United States (“U.S. GAAP”). The historical combined financial information prior to the Spin-Off may not be indicative of our future performance and does not necessarily reflect what our consolidated and combined results of operations, financial condition and cash flows would have been had we operated as a separate, publicly traded company during the periods presented, particularly because of changes that we have experienced and may continue to experience as a result of our separation from Honeywell, including changes in the financing, cash management, operations, cost structure and personnel needs of our Company. The Combined Financial Statements prior to the Spin-Off include certain assets and liabilities that were held at the Honeywell corporate level but were specifically identifiable or otherwise attributable to us. Additionally, Honeywell historically provided certain services, such as legal, accounting, information technology, human resources and other infrastructure support, on behalf of us. The cost of these services were allocated to us on the basis of the proportion of net revenue. Actual costs that would have been incurred if we had been a stand-alone company for the entire period being presented would depend on multiple factors, including organizational structure and strategic decisions made in various areas, including information technology and infrastructure. Both we and Honeywell consider the basis on which the expenses were allocated during the period before the Spin-Off to be a reasonable reflection of the utilization of services provided to or the benefits received by us during the periods presented. Since the completion of the Spin-Off, we have incurred and expect to continue to incur expenditures consisting of employee-related costs, costs to start up certain stand-alone functions and information technology systems and other one-time transaction related costs. Recurring stand-alone costs include establishing the internal audit, treasury, investor relations, tax and corporate secretary functions as well as the annual expenses associated with running an independent publicly traded company including listing fees, compensation of non-employee directors, related board of director fees and other fees and expenses related to insurance, legal and external audit. Our environmental expenses prior to Spin-Off and our Honeywell reimbursement expenses are reported within Other expense, net in our Consolidated and Combined Statements of Operations, which reflect an estimated liability for resolution of pending and future environmental-related liabilities. Prior to the Spin-Off, this estimated liability was calculated as if we were responsible for 100% of the environmental-liability payments associated with certain sites. See Environmental Matters and Honeywell Reimbursement Agreement in Note 21. Commitments and Contingencies of Notes to Consolidated and Combined Financial Statements for additional information. In connection with our’s separation from Honeywell, we became a party to the Honeywell Reimbursement Agreement, which was entered into on October 14, 2018, pursuant to which we agreed to indemnify Honeywell in amounts equal to 90% of payments which include amounts billed with respect to certain environmental claims, remediation and, to the extent arising after the Spin-Off, hazardous exposure or toxic tort claims, in each case including consequential damages (the “liabilities”), in respect of specified properties contaminated through historical business operations, including the legal and other costs of defending and resolving such liabilities, less 90% of Honeywell’s net insurance receipts relating to such liabilities, and less 90% of the net proceeds received by Honeywell in connection with (i) affirmative claims relating to such liabilities, (ii) contributions by other parties relating to such liabilities and (iii) certain property sales. Pursuant to the Honeywell Reimbursement Agreement, we are responsible for paying to Honeywell such amounts, up to a cap of $140 million in respect of liabilities arising in any given calendar year (exclusive of any late payment fees up to 5% per annum). See “Certain Relationships and Related Party Transactions-Agreements with Honeywell-Honeywell Reimbursement Agreement”. Components of Operating Results Our fiscal year ends on December 31. The key elements of our operating results include: RESIDEO TECHNOLOGIES, INC. Net Revenue We globally manage our business operations through two reportable segments, Products and Solutions and Global Distribution: Products and Solutions. We generate the majority of our Product net revenue primarily from residential end-markets. Our Products and Solutions segment includes traditional products, as well as connected products, which we define as any device with the capability to be monitored or controlled from a remote location by an end-user or service provider. Our products are sold through a network of distributors (e.g. HVAC, Plumbing, Security, Electrical), OEMs, and service providers such as HVAC contractors, Security dealers and Plumbers including our ADI business. We also sell some products via retail and online channels. Global Distribution. We generate revenue through the distribution of security and low voltage fire protection products that are delivered through a comprehensive network of professional contractors, distributors and original equipment manufacturers (“OEMs”), as well as major retailers and online merchants. In addition to our own Security products, ADI distributes products from industry-leading manufacturers including Assa Abloy, Axis Communications, Honeywell and Nortek Security & Control, and ADI also carries a line of private label products. We sell these products to contractors that service non-residential and residential end-users. 14% of ADI’s net revenue is supplied by our Products and Solutions Segment. Management estimates that in 2018 approximately two-thirds of ADI’s net revenue were attributed to non-residential end markets and one-third to residential end markets. Cost of Goods Sold Products and Solutions: Cost of goods sold includes costs associated with raw materials, assembly, shipping and handling of those products; costs of personnel-related expenses, including pension benefits, and equipment associated with manufacturing support, logistics and quality assurance; costs of certain intangible assets; and costs of research and development. Research and development expense consists primarily of development of new products and product applications. Global Distribution: Cost of goods sold consists primarily of inventory-related costs and includes labor and personnel-related expenses. Selling, General, and Administrative Expense Selling, general and administrative expense includes trademark royalty expenses, sales incentives and commissions, professional fees, legal fees, promotional and advertising expenses, and personnel-related expenses, including stock based compensation and pension benefits. In addition, prior to the Spin-Off our selling general and administrative expense included an allocated portion of general corporate expenses. Other Expense, Net Other expense, net consists primarily of Honeywell reimbursement expenses for certain environmental claims related to approximately 230 sites or groups of sites that are undergoing environmental remediation under U.S. federal or state law and agency oversight for contamination associated with Honeywell legacy business operations. Prior to the Spin-Off other expenses also included the environmental expenses related to these same sites. For further information see “Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations - Honeywell Reimbursement Agreement” and “Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations - Environmental Matters”. Interest Expense Interest expense consists of interest on our short and long-term obligations, including our senior notes and term credit facility. Interest expense on our obligations includes contractual interest, amortization of the debt discount and amortization of debt issuance costs. RESIDEO TECHNOLOGIES, INC. Tax Expense Provision for income taxes includes both domestic and foreign income taxes at the applicable tax rates adjusted for non-deductible expenses, research and development tax credits and other permanent differences. Results of Operations The following table sets forth our selected consolidated statements of operations for the periods presented: Consolidated Statements of Operations Results of Operations for the Years Ended December 31, 2018, 2017 and 2016 Net Revenue The change in net revenue compared to prior year period is attributable to the following: A discussion of net revenue by segment can be found in the Review of Business Segments section of this Management’s Discussion and Analysis of Financial Condition and Results of Operations. RESIDEO TECHNOLOGIES, INC. Cost of Goods Sold 2018 compared with 2017 Cost of goods sold for 2018 was $3,461 million, an increase of $258 million, or 8%, from $3,203 million in 2017. This increase was primarily driven by $145 million in higher revenue in both the Global Distribution and Products and Solutions segments, $44 million of material and labor inflation, net of productivity and $43 million of foreign currency translation. The decrease in gross profit percentage was primarily driven by the impact of net direct material and labor inflation (approximately 20bps impact) partially offset by higher sales prices (approximately 100bps impact). 2017 compared with 2016 Cost of goods sold for 2017 was $3,203 million, an increase of $113 million, or 4%, from $3,090 million in 2016. This increase was primarily driven by $92 million in higher direct material costs in the Global Distribution Segment (driven by higher sales of $122 million) and approximately $25 million of investments in research and development, primarily in the connected homes product offerings. The decrease in gross profit percentage was primarily driven by the impact of unfavorable mix between products and distribution (approximately 130bps impact) and investments in research and development (approximately 50bps impact), partially offset by higher sales prices (approximately 20bps impact). Selling, General and Administrative Expense 2018 compared with 2017 Selling, general and administrative expense for 2018 was $873 million, essentially flat from $871 million in 2017, with the impact of foreign currency, higher corporate allocations, labor cost inflation and investment being offset by savings attributed to restructuring actions and lower selling costs. 2017 compared with 2016 Selling, general and administrative expense for 2017 was $871 million, essentially flat from $870 million in 2016, with the impact of higher corporate allocations, labor cost inflation and investment being offset by savings attributed to restructuring actions and lower selling costs. RESIDEO TECHNOLOGIES, INC. Other Expense, Net 2018 compared with 2017 Other expense, net for 2018, was $369 million, an increase of $90 million from $279 million in 2017. This increase mainly relates to the cost of certain environmental remedial actions agreed to with the regulators. Following the Spin-Off, these environmental expenses are now subject to the Honeywell Reimbursement Agreement where cash payments are capped at $140 million per year. 2017 compared with 2016 Other expense, net for 2017, was $279 million, an increase of $94 million from $185 million in 2016. This increase mainly relates to the cost of certain environmental remedial actions agreed to by the regulators. Tax Expense (Benefit) 2018 compared with 2017 The effective tax rate decreased in 2018 compared to 2017. The decrease was primarily due to tax benefits attributable to the internal restructuring of our business in advance of its anticipated spin-off, adjustments to the provisional tax amount related to U.S. Tax Reform, adjustments to income tax reserves, partially offset by tax expense related to Global Intangible Low Taxed Income (“GILTI”).Our non-U.S. effective tax rate was (95)%, a decrease compared to 2017. The year-over-year decrease in the non-U.S. effective tax rate was primarily driven by increased tax benefits attributable to internal restructuring of our business and a change in assertion to permanently reinvest unremitted earnings. On December 22, 2017, the U.S. enacted H.R.1, formerly known as the TCJA, that instituted fundamental changes to the taxation of multinational corporations. The TCJA includes changes to the taxation of foreign earnings by implementing a dividend exemption system, expansion of the current anti-deferral rules, a minimum tax on low-taxed foreign earnings and new measures to deter base erosion. The TCJA also imposes a one-time mandatory transition tax on the historical earnings of foreign affiliates and implements a territorial-style tax system. Changes to the TCJA provisional charges were the primary driver of the decrease in the effective tax rate in 2018. Non-deductible expenses had a material impact on the current effective tax rate and management estimates non-deductible expenses will have a material impact on the future effective tax rate. 2017 compared with 2016 The effective tax rate increased in 2017 compared to 2016. The increase was primarily attributable to the provisional impact of U.S. tax reform (see “the Tax Act” further discussed below) and an increase in non-deductible expenses. Our non-U.S. effective tax rate was 128.6%, an increase compared to 2016. The year-over-year increase in the non-U.S. effective tax rate was primarily driven by our change in assertion regarding foreign unremitted earnings in connection with the Tax Act. On December 22, 2017, the U.S. enacted H.R.1, formerly known as the TCJA, that instituted fundamental changes to the taxation of multinational corporations. The TCJA includes changes to the taxation of foreign earnings by implementing a dividend exemption system, expansion of the current anti-deferral rules, a minimum tax on low-taxed foreign earnings and new measures to deter base erosion. The TCJA also permanently reduces the corporate tax rate from 35% to 21%, imposes a one-time mandatory transition tax on the historical earnings of foreign affiliates and implements a territorial-style tax system. The primary changes, which are RESIDEO TECHNOLOGIES, INC. reflected in the 2017 tax expense, resulted from provisional charges of approximately $314 million due to our change in assertion regarding foreign unremitted earnings and $156 million due to the mandatory transition tax. These charges are subject to adjustment given the provisional nature of the charges. The TCJA provisional charges were the primary driver of the increase in the effective tax rate in 2017. Most of the $314 million provisional charge described above relates to non-U.S. withholding taxes that will be payable at the time of the actual cash distribution and is based on the legal entity structure that existed at December 31, 2017. Changes to the legal entity structure or changes in future management’s intent whether to permanently reinvest our foreign undistributed earnings could result in a significantly different tax liability. Review of Business Segments We operate two segments: Products and Solutions and Global Distribution. Management evaluates segment performance based on segment profit. Segment profit is measured as segment income (loss) before taxes excluding other expense, net (primarily environmental cost now subject to the Honeywell Reimbursement Agreement), interest expense, pension expense, environmental expense related to our owned sites and repositioning charges. Products and Solutions 2018 compared with 2017 Products and Solutions revenue increased by 6% primarily due to an increase in external sales volume and higher prices in the Comfort and RTS product lines, and the impact of favorable currency translation. Products and Solutions segment profit increased by 8%, moderated by the impact of higher corporate cost assessments of $18 million. Excluding this impact Products and Solutions segment profit increased 13% primarily due to volume growth, the impact of higher prices, and favorable currency translation, partially offset with inflation net of productivity and adverse product mix impact. 2017 compared with 2016 Products and Solutions revenue decreased by 3% primarily due to a decrease in external sales volume in the Comfort product line, partially offset by the impacts of higher prices. RESIDEO TECHNOLOGIES, INC. Products and Solutions segment profit decreased by 17% due to a decrease in sales volume, investment in research and development, higher corporate allocations and unfavorable product mix driven by lower sales in the Comfort product line, partially offset by productivity net of inflation and higher price. Global Distribution 2018 compared with 2017 Global Distribution sales increased by 7% primarily due to volume growth across all of our key geographic markets. Global Distribution segment profit increased by 13% primarily due to higher sales volumes, and productivity net of inflation. 2017 compared with 2016 Global Distribution sales increased by 5% primarily due to volume growth across all of our key geographic markets. Global Distribution segment profit increased by 26% primarily due to higher sales volumes, and productivity net of inflation, partially offset by higher corporate allocations. Capital Resources and Liquidity Our liquidity is primarily dependent on our ability to continue to generate positive cash flows from operations. Additional liquidity may also be provided through access to the financial capital markets and a committed global credit facility. The following is a summary of our liquidity position: • As of December 31, 2018, total cash and cash equivalents were $265 million, of which 62% were held by foreign subsidiaries. At December 31, 2018, there were no borrowings and $19 million of letters of credit issued under our $350 million Credit Facility. • Historically, we have delivered positive cash flows from operations. Operating cash flows from continuing operations were $462 million, $37 million and $151 million for the three years ended December 31, 2018, respectively. RESIDEO TECHNOLOGIES, INC. Liquidity prior to the Spin-Off Prior to the Spin-Off from Honeywell, we were dependent upon Honeywell for all of our working capital and financing requirements. Honeywell uses a centralized approach to cash management and financing of its operations. The majority of the Business’s cash was transferred to Honeywell daily and Honeywell funded our operating and investing activities as needed. This arrangement was not reflective of the manner in which we would have been able to finance our operations had it been a stand-alone business separate from Honeywell during all periods presented. Prior to the Spin-Off, cash and cash equivalents held by Honeywell at the corporate level are not specifically identifiable to us and therefore were not allocated for any of the periods presented. Honeywell third party debt and the related interest expense were not allocated for any of the periods presented as Honeywell’s borrowings were not directly attributable to us. Liquidity subsequent to the Spin-Off Our future capital requirements will depend on many factors, including the rate of sales growth, market acceptance of our products, the timing and extent of research and development projects, potential acquisitions of companies or technologies and the expansion of our sales and marketing activities. We believe our existing cash, cash equivalents, investments and credit under our Credit Facilities are sufficient to meet our capital requirements through at least the next 12 months, although we could be required, or could elect, to seek additional funding prior to that time. We may enter into acquisitions or strategic arrangements in the future which also could require us to seek additional equity or debt financing. Credit Agreement On October 25, 2018, we entered into a Credit Agreement, which provides for (i) a seven-year senior secured first-lien term B loan facility in an aggregate principal amount of $475 million (the “Term B Facility”); (ii) a five-year senior secured first-lien term A loan facility in an aggregate principal amount of $350 million (the “Term A Facility” and, together with the Term B Facility, the “Term Loan Facilities”); and (iii) a five-year senior secured first-lien revolving credit facility in an aggregate principal amount of $350 million (the “Revolving Credit Facility” and, together with the Term Loan Facilities, the “Senior Credit Facilities”). We incurred indebtedness under the Term Loan Facilities in an aggregate principal amount of approximately $825 million on October 25, 2018, and relied on the Revolving Credit Facility to support working capital needs during the quarter. As of December 31, 2018 there were no borrowings and $19 million of Letters of Credit outstanding under the Revolving Credit Facility. We are obligated to make quarterly principal payments throughout the term of the Term Loan Facilities according to the amortization provisions in the Credit Agreement and in addition to paying interest on outstanding borrowings under the Revolving Credit Facility, we are required to pay a quarterly commitment fee based on the unused portion of the Revolving Credit Facility. Borrowings under the Credit Agreement can be prepaid at our option without premium or penalty other than a 1.00% prepayment premium that may be payable in connection with certain repricing transactions within a certain period of time after the closing date. Up to $75 million may be utilized under the Revolving Credit Facility for the issuance of letters of credit to the Borrower or any of our subsidiaries. Letters of credit are available for issuance under the Credit Agreement on terms and conditions customary for financings of this kind, which issuances will reduce the available funds under the Revolving Credit Facility. The Senior Credit Facilities are subject to an interest rate and interest period which we will elect. If we choose to make a base rate borrowing on an overnight basis, the interest rate will be based on the highest of (1) the rate of interest last quoted by The Wall Street Journal as the “prime rate” in the United States, (2) the greater of the federal funds effective rate and the overnight bank funding rate, plus 0.5% and (3) the one month adjusted LIBOR rate, plus 1.00% per annum. If we choose to make a LIBOR borrowing on a one, two, three or six-month basis, the interest rate will be based on an adjusted LIBOR rate (which shall not be less than zero) based on the interest period for the borrowing. The applicable margin for the Term B Facility is currently 2.00% per annum (for LIBOR loans) and 1.00% per annum (for base rate loans). The applicable margin for each of the Term A Facility and the Revolving Credit Facility varies from 2.00% per annum to 1.50% per annum (for LIBOR loans) and 1.00% to 0.50% per annum (for base rate loans) based on our leverage ratio. Accordingly, the interest rates for the Senior Credit Facilities will fluctuate during the term of the Credit Agreement based on changes in the base rate, LIBOR or future changes in our leverage ratio. Interest payments with respect to the borrowings are required either on a quarterly basis (for base rate loans) or at the end of each interest period (for LIBOR loans) or, if the duration of the applicable interest period exceeds three months, then every three months. RESIDEO TECHNOLOGIES, INC. The Credit Agreement contains certain affirmative and negative covenants customary for financings of this type that, among other things, limit our and our subsidiaries’ ability to incur additional indebtedness or liens, to dispose of assets, to make certain fundamental changes, enter into restrictive agreements, to make certain investments, loans, advances, guarantees and acquisitions, to prepay certain indebtedness and to pay dividends, to make other distributions or redemptions/repurchases, in respect of our and our subsidiaries’ equity interests, to engage in transactions with affiliates or amend certain material documents. In addition, the Credit Agreement also contains financial covenants requiring the maintenance of a consolidated total leverage ratio of not greater than 4.00 to 1.00 (with step-downs to (i) 3.75 to 1.00 starting in the fiscal quarter ending December 31, 2019, (ii) 3.50 to 1.00 starting in the fiscal quarter ending December 31, 2020 and (iii) 3.25 to 1.00 starting in the fiscal quarter ending December 31, 2021), and a consolidated interest coverage ratio of not less than 2.75 to 1.00. The Credit Agreement contains customary events of default, including with respect to a failure to make payments under the Senior Credit Facilities, cross-default, certain bankruptcy and insolvency events and customary change of control events. All obligations under the Senior Credit Facilities are or will be unconditionally guaranteed jointly and severally, by: (a) our Company and (b) substantially all of the direct and indirect wholly owned subsidiaries of our Company that are organized under the laws of the United States, any state thereof or the District of Columbia (collectively, the “Guarantors”). The Guarantors entered into a guarantee under the Credit Agreement concurrently with the effectiveness of the Credit Agreement. Subject to certain limitations, the Senior Credit Facilities are or will be secured on a first priority basis by: (x) a perfected security interest in the equity interests of each direct subsidiary of the Borrower and each Guarantor under the Senior Credit Facilities (subject to certain customary exceptions) and (y) perfected, security interests in, and mortgages on, substantially all tangible and intangible personal property and material real property of the Borrower and each of the Guarantors under the Senior Credit Facilities, subject, in each case, to certain exceptions. The Borrower and the Guarantors entered into security documents concurrently with effectiveness of the Credit Agreement. We incurred approximately $16 million in debt issuance costs related to the Term Loans and $5 million in costs related to the Revolving Credit Facility. The debt issuance costs associated with the Term Loans were recorded as a reduction of the principal balance of the debt, and the Revolving Credit Facility costs were capitalized in Other assets. The issuance costs are being amortized through Interest expense for the duration of each respective debt facility. Senior Notes In October of 2018, we issued $400 million in principal amount 6.125% senior unsecured notes due in 2026 (the "Senior Notes"). The Senior Notes guarantees are unsecured senior debt obligations of the Senior Notes guarantors. The net proceeds from the borrowings under the Senior Credit Facilities and the offering of the Senior Notes were used as part of financing the Spin-Off. We incurred approximately $8 million in debt issuance costs related to the Senior Notes. The debt issuance costs associated with the Senior Notes are recorded as a reduction of the principal balance of the debt. The interest expense for the Senior Notes and Credit Agreement during the year ended December 31, 2018 was $13 million, which includes the amortization of debt issuance cost and debt discounts. Honeywell Reimbursement Agreement In connection with the Spin-Off, we entered into the Honeywell Reimbursement Agreement (as defined below), pursuant to which we have an obligation to make cash payments to Honeywell in amounts equal to 90% of payments, which include amounts billed (“payments”), with respect to certain environmental claims, remediation and, following the Spin-Off, hazardous exposure or toxic tort claims, in each case including consequential damages (the “liabilities”) in respect of specified properties contaminated through historical business operations, including the legal and other costs of defending and resolving such liabilities, less 90% of Honeywell’s net insurance receipts relating to such liabilities, and less 90% of the net proceeds received by Honeywell in connection with (i) affirmative claims relating to such liabilities, (ii) contributions by other parties relating to such liabilities and (iii) certain property sales (the “recoveries”). The amount payable by us in respect of such liabilities arising in any given year is subject to a cap of $140 million (exclusive of any late payment fees up to 5% per annum). Payments in respect of the liabilities arising in a given year will be made quarterly throughout such year on the basis of an estimate of the liabilities and recoveries provided by Honeywell. Following the end of any such year, Honeywell will provide us with a calculation of the amount of payments and the recoveries actually received. Subject to the RESIDEO TECHNOLOGIES, INC. aforementioned cap, if the amount of payments (net of recoveries) is greater than the previously provided estimate, we will pay Honeywell the amount of such difference (the “true-up payment”) and, if the amount of the previously provided estimate is greater than the amount of payments (net of recoveries), we will receive a credit in the amount of such difference that will be applied to future payments. If a true-up payment exceeds $30 million, such true-up payment will be made in equal installments, payable on a monthly basis following the date the true-up payment is due. Cash Flow Summary for the Years Ended December 31, 2018, 2017 and 2016 Our cash flows from operating, investing and financing activities for the years ended December 31, 2018, 2017 and 2016, as reflected in the audited Consolidated and Combined Financial Statements are summarized as follows: 2018 compared with 2017 Cash provided by operating activities for 2018 increased by $425 million, primarily due to higher payments for income taxes of approximately $233 million in 2017 due to expenses related to U.S. Tax Reform. Cash from operating activities also increased due to a decrease in net working capital driven primarily by an increase in accounts payable due to timing of payments under our TSA with Honeywell partially offset by an increase in inventory related to new product lines and increased sales. Cash used for investing activities increased by $23 million, primarily due to an increase in expenditures on property, plant and equipment and software related to becoming an independent company. Net cash used for financing activities increased by $188 million. The increase in usage was primarily due to a $1.4 billion distribution to Honeywell in connection with Spin-Off partially offset by $1.2 billion in proceeds received on long-term debt. 2017 compared with 2016 Cash provided by operating activities decreased by $114 million, primarily driven by payments to Honeywell in relation to the provisional impact of U.S. tax reform which was settled as part of our cash pooling arrangements and an increase in non-deductible expenses offset by favorable impacts from working capital of approximately $57 million, with reduced purchases of raw materials and finished goods inventory for Products and Solutions due to sales of inventory built in the prior period for new product launches, and higher receivables collections on increased sales volumes. Cash used for investing activities decreased by $140 million, primarily due to a decrease in cash paid in 2016 for the RSI acquisition of $120 million net of cash acquired of $4 million and a decrease of cash used for expenditures on property, plant and equipment of $11 million. Net cash provided by financing activities increased by $17 million. The increase in usage was primarily due to an increase in invested equity of $18 million. RESIDEO TECHNOLOGIES, INC. Contractual Obligations and Probable Liability Payments Following is a summary of our significant contractual obligations and probable liability payments at December 31, 2018: 1) The table excludes tax liability payments, including those for unrecognized tax benefits. See Note 9. Income Taxes. 2) Assumes all long-term debt is outstanding until scheduled maturity. 3) Interest payments are estimated based on the interest rate applicable as of December 31, 2018 4) On October 29, 2018, in connection with the Spin-Off, we entered into the Honeywell Reimbursement Agreement with Honeywell pursuant to which we have an obligation to make cash payments to Honeywell in amounts equal to 90% of payments, which include amounts billed (“payments”), less 90% of Honeywell’s net insurance receipts relating to such liabilities, and less 90% of the net proceeds received by Honeywell in connection with (i) affirmative claims relating to such liabilities, (ii) contributions by other parties relating to such liabilities and (iii) certain property sales (the “recoveries”). The amount payable by us in respect of such liabilities arising in respect of any given year will be subject to a cap of $140 million (exclusive of any late payment fees up to 5% per annum). 5) Represents estimated environmental liability payments for sites which we own and are directly responsible for. 6) Purchase obligations are entered into with various vendors in the normal course of business and are consistent with our expected requirements. Environmental Matters Expenses for environmental matters deemed probable and reasonably estimable were $340 million, $282 million and $190 million in 2018, 2017 and 2016, respectively. In addition, in 2018, 2017 and 2016 we incurred operating costs for ongoing businesses of approximately $17 million, $1 million, and $2 million, respectively, relating to compliance with environmental regulations. Spending related to environmental matters was $179 million, $198 million and $211 million in 2018, 2017 and 2016, respectively. We do not currently possess sufficient information to reasonably estimate the amounts of environmental liabilities to be recorded upon future completion of studies, litigation or settlements, and neither the timing nor the amount of the ultimate costs associated with environmental matters can be determined although they could be material to our consolidated and combined results of operations and operating cash flows in the periods recognized or paid. See Note 21. Commitments and Contingencies of Notes to Consolidated and Combined Financial Statements for further discussion of our environmental matters. Capital Expenditures We believe our capital spending in recent years has been sufficient to maintain efficient production capacity, to implement important product and process redesigns and to expand capacity to meet increased demand. Productivity projects have freed up capacity in our manufacturing facilities and are expected to continue to do so. We expect to continue investing to expand and modernize our existing facilities and to create capacity for new product development. Capital expenditures for full year 2019 are expected to be $135 million of which, $74 million relates to costs associated with investments in infrastructure as a stand alone company. RESIDEO TECHNOLOGIES, INC. Off-Balance Sheet Arrangements We do not engage in any off-balance sheet financial arrangements that have or are reasonably likely to have a material current or future effect on our financial condition, changes in financial condition, net revenue or expenses, results of operations, liquidity, capital expenditures or capital resources. Critical Accounting Policies The preparation of our Consolidated and Combined Financial Statements in accordance with generally accepted accounting principles is based on the selection and application of accounting policies that require us to make significant estimates and assumptions about the effects of matters that are inherently uncertain. We consider the accounting policies discussed below to be critical to the understanding of our Consolidated and Combined Financial Statements. Actual results could differ from our estimates and assumptions, and any such differences could be material to our Consolidated and Combined Financial Statements. Revenue - Product and service revenues are recognized when or as the Company transfers control of the promised products or services to the customer, in an amount the Company expects to receive in exchange for transferring goods or providing services. Each distinct performance obligation within a contract is identified, and a contract’s transaction price is then allocated to each distinct performance obligation and recognized as revenue when, or as, the performance obligation is satisfied. In the sale of products, the terms of a contract or the historical business practice can give rise to variable consideration due to, but not limited to, discounts, bonuses, and the right of return. The Company estimates variable consideration at the most likely amount that will be received from customers and reduce revenues recognized accordingly. The Company includes estimated amounts in the transaction price to the extent it is probable that a significant reversal of cumulative revenue recognized will not occur when the uncertainty associated with the variable consideration is resolved. The estimates of variable consideration and determination of whether to include estimated amounts in the transaction price are based largely on an assessment of our anticipated performance and all information (historical, current and forecasted) that is reasonably available to the Company. Environmental - We accrue costs related to environmental matters for our owned sites for which we are directly responsible when it is probable that we have incurred a liability related to a contaminated site and the amount can be reasonably estimated. Environmental-related expenses are presented within Cost of goods sold for operating sites in the Consolidated and Combined Statements of Operations. For additional information, see Note 21. Commitments and Contingencies of Notes to Consolidated and Combined Financial Statements included herein for additional detail. Honeywell Reimbursement Agreement - In connection with the Spin-Off, we entered into the Honeywell Reimbursement Agreement with Honeywell on October 14, 2018, pursuant to which we have an obligation to make cash payments to Honeywell in amounts equal to 90% of payments, which include amounts billed, with respect to certain environmental claims, remediation and, to the extent arising after the Spin-Off, hazardous exposure or toxic tort claims, in each case, including consequential damages (the “liabilities”) in respect of specified properties contaminated through historical business operations, including the legal and other costs of defending and resolving such liabilities, less 90% of Honeywell’s net insurance receipts relating to such liabilities, and less 90% of the net proceeds received by Honeywell in connection with (i) affirmative claims relating to such liabilities, (ii) contributions by other parties relating to such liabilities and (iii) certain property sales. The amount payable by us in respect of such liabilities arising in any given year is subject to a cap of $140 million (exclusive of any late payment fees up to 5% per annum). Through the Honeywell Reimbursement Agreement we are subject to a number of environmental claims, remediation and, to the extent arising after the Spin-Off, hazardous exposure or toxic tort claims. We continually assess the likelihood of any adverse judgments or outcomes related to the Honeywell Reimbursement Agreement, as well as potential amounts or ranges of probable losses, and recognize a liability, if any, for these contingencies based on a thorough analysis of each matter with the assistance of outside legal counsel and Honeywell, and, if applicable, other experts. Such analysis includes making judgments concerning matters such as the costs associated with environmental matters, the outcome of negotiations, the number and cost of pending and future claims related to the sites covered by the Honeywell Reimbursement Agreement, and the impact of evidentiary requirements. Because most contingencies are resolved over long periods of time, we do not currently possess sufficient information to reasonably estimate the amounts of the Honeywell Reimbursement Agreement liabilities to be recorded upon future RESIDEO TECHNOLOGIES, INC. completion of studies, litigations or settlements, and neither the timing nor the amount of the ultimate costs associated with environmental matters, can be determined. Expenses related to the indemnification are presented within Other expense, net in the Consolidated and Combined Statement of Operations. See Note 21. Commitments and Contingencies for a discussion of management’s judgment applied in the recognition and measurement of our environmental liabilities. Goodwill - Goodwill has an indefinite life and is not amortized, but is subject to annual, or more frequent if necessary, impairment testing. In testing goodwill, the fair value of each reporting unit is estimated utilizing a discounted cash flow approach utilizing cash flow forecasts in our five year strategic and annual operating plans adjusted for terminal value assumptions. These impairment tests involve the use of accounting estimates and assumptions, changes in which could materially impact our financial condition or operating performance if actual results differ from such estimates and assumptions. To address this uncertainty we perform sensitivity analysis on key estimates and assumptions. Income Taxes - Our provision for income tax expense is based on our income, the statutory tax rates and other provisions of the tax laws applicable to us in each of these various jurisdictions. These laws are complex, and their application to our facts is at times open to interpretation. The process of determining our consolidated and combined income tax expense includes significant judgments and estimates, including judgments regarding the interpretation of those laws. Our provision for income taxes and our deferred tax assets and liabilities incorporate those judgments and estimates, and reflect management’s best estimate of current and future income taxes to be paid. Deferred tax assets and liabilities relate to temporary differences between the financial reporting and income tax bases of our assets and liabilities, as well as the impact of tax loss carryforwards or carrybacks. Deferred income tax expense or benefit represents the expected increase or decrease to future tax payments as these temporary differences reverse over time. Deferred tax assets are specific to the jurisdiction in which they arise, and are recognized subject to management’s judgment that realization of those assets is “more likely than not.” In making decisions regarding our ability to realize tax assets, we evaluate all positive and negative evidence, including projected future taxable income, taxable income in carryback periods, expected reversal of deferred tax liabilities, and the implementation of available tax planning strategies. Significant judgment is required in evaluating tax positions. We establish additional reserves for income taxes when, despite the belief that tax positions are fully supportable, there remain certain positions that do not meet the minimum recognition threshold. The approach for evaluating certain and uncertain tax positions is defined by the authoritative guidance which determines when a tax position is more likely than not to be sustained upon examination by the applicable taxing authority. In the normal course of business, we are examined by various federal, state and foreign tax authorities. We regularly assess the potential outcomes of these examinations and any future examinations for the current or prior years in determining the adequacy of our provision for income taxes. We continually assess the likelihood and amount of potential adjustments and adjust the income tax provision, the current tax liability and deferred taxes in the period in which the facts that give rise to a change in estimate become known. For period prior to the Spin-Off, the tax provision is presented on a separate company basis as if we were a separate filer. The effects of tax adjustments and settlements from taxing authorities are presented in our Consolidated and Combined Financial Statements in the period to which they relate as if we were a separate filer. Prior to the Spin-Off, our current obligations for taxes were settled with Honeywell on an estimated basis. All income taxes that were due to or due from Honeywell that were not settled or recovered by the end of the period were reflected in invested equity within the Consolidated and Combined Financial Statements. We are subject to income tax in the United States (federal, state and local) as well as other jurisdictions in which we operate. Pension Benefits - We have a defined benefit plan covering certain employees. The benefits are accrued over the employees’ service periods. We use actuarial methods and assumptions in the valuation of defined benefit obligations and the determination of net periodic pension income or expense. Differences between actual and expected results or changes in the value of defined benefit obligations and plan assets, if any, are not recognized in earnings as they occur but rather systematically over subsequent periods when net actuarial gains or losses are in excess of 10% of the greater of the fair value of plan assets or the plan’s projected benefit obligation. A 25 basis point increase in the discount rate would result in a decrease of approximately $0.4 million to the net periodic benefit cost for 2018, while a 25 basis point decrease in the discount rate would result in an increase RESIDEO TECHNOLOGIES, INC. of approximately $0.3 million. The resulting impact on the pension benefit obligation would be a decrease of $1.3 million and an increase of $1.4 million, respectively. Other Matters Litigation and Environmental Matters See Note 21. Commitments and Contingencies of Notes to Consolidated and Combined Financial Statements for a discussion of environmental and other litigation matters. Recent Accounting Pronouncements See Note 2. Summary of Significant Accounting Policies of Notes to Consolidated and Combined Financial Statements for a discussion of recent accounting pronouncements.

<s>[INST] The following Management’s Discussion and Analysis of Financial Condition and Results of Operations is intended to help you understand the results of operations and financial condition of Resideo Technologies, Inc. and its consolidated subsidiaries (“Resideo” or “the Company”, “we”, “us” or “our”) for the three years ended December 31, 2018 and should be read in conjunction with the Consolidated and Combined Financial Statements and the notes thereto contained elsewhere in this Form 10K. Overview and Business Trends We are a leading global provider of critical comfort, residential and thermal solutions and security solutions primarily in residential environments. Our products consist of solutions in Comfort, Residential Thermal Solutions and Security categories and include temperature and humidity control, thermal, water and air solutions and remote patient monitoring software solutions as well as security panels, sensors, peripherals, wire and cable, communications devices, video cameras, awareness solutions, cloud infrastructure, installation and maintenance tools and related software. Our ADI Global Distribution business is the leading wholesale distributor of security and low voltage electronic products which include video surveillance, intrusion, access control, fire and life safety, wire, networking and professional audio visual systems. We manage our business operations through two segments, Products and Solutions and Global Distribution. The Products and Solutions segment offerings include our Comfort, Residential Thermal Solutions and Security products, which, consistent with our industry, has a higher gross and operating margin profile in comparison to the Global Distribution segment. Our financial performance over the last three years has been supported by several macro trends. Steady growth in residential and nonresidential construction and growth in renovation and remodeling in the United States has had a positive impact on the growth of our Products and Solutions and Global Distribution businesses. The financial performance of our Products and Solutions business has further benefited from increasing penetration of wireless connectivity and the proliferation of connected devices. The financial performance of our Global Distribution business has been further aided by increasing contractor needs for training and technical expertise, and increasing demand for same day order fulfilment. Recent Developments Separation from Honeywell The Company was incorporated in Delaware on April 24, 2018. We separated from Honeywell International Inc. (“Honeywell”) on October 29, 2018 (the “Distribution Date”), becoming an independent publicly traded company as a result of a pro rata distribution of our common stock to shareholders of Honeywell (the “SpinOff”). On October 29, 2018, Honeywell’s shareholders of record as of October 16, 2018 (the “Record Date”) received one share of our common stock, par value $0.001 per share, for every six shares of Honeywell’s common stock, par value $1.00 per share, held as of the Record Date. We began trading “regular way” under the ticker symbol “REZI” on the New York Stock Exchange on October 29, 2018. In connection with the SpinOff, we entered into certain agreements with Honeywell, such as the Honeywell Reimbursement Agreement, the Trademark License Agreement, Tax Matters Agreement, Employee Matters Agreement, Patent CrossLicense Agreement and Transition Services Agreement, which will cause us to incur new costs. See Note 21. Commitments and Contingencies of Notes to Consolidated and Combined Financial Statements for a description of the material terms thereof. Basis of Presentation Our Consolidated Balance Sheet as of December 31, 2018 consists of the consolidated balances of Resideo as prepared on a standalone basis. Our Combined Balance Sheet as of December 31, 2017, and Consolidated and Combined Statements of Operations, Comprehensive Income (Loss), Equity, and Cash Flows for the years ended December 31, 2018, 2017 and 2016, have been prepared on a “carveout” basis for the periods and dates prior to the SpinOff and include standalone results for the period subsequent to the date of SpinOff. Prior [/INST] Positive. </s>

RESIDEO TECHNOLOGIES, INC.

2020-02-27

2019-12-31

Item 7.Management’s Discussion and Analysis of Financial Condition and Results of Operations (Dollars in millions, except per share amounts) The following Management’s Discussion and Analysis of Financial Condition and Results of Operations is intended to help you understand the results of operations and financial condition of Resideo Technologies, Inc. and its consolidated subsidiaries (“Resideo” or “the Company”, “we”, “us” or “our”) for the three years ended December 31, 2019 and should be read in conjunction with the Consolidated and Combined Financial Statements and the notes thereto contained elsewhere in this Form 10-K. Overview and Business Trends We are a leading global provider of products, software solutions and technologies that help homeowners stay connected and in control of their comfort, security and energy use. We manage our business operations through two segments, Products & Solutions and ADI Global Distribution. Our Products & Solutions segment consists of solutions in Comfort, Residential Thermal Solutions (“RTS”) and Security categories and includes temperature and humidity control, thermal, water and air solutions as well as security panels, sensors, peripherals, wire and cable, communications devices, video cameras, awareness solutions, cloud infrastructure, installation and maintenance tools and related software. Our ADI Global Distribution business is the leading wholesale distributor of low-voltage electronic and security products which include intrusion and smart home, fire, video surveillance, access control, power, audio and video, Pro AV, networking, communications, wire and cable, enterprise connectivity and structured wiring. Our Chief Operating Decision Maker evaluates segment performance based on Segment Adjusted EBITDA. Segment Adjusted EBITDA is defined as segment net income before income taxes, net interest expense (income), depreciation and amortization plus or minus environmental expense, Honeywell Reimbursement Agreement expense, stock compensation expense, restructuring charges, other expense, net and other costs not directly relating to future ongoing business of the segments, such as Spin-Off related costs and consulting fees related to restructuring programs. We evaluate our results of operations on both an as reported and constant currency basis. The constant currency presentation, which is a non-GAAP financial measure, excludes the impact of fluctuations in foreign currency exchange rates. We believe providing constant currency information provides valuable supplemental information regarding our results of operations, thereby facilitating period-over-period comparisons of the Company’s business performance and is consistent with how management evaluates the Company’s performance. We calculate constant currency percentages by converting both our prior period local currency financial results and current period local currency financial results at a fixed exchange rate and comparing these adjusted amounts. These metrics should be considered in addition to, and not as replacements for, the most comparable measure in accordance with accounting principles generally accepted in the United States of America (“U.S. GAAP”). They should be read in connection with our financial statements presented in accordance with U.S. GAAP. Our financial performance is influenced by several macro factors such as repair and remodeling activity, residential and non-residential construction, employment rates, and overall macro environment. During 2019, the Products & Solutions segment experienced flat revenue compared to 2018, with mixed results in the lines of businesses. Security maintained strong growth throughout the year, while Comfort and RTS results decelerated in the second half of the year. Segment adjusted EBITDA was impacted by negative product and channel mix, inventory write-downs, and high product rebates from a contract entered into prior to Spin-Off. The RTS business experienced a slowdown across large original equipment manufacturers (“OEMs”) customers, which included impacts due to recent regulatory changes. The Comfort business revenue declines were primarily due to lower thermostat sales. Our ADI Global Distribution business has been further aided by increasing contractor needs for training and technical expertise and increasing demand for same-day ordering. Throughout 2019, the ADI Global Distribution business continued its strong performance, achieving constant currency growth across all regions and expansion in top product lines. ADI Global Distribution accelerated the adoption of digital tools, which is reflected in strong e-commerce growth. ADI Global Distribution continued to expand its footprint, including recent opening and remodeling of branches in Eastern Europe. RESIDEO TECHNOLOGIES, INC. Current Period Highlights Net revenues increased $161 million in 2019 compared to 2018, primarily due to increased volume and price partially offset by foreign exchange translation. Gross profit as a percent of net revenues decreased to 24%, or $176 million, compared to 28% in 2018. The primary drivers to the decrease in gross profit percentage were a 200 bps impact from sales mix changes, 100 bps impact from material and labor inflation and fixed production costs which include inventory write-downs, and 100 bps impact from headquarter allocations previously classified in selling, general and administrative expense in the period prior to the Spin-Off. Net income for 2019 was $36 million compared to $405 million for 2018, which included an income tax benefit of $301 million. Selling, general and administrative expenses increased by $59 million in 2019 compared to 2018. The increase was driven by Spin-Off related costs, license fees associated with the Trademark License Agreement, restructuring costs, labor cost inflation, legal expenses and impact of acquisitions totaling $146 million. These increases were partially offset by the impact of headquarter cost allocations previously classified in selling, general and administrative expense in the period prior to the Spin-Off, foreign currency translation, and miscellaneous cost reductions totaling $87 million. We ended 2019 with $122 million in cash and cash equivalents. Net cash provided by operating activities was $23 million for the year. At December 31, 2019, accounts receivable were $817 million and inventories were $671 million. Recent Developments Operational and Financial Review On October 22, 2019, we announced the commencement of a comprehensive operational and financial review focused on product cost and gross margin improvement, and general and administrative expenses simplification. The review is being overseen by the Strategic and Operational Committee of the board, comprised of independent directors. We have retained industry-recognized experts in supply chain optimization and organizational excellence to assist in the review. Basis of Presentation Prior to becoming an independent publicly traded company (the “Spin-Off”) on October 29, 2018, our historical financial statements were prepared on a stand-alone combined basis and were derived from the consolidated financial statements and accounting records of Honeywell. Accordingly, for periods prior to October 29, 2018, our financial statements are presented on a combined basis and for the periods subsequent to October 29, 2018 are presented on a consolidated basis (collectively, the historical financial statements for all periods presented are referred to as “Consolidated and Combined Financial Statements”). The Consolidated and Combined Financial Statements have been prepared in accordance with U.S. GAAP. The historical combined financial information prior to the Spin-Off may not be indicative of our future performance and does not necessarily reflect what our consolidated and combined results of operations, financial condition and cash flows would have been had we operated as a separate, publicly traded company during the periods presented, particularly because of changes that we have experienced and may continue to experience as a result of our separation from Honeywell, including changes in the financing, cash management, operations, cost structure and personnel needs of our Company. The Combined Financial Statements prior to the Spin-Off include certain assets and liabilities that were held at the Honeywell corporate level but were specifically identifiable or otherwise attributable to us. Additionally, Honeywell historically provided certain services, such as legal, accounting, information technology, human resources and other infrastructure support, on our behalf. The costs of these services were allocated to us on the basis of the proportion of net revenue. Actual costs that would have been incurred if we had been a stand-alone company for the entire period being presented would depend on multiple factors, including organizational structure and strategic decisions made in various areas, including information technology and infrastructure. Both we and Honeywell consider the basis on which the expenses were allocated during the period before the Spin-Off to be a reasonable reflection of the utilization of services provided to or the benefits received by us during the periods presented. RESIDEO TECHNOLOGIES, INC. Since the completion of the Spin-Off, we have incurred and expect to continue to incur expenditures consisting of employee-related costs, costs to start up certain stand-alone functions and information technology systems and other one-time transaction related costs. Recurring stand-alone costs include establishing the internal audit, treasury, investor relations, tax and corporate secretary functions as well as the annual expenses associated with running an independent publicly traded company including listing fees, compensation of non-employee directors, related board of director fees and other fees and expenses related to insurance, legal and external audit. Prior to Spin-Off, our environmental expenses for specified Honeywell properties contaminated through historical business operations (“Honeywell Sites”) now subject to the Honeywell Reimbursement Agreement were reported within other expense, net in our Consolidated and Combined Statement of Operations, which reflect an estimated liability for resolution of pending and future environmental-related liabilities. Prior to the Spin-Off, this estimated liability was calculated as if we were responsible for 100% of the environmental-liability payments associated with certain sites. See Environmental Matters and Honeywell Reimbursement Agreement in Note 19. Commitments and Contingencies of Notes to Consolidated and Combined Financial Statements for additional information. Components of Operating Results Our fiscal year ends on December 31. The key elements of our operating results include: Net Revenue We manage our global business operations through two reportable segments, Products & Solutions and ADI Global Distribution: Products & Solutions. We generate the majority of our Products & Solutions net revenue primarily from residential end-markets. Our Products & Solutions segment includes traditional products, as well as connected products, which we define as any device with the capability to be monitored or controlled from a remote location by an end-user or service provider. Our products are sold through a network of distributors (e.g. HVAC, Plumbing, Security, Electrical), OEMs, and service providers such as HVAC contractors, security dealers and plumbers including our ADI Global Distribution business. We also sell some products via retail and online channels. ADI Global Distribution. We generate revenue through the distribution of low-voltage electronic and security products that are delivered through a comprehensive network of professional contractors, distributors and OEMs, as well as major retailers and online merchants. In addition to our own Security products, ADI Global Distribution distributes products from industry-leading manufacturers, and ADI Global Distribution also carries a line of private label products. We sell these products to contractors that service non-residential and residential end-users. 13% of ADI Global Distribution’s net revenue is supplied by our Products & Solutions Segment. Management estimates that in 2019 approximately two-thirds of ADI Global Distribution’s net revenue was attributed to non-residential end markets and one-third to residential end markets. Cost of Goods Sold Products & Solutions: Cost of goods sold includes costs associated with raw materials, assembly, shipping and handling of those products; costs of personnel-related expenses, including pension benefits, and equipment associated with manufacturing support, logistics and quality assurance; costs of certain intangible assets; and costs of research and development. Research and development expense consists primarily of support to existing customers with installed base and enhancements and improvements to existing products, as well as development of new products and product applications. ADI Global Distribution: Cost of goods sold consists primarily of inventory-related costs and includes labor and personnel-related expenses. RESIDEO TECHNOLOGIES, INC. Selling, General and Administrative Expense Selling, general and administrative expense includes trademark royalty expenses, sales incentives and commissions, professional fees, legal fees, promotional and advertising expenses, and personnel-related expenses, including stock compensation expense and pension benefits. In addition, prior to the Spin-Off, our selling, general and administrative expense included an allocated portion of general corporate expenses. Other Expense, Net Other expense, net consists primarily of Honeywell Reimbursement Agreement expenses (partially offset by certain reductions) for certain environmental claims related to approximately 230 sites or groups of sites that are undergoing environmental remediation under U.S. federal or state law and agency oversight for contamination associated with Honeywell historical business operations. Prior to the Spin-Off, other expense, net also included the environmental expenses related to these same sites. For further information see the “Honeywell Reimbursement Agreement” and “Environmental Matters” sections of this Management’s Discussion and Analysis of Financial Condition and Results of Operations. Interest Expense Interest expense consists of interest on our short and long-term obligations, including our senior notes, term credit facility, and revolving credit facility. Interest expense on our obligations includes contractual interest, amortization of the debt discount and amortization of deferred financing costs. Tax Expense Provision for income taxes includes both domestic and foreign income taxes at the applicable tax rates adjusted for U.S. taxation of foreign earnings and other non-deductible expenses, research and development tax credits and other permanent differences. RESIDEO TECHNOLOGIES, INC. Results of Operations for the Years Ended December 31, 2019, 2018 and 2017 The following table sets forth our selected consolidated and combined statement of operations for the periods presented: Consolidated and Combined Statement of Operations (Dollars in millions except share and per share data) Net Revenue The change in net revenue compared to prior period is attributable to the following: A discussion of net revenue by segment can be found in the Review of Business Segments section of this Management’s Discussion and Analysis of Financial Condition and Results of Operations. Cost of Goods Sold RESIDEO TECHNOLOGIES, INC. 2019 compared with 2018 Cost of goods sold for 2019 was $3,798 million, an increase of $337 million, or 10%, from $3,461 million in 2018. This $337 million increase in cost of goods sold was primarily driven by higher revenue in the ADI Global Distribution segment, material and labor inflation and increased production costs including inventory write-downs, changes in sales mix, headquarter allocations previously classified in selling, general and administrative expense in the period prior to the Spin-Off, restructuring costs and Spin-Off related costs totaling $416 million. The increased costs were partially offset by foreign currency translation and savings in other miscellaneous costs of goods sold totaling $79 million. The primary drivers to the decrease in gross profit percentage were a 200 basis points (“bps”) impact from changes in sales mix, 100 bps impact from material and labor inflation and fixed production costs, and 100 bps impact from headquarter allocations previously classified in selling, general and administrative expense in the period prior to the Spin-Off. 2018 compared with 2017 Cost of goods sold for 2018 was $3,461 million, an increase of $258 million, or 8%, from $3,203 million in 2017. This increase in cost of goods sold was primarily driven by higher revenue in both the ADI Global Distribution and Products & Solutions segments, foreign currency translation, material and labor inflation, and changes in sales mix totaling $258 million. The decrease in gross profit percentage was primarily driven by a 200 bps impact of net direct material and labor inflation partially offset by 100 bps impact from higher sales prices. Selling, General and Administrative Expense 2019 compared with 2018 Selling, general and administrative expense for 2019 was $932 million, an increase of $59 million, from $873 million in 2018. The increase was driven by Spin-Off related costs, license fees associated with the Trademark License Agreement, restructuring costs, labor cost inflation, legal expenses, and impact of acquisitions totaling $146 million. These increases were partially offset by headquarter cost allocation now partially classified in cost of goods sold, foreign currency translation, and miscellaneous cost reductions totaling $87 million. 2018 compared with 2017 Selling, general and administrative expense for 2018 was $873 million, essentially flat from $871 million in 2017. The increase was driven by the impact of foreign currency translation totaling $10 million and offset by savings attributed to restructuring actions taken and lower selling costs of $8 million. Other Expense, Net RESIDEO TECHNOLOGIES, INC. 2019 compared with 2018 Other expense, net for 2019 was $118 million, a decrease of $251 million from $369 million in 2018. The decrease is mainly due to lower environmental remediation expense, now subject and presented as Honeywell Reimbursement Agreement expense subsequent to the Spin-Off. 2018 compared with 2017 Other expense, net for 2018 was $369 million, an increase of $90 million from $279 million in 2017. This increase mainly relates to the cost of certain environmental remediation expense. Tax Expense (Benefit) 2019 compared with 2018 The effective tax rate increased in 2019 compared to 2018. The increase in effective tax rate was primarily attributable to tax benefits generated in 2018 related to the internal restructuring of Resideo’s business in advance of its anticipated Spin-Off, currency impacts on withholding taxes on undistributed foreign earnings, and adjustments to the provisional tax amount related to U.S. Tax Reform, partially offset by decreases in tax expense related to Global Intangible Low Taxed Income (“GILTI”) and non-deductible expenses. Non-deductible expenses had a material impact which increased the current effective tax rate by 31.5% and management estimates non-deductible expenses will have a material impact on the future effective tax rate. 2018 compared with 2017 The effective tax rate decreased in 2018 compared to 2017. The decrease was primarily due to tax benefits attributable to the internal restructuring of our business in advance of its anticipated Spin-Off, adjustments to the provisional tax amount related to U.S. Tax Reform, adjustments to income tax reserves, partially offset by tax expense related to GILTI. On December 22, 2017, the U.S. enacted H.R.1, formerly known as the Tax Cuts and Jobs Act (“TCJA”), that instituted fundamental changes to the taxation of multinational corporations. The TCJA includes changes to the taxation of foreign earnings by implementing a dividend exemption system, expansion of the current anti-deferral rules, a minimum tax on low-taxed foreign earnings and new measures to deter base erosion. The TCJA also imposed a one-time mandatory transition tax on the historical earnings of foreign affiliates and implemented a territorial-style tax system. Changes to the TCJA provisional charges recorded upon enactment were the primary driver of the decrease in the effective tax rate in 2018. Non-deductible expenses had a material impact on the current effective tax rate and management estimates non-deductible expenses will have a material impact on the future effective tax rate. Review of Business Segments Products & Solutions RESIDEO TECHNOLOGIES, INC. 2019 compared with 2018 Products & Solutions revenue remained flat driven primarily by the Security business and the first quarter launch of a new residential intrusion security platform, offset by softness in Comfort and RTS product lines. Segment Adjusted EBITDA declined from $460 million to $314 million, or 32%. Segment Adjusted EBITDA was negatively impacted by $181 million from unfavorable product and channel mix, inventory variances, production cost increases including inventory write-downs, high product rebates from a contract entered into prior to the Spin-Off, license fee paid to Honeywell associated with the Trademark License Agreement, and impact of acquisitions. These negative impacts were partially offset by $35 million of profit from increased selling prices, material productivity, and miscellaneous cost reductions. 2018 compared with 2017 Products & Solutions revenue increased by 6% primarily due to an increase in external sales volume and higher prices in the Comfort and RTS product lines, and the impact of favorable currency translation. Segment Adjusted EBITDA increased from $409 million to $460 million, or 12%. Segment Adjusted EBITDA was positively impacted $72 million by volume growth, higher prices, and favorable currency translation. These positive impacts were partially offset by $21 million of inflation net of productivity and adverse product mix. ADI Global Distribution RESIDEO TECHNOLOGIES, INC. 2019 compared with 2018 ADI Global Distribution revenue increased 6% on a reported basis, and 7% on a constant currency basis. ADI Global Distribution segment constant currency performance was driven by increased sales volume growth across all regions. Segment Adjusted EBITDA increased from $164 million to $188 million, or 15%. This increase was due to increased volume and productivity, net of inflation which was partially offset by unfavorable foreign exchange rates. 2018 compared with 2017 ADI Global Distribution revenue increased by 7% primarily due to volume growth across all of our key geographic markets. Segment Adjusted EBITDA increased from $143 million to $164 million, or by 15%. This increase was due to increased volume, and productivity, net of inflation. Restructuring Charges During the second quarter of 2019, management began a restructuring plan to reduce operating costs and better align our workforce with the needs of the business going forward. These restructuring actions generated incremental pre-tax savings of $15 million in 2019 compared with 2018 principally from planned workforce reductions. Cash spending related to our restructuring actions was $31 million for the year ended December 31, 2019 and was funded through operating cash flows. Net restructuring and related expenses were $37 million, $5 million and $23 million for December 31, 2019, 2018 and 2017, respectively, primarily related to severance. For further discussion of restructuring activities, refer to Note 7. Restructuring Charges of Notes to Consolidated and Combined Financial Statements. Capital Resources and Liquidity Our liquidity is primarily dependent on our ability to continue to generate positive cash flows from operations. Additional liquidity may also be provided through access to the financial capital markets and a committed global credit facility. The following is a summary of our liquidity position: • As of December 31, 2019, total cash and cash equivalents were $122 million, of which 74% were held by foreign subsidiaries. At December 31, 2019, there were no borrowings and no letters of credit issued under our $350 million Credit Facility. • Historically, we have delivered positive cash flows from operations. Operating cash flows from continuing operations were $23 million, $462 million and $37 million for the three years ended December 31, 2019, 2018 and 2017, respectively. Liquidity Our future capital requirements will depend on many factors, including the rate of sales growth, market acceptance of our products, the timing and extent of research and development projects, potential acquisitions of companies or technologies and the expansion of our sales and marketing activities. We believe our existing cash, cash equivalents and credit under our credit facilities are sufficient to meet our capital requirements through at least the next 12 months, although we could be required, or could elect, to seek additional funding prior to that time. We may enter into acquisitions or strategic arrangements in the future which also could require us to seek additional equity or debt financing. Credit Agreement On October 25, 2018, we entered into a credit agreement (the “Credit Agreement”), which provides for (i) a seven-year senior secured first-lien term B loan facility in an aggregate principal amount of $475 million (the “Term B Facility”); (ii) a five-year senior secured first-lien term A loan facility in an aggregate principal amount of $350 million (the “Term A Facility” and, together with the Term B Facility, the “Term Loans or “Term Loan Facilities”); and (iii) a five-year senior secured first-lien revolving credit facility in an aggregate principal amount of $350 million (the “Revolving Credit Facility” and, together with the Term Loan Facilities, the “Senior Credit Facilities”). RESIDEO TECHNOLOGIES, INC. We incurred indebtedness under the Term Loan Facilities in an aggregate principal amount of approximately $825 million on October 25, 2018, and relied on the Revolving Credit Facility to support working capital needs during the remainder of 2018. As of December 31, 2019, there were no borrowings and no Letters of Credit outstanding under the Revolving Credit Facility. We are obligated to make quarterly principal payments throughout the term of the Term Loan Facilities according to the amortization provisions in the Credit Agreement. During 2019 we made payments of $22 million. In addition to paying interest on outstanding borrowings under the Revolving Credit Facility, we are required to pay a quarterly commitment fee based on the unused portion of the Revolving Credit Facility. Borrowings under the Credit Agreement can be prepaid at our option without premium or penalty other than a 1.00% prepayment premium that may be payable in connection with certain repricing transactions within a certain period of time after the closing date. Up to $75 million may be utilized under the Revolving Credit Facility for the issuance of letters of credit to the Company or any of our subsidiaries. Letters of credit are available for issuance under the Credit Agreement on terms and conditions customary for financings of this kind, which issuances will reduce the available funds under the Revolving Credit Facility. The Senior Credit Facilities are subject to an interest rate and interest period which we will elect. If we choose to make a base rate borrowing on an overnight basis, the interest rate will be based on the highest of (1) the rate of interest last quoted by The Wall Street Journal as the “prime rate” in the United States, (2) the greater of the federal funds effective rate and the overnight bank funding rate, plus 0.5% and (3) the one month adjusted LIBOR rate, plus 1.00% per annum. If we choose to make a LIBOR borrowing on a one, two, three or six-month basis, the interest rate will be based on an adjusted LIBOR rate (which shall not be less than zero) based on the interest period for the borrowing. The applicable margin for the Term B Facility is currently 2.25% per annum (for LIBOR loans) and 1.25% per annum (for base rate loans). The applicable margin for each of the Term A Facility and the Revolving Credit Facility varies from 2.25% per annum to 1.75% per annum (for LIBOR loans) and 1.25% to 0.75% per annum (for base rate loans) based on our leverage ratio. Accordingly, the interest rates for the Senior Credit Facilities will fluctuate during the term of the Credit Agreement based on changes in the base rate, LIBOR or future changes in our leverage ratio. Interest payments with respect to the borrowings are required either on a quarterly basis (for base rate loans) or at the end of each interest period (for LIBOR loans) or, if the duration of the applicable interest period exceeds three months, then every three months. The Credit Agreement contains certain affirmative and negative covenants customary for financings of this type that, among other things, limit our and our subsidiaries’ ability to incur additional indebtedness or liens, to dispose of assets, to make certain fundamental changes, enter into restrictive agreements, to make certain investments, loans, advances, guarantees and acquisitions, to prepay certain indebtedness and to pay dividends, to make other distributions or redemptions/repurchases, in respect of our and our subsidiaries’ equity interests, to engage in transactions with affiliates or amend certain material documents. In addition, the Credit Agreement also contains financial maintenance and coverage covenants. The Credit Agreement contains customary events of default, including with respect to a failure to make payments under the Senior Credit Facilities, cross-default, certain bankruptcy and insolvency events and customary change of control events. All obligations under the Senior Credit Facilities are or will be unconditionally guaranteed jointly and severally, by: (a) our Company and (b) substantially all of the direct and indirect wholly owned subsidiaries of our Company that are organized under the laws of the United States, any state thereof or the District of Columbia (collectively, the “Guarantors”). The Guarantors entered into a guarantee under the Credit Agreement concurrently with the effectiveness of the Credit Agreement. Subject to certain limitations, the Senior Credit Facilities are or will be secured on a first priority basis by: (x) a perfected security interest in the equity interests of each direct subsidiary of the Company and each Guarantor under the Senior Credit Facilities (subject to certain customary exceptions) and (y) perfected, security interests in, and mortgages on, substantially all tangible and intangible personal property and material real property of the Company and each of the Guarantors under the Senior Credit Facilities, subject, in each case, to certain exceptions. The Company and the Guarantors entered into security documents concurrently with effectiveness of the Credit Agreement. RESIDEO TECHNOLOGIES, INC. In 2018, we incurred approximately $16 million in debt issuance costs related to the Term Loans and $5 million in costs related to the Revolving Credit Facility. The debt issuance costs associated with the Term Loans were recorded as a reduction of the principal balance of the debt, and the Revolving Credit Facility costs were capitalized in Other assets. The issuance costs are being amortized through Interest expense for the duration of each respective debt facility. On November 26, 2019, the Company entered into a First Amendment to the Credit Agreement (the “Credit Agreement Amendment”). The Credit Agreement Amendment amended the Credit Agreement to, among other things: (i) increase the levels of the maximum consolidated total leverage ratio under the Credit Agreement, to not greater than 5.25 to 1.00 for the quarter ended December 31, 2019, with step-downs to 4.75 to 1.00 starting in the quarter ending December 31, 2020, 4.25 to 1.00 starting in the quarter ending December 31, 2021, and 3.75 to 1.00 starting in the quarter ending December 31, 2022; (ii) increase each applicable interest rate margin on loans outstanding after the first amendment effective date by 25 basis points per annum, to 2.25% per annum (for LIBOR loans) and 1.25% per annum (for alternate base rate “ABR” loans) in respect of the Term B Loan Facility, and based on our leverage ratio, from 2.25% per annum to 1.75% per annum (for LIBOR loans) and 1.25% to 0.75% per annum (for ABR loans) for the Term A Loan Facility and the Revolving Credit Facility; and (iii) modify the defined terms “Consolidated EBITDA” and “Pro Forma Basis” set forth in the Credit Agreement. In connection with the Credit Agreement Amendment, the Company incurred costs of approximately $4 million. The Term Loan costs were recorded as a reduction of the principal balance of the debt and the Revolving Credit Facility costs were capitalized in Other assets. Senior Notes In October of 2018, we issued $400 million in principal amount of 6.125% senior unsecured notes due in 2026 (the "Senior Notes"). The Senior Notes guarantees are unsecured senior debt obligations of the Senior Notes guarantors. The net proceeds from the borrowings under the Senior Credit Facilities and the offering of the Senior Notes were used as part of financing the Spin-Off. In 2018, we incurred approximately $8 million in debt issuance costs related to the Senior Notes. The debt issuance costs associated with the Senior Notes are recorded as a reduction of the principal balance of the debt. The interest expense for the Senior Notes and Credit Agreement during the year ended December 31, 2019 and 2018 was $69 million and $13 million, respectively, which includes the amortization of debt issuance cost and debt discounts. Honeywell Reimbursement Agreement In connection with the Spin-Off, we entered into the Honeywell Reimbursement Agreement, pursuant to which we have an obligation to make cash payments to Honeywell International Inc. (“Honeywell”) in amounts equal to 90% of payments, which include amounts billed (“payments”), with respect to certain environmental claims, remediation and, following the Spin-Off, hazardous exposure or toxic tort claims, in each case including consequential damages (the “liabilities”) in respect of the Honeywell Sites, including the legal and other costs of defending and resolving such liabilities, less 90% of Honeywell’s net insurance receipts relating to such liabilities, and less 90% of the net proceeds received by Honeywell in connection with (i) affirmative claims relating to such liabilities, (ii) contributions by other parties relating to such liabilities and (iii) certain property sales (the “recoveries”). The amount payable by us in respect of such liabilities arising in any given year is subject to a cap of $140 million (exclusive of any late payment fees up to 5% per annum). Payments in respect of the liabilities arising in a given year will be made quarterly throughout such year on the basis of an estimate of the liabilities and recoveries provided by Honeywell. Following the end of any such year, Honeywell will provide us with a calculation of the amount of payments and the recoveries actually received. Subject to the aforementioned cap, if the amount of payments (net of recoveries) is greater than the previously provided estimate, we will pay Honeywell the amount of such difference (the “true-up payment”) and, if the amount of the previously provided estimate is greater than the amount of payments (net of recoveries), we will receive a credit in the amount of such difference that will be applied to future payments. If a true-up payment exceeds $30 million, such true-up payment will be made in equal installments, payable on a monthly basis following the date the true-up payment is due. RESIDEO TECHNOLOGIES, INC. In addition to the sites under the Honeywell Reimbursement Agreement, we have environmental expense related to sites owned and operated by Resideo (“Resideo Sites”). Prior to the Spin-Off, both of these expenses were combined and were presented as environmental expense. Expenses for environmental matters deemed probable and reasonably estimable were $323 million for the period from January 1, 2018 through October 29, 2018 and $282 million in 2017. Subsequent to the Spin-Off, environmental expense was $2 million for 2019 and $17 million for the period October 30, 2018 through December 31, 2018 and Honeywell Reimbursement Agreement expense was $108 million for 2019 and $49 million for the period October 30, 2018 through December 31, 2018. See Note 19. Commitments and Contingencies of Notes to Consolidated and Combined Financial Statements for further discussion. Cash Flow Summary for the Years Ended December 31, 2019, 2018 and 2017 Our cash flows from operating, investing and financing activities for the years ended December 31, 2019, 2018 and 2017, as reflected in the audited Consolidated and Combined Financial Statements are summarized as follows: 2019 compared with 2018 Cash provided by operating activities for 2019 decreased by $439 million, due to lower net income of $369 million and a decrease in accounts payable and accruals, which includes the Honeywell Reimbursement Agreement liability of $553 million, offset by a favorable change in $298 million in deferred taxes and a $197 million reduction in inventory and accounts receivable. Cash used for investing activities for 2019 increased by $38 million, primarily due to an increase of $17 million cash paid for acquisitions, an increase of $14 million cash paid for capital expenditures, and a decrease of $7 million in proceeds received related to amounts due from related parties. Cash used for financing activities for 2019 decreased by $114 million. The decrease in usage was primarily due to the Spin-Off. Cash used for 2019 primarily consisted of $22 million of repayment of long-term debt and $24 million of non-operating obligations from Honeywell, net. Cash used for financing activities in 2018 primarily consisted of a $1.4 billion distribution to Honeywell in connection with the Spin-Off partially offset by $1.2 billion in proceeds received on long-term debt. 2018 compared with 2017 Cash provided by operating activities for 2018 increased by $425 million, primarily due to higher payments for income taxes of approximately $233 million in 2017 due to expenses related to U.S. Tax Reform. Cash from operating activities also increased due to a decrease in net working capital driven primarily by an increase in accounts payable due to timing of payments under our Transition Services Agreement (“TSA”) with Honeywell, partially offset by an increase in inventory related to new product lines and increased sales. Cash used for investing activities increased by $23 million, primarily due to an increase in expenditures on property, plant and equipment and software related to becoming an independent company. RESIDEO TECHNOLOGIES, INC. Cash used for financing activities increased by $188 million. The increase in usage was primarily due to a $1.4 billion distribution to Honeywell in connection with Spin-Off partially offset by $1.2 billion in proceeds received on long-term debt. Contractual Obligations and Probable Liability Payments Following is a summary of our significant contractual obligations and probable liability payments at December 31, 2019: 1) The table excludes tax liability payments, including those for unrecognized tax benefits. See Note 9. Income Taxes of Notes to Consolidated and Combined Financial Statements. 2) Assumes all long-term debt is outstanding until scheduled maturity. 3) Interest payments are estimated based on the interest rate applicable as of December 31, 2019. 4) In connection with the Spin-Off, we entered into the Honeywell Reimbursement Agreement with Honeywell. As of December 31, 2019, $585 million was deemed probable and reasonably estimable, however, it is possible we could pay $140 million per year (exclusive of any late payment fees up to 5% per annum) until the earlier of: (1) December 31, 2043; or (2) December 31 of the third consecutive year during which the annual reimbursement obligation (including in respect of deferred payment amounts) has been less than $25 million. For further discussion on the Honeywell Reimbursement Agreement refer to Note 19. Commitments and Contingencies of Notes to Consolidated and Combined Financial Statements. 5) Represents estimated environmental liability payments for sites which we own and are directly responsible for. 6) Purchase obligations are entered into with various vendors in the normal course of business and are consistent with our expected requirements. Capital Expenditures We believe our capital spending in recent years has been sufficient to maintain efficient production capacity, to implement important product and process redesigns and to expand capacity to meet increased demand. Productivity projects have freed up capacity in our manufacturing facilities and are expected to continue to do so. We expect to continue investing to expand and modernize our existing facilities and to create capacity for new product development. Capital expenditures for 2020 are expected to be $70 million to $80 million excluding any potential capital expenditures related to the operational and financial review. Off-Balance Sheet Arrangements We do not engage in any off-balance sheet financial arrangements that have or are reasonably likely to have a material current or future effect on our financial condition, changes in financial condition, net revenue or expenses, results of operations, liquidity, capital expenditures or capital resources. RESIDEO TECHNOLOGIES, INC. Critical Accounting Policies The preparation of our Consolidated and Combined Financial Statements in accordance with generally accepted accounting principles is based on the selection and application of accounting policies that require us to make significant estimates and assumptions about the effects of matters that are inherently uncertain. We consider the accounting policies discussed below to be critical to the understanding of our Consolidated and Combined Financial Statements. Actual results could differ from our estimates and assumptions, and any such differences could be material to our Consolidated and Combined Financial Statements. Revenue - Product and service revenues are recognized when or as the Company transfers control of the promised products or services to the customer, in an amount the Company expects to receive in exchange for transferring goods or providing services. Each distinct performance obligation within a contract is identified, and a contract’s transaction price is then allocated to each distinct performance obligation and recognized as revenue when, or as, the performance obligation is satisfied. In the sale of products, the terms of a contract or the historical business practice can give rise to variable consideration due to, but not limited to, discounts, bonuses, and the right of return. The Company estimates variable consideration at the most likely amount that will be received from customers and reduces revenues recognized accordingly. The Company includes estimated amounts in the transaction price to the extent it is probable that a significant reversal of cumulative revenue recognized will not occur when the uncertainty associated with the variable consideration is resolved. The estimates of variable consideration and determination of whether to include estimated amounts in the transaction price are based largely on an assessment of our anticipated performance and all information (historical, current and forecasted) that is reasonably available to the Company. Environmental - We accrue costs related to environmental matters for our Resideo Sites for which we are directly responsible when it is probable that we have incurred a liability related to a contaminated site and the amount can be reasonably estimated. Environmental-related expenses are for our owned sites presented within Cost of goods sold for operating sites in the Consolidated and Combined Statement of Operations. Prior to the Spin-Off, Honeywell Sites now under the Honeywell Reimbursement Agreement were presented within Other expense. For additional information, see Note 19. Commitments and Contingencies of Notes to Consolidated and Combined Financial Statements included herein for additional detail. Honeywell Reimbursement Agreement - In connection with the Spin-Off, we entered into the Honeywell Reimbursement Agreement, pursuant to which we have an obligation to make cash payments to Honeywell in amounts equal to 90% of payments, which include amounts billed, with respect to certain environmental claims, remediation and, to the extent arising after the Spin-Off, hazardous exposure or toxic tort claims, in each case, including consequential damages (the “liabilities”) in respect of the Honeywell Sites, including the legal and other costs of defending and resolving such liabilities, less 90% of Honeywell’s net insurance receipts relating to such liabilities, and less 90% of the net proceeds received by Honeywell in connection with (i) affirmative claims relating to such liabilities, (ii) contributions by other parties relating to such liabilities and (iii) certain property sales. The amount payable by us in respect of such liabilities arising in any given year is subject to a cap of $140 million (exclusive of any late payment fees up to 5% per annum). Through the Honeywell Reimbursement Agreement, we are subject to a number of environmental claims, remediation and, to the extent arising after the Spin-Off, hazardous exposure or toxic tort claims. We continually assess the likelihood of any adverse judgments or outcomes related to the Honeywell Reimbursement Agreement, as well as potential amounts or ranges of probable losses, and recognize a liability, if any, for these contingencies based on a thorough analysis of each matter with the assistance of outside legal counsel and Honeywell, and, if applicable, other experts. Such analysis includes making judgments concerning matters such as the costs associated with environmental matters, the outcome of negotiations, the number and cost of pending and future claims related to the sites covered by the Honeywell Reimbursement Agreement, and the impact of evidentiary requirements. Because most contingencies are resolved over long periods of time, we do not currently possess sufficient information to reasonably estimate the amounts of the Honeywell Reimbursement Agreement liabilities to be recorded upon future completion of studies, litigations or settlements, and neither the timing nor the amount of the ultimate costs associated with environmental matters can be determined. Expenses related to the indemnification are presented within Other expense, net in the Consolidated and Combined Statement of Operations. See Note 19. Commitments and Contingencies of Notes to Consolidated and Combined Financial Statements for a discussion of management’s judgment applied in the recognition and measurement of our environmental liabilities. RESIDEO TECHNOLOGIES, INC. Goodwill - We perform goodwill impairment testing annually on October 1st of each year or more frequently if indicators of potential impairment exist. The goodwill impairment test is performed at the reporting unit level. We have two reporting units, Products & Solutions and ADI Global Distribution. In determining if goodwill is impaired, we compare the fair value of a reporting unit with its carrying amount and recognize an impairment charge for the amount by which the carrying amount exceeds the reporting unit’s fair value provided the loss recognized does not exceed the total amount of goodwill allocated to that reporting unit. For the 2019 annual impairment test, we determined the fair value of each reporting unit using a weighting of fair values derived from the income approach and the market approach. Under the income approach, we calculate the fair value of a reporting unit based on the present value of estimated future cash flows. Cash flow projections are based on management’s estimates of operating results, taking into consideration industry and market conditions. The discount rate used is based on the weighted-average cost of capital adjusted for the relevant risk associated with business-specific characteristics and the uncertainty related to the business’s ability to execute on the projected cash flows. The terminal value is estimated using a constant growth method which requires an assumption about the expected long-term growth rate. The estimates are based on historical data and experience, industry projections, economic conditions, and management’s expectations. Under the market approach, we estimate the fair value based on market multiples of cash flow and earnings derived from comparable publicly traded companies with similar operating and investment characteristics as the reporting unit and considering a reasonable control premium. Due to the inherent uncertainty involved in making these estimates, actual results could differ from those estimates. We believe the estimates and assumptions used in the calculations are reasonable. However, if there was an adverse change in the facts and circumstances, then an impairment charge may be necessary in the future. Specifically, the fair value of our Products & Solutions reporting unit, with goodwill of approximately $2,004 million, exceeded its carrying value by 10% and therefore is highly sensitive to adverse changes in the facts and circumstances that could result in a possible future impairment. Should the fair value of the Company’s reporting units fall below its carrying amount because of reduced operating performance, market declines, changes in the discount rate, or other conditions, charges for impairment may be necessary. The Company monitors its reporting units to determine if there is an indicator of potential impairment. Income Taxes - Our provision for income tax expense is based on our income, the statutory tax rates and other provisions of the tax laws applicable to us in each of the various jurisdictions in which we conduct business. These laws are complex, and their application to our facts is at times open to interpretation. The process of determining our consolidated and combined income tax expense includes significant judgments and estimates, including judgments regarding the interpretation of those laws. Our provision for income taxes and our deferred tax assets and liabilities incorporate those judgments and estimates and reflect management’s best estimate of current and future income taxes to be paid. Deferred tax assets and liabilities relate to temporary differences between the financial reporting and income tax bases of our assets and liabilities, as well as the impact of tax loss carryforwards or carrybacks. Deferred income tax expense or benefit represents the expected increase or decrease to future tax payments as these temporary differences reverse over time. Deferred tax assets are specific to the jurisdiction in which they arise and are recognized subject to management’s judgment that realization of those assets is “more likely than not.” In making decisions regarding our ability to realize tax assets, we evaluate all positive and negative evidence, including projected future taxable income, taxable income in carryback periods, expected reversal of deferred tax liabilities, and the implementation of available tax planning strategies. Significant judgment is required in evaluating tax positions. We establish additional reserves for income taxes when, despite the belief that tax positions are fully supportable, there remain certain positions that do not meet the minimum recognition threshold. The approach for evaluating certain and uncertain tax positions is defined by the authoritative guidance which determines when a tax position is more likely than not to be sustained upon examination by the applicable taxing authority. In the normal course of business, we are examined by various federal, state and foreign tax authorities. We regularly assess the potential outcomes of these examinations and any future examinations for the current or prior years in determining the adequacy of our provision for income taxes. We continually assess the likelihood and amount of potential adjustments and adjust the income tax provision, the current tax liability and deferred taxes in the period in which the facts that give rise to a change in estimate become known. RESIDEO TECHNOLOGIES, INC. Pension - We have defined benefit plans covering certain employees. The benefits are accrued over the employees’ service periods. We use actuarial methods and assumptions in the valuation of defined benefit obligations and the determination of net periodic pension income or expense. Differences between actual and expected results or changes in the value of defined benefit obligations and plan assets, if any, are not recognized in earnings as they occur but rather systematically over subsequent periods when net actuarial gains or losses are in excess of 10% of the greater of the fair value of plan assets or the plan’s projected benefit obligation. A 25 basis point increase in the discount rate would result in a decrease of approximately $6.4 million to the net periodic benefit cost for 2019, while a 25 basis point decrease in the discount rate would result in an increase of approximately $7.9 million. The resulting impact on the pension benefit obligation would be a decrease of $18.7 million and an increase of $20.6 million, respectively. Other Matters Litigation, Environmental Matters and the Honeywell Reimbursement Agreement See Note 19. Commitments and Contingencies of Notes to Consolidated and Combined Financial Statements for a discussion of environmental and other litigation matters. Recent Accounting Pronouncements See Note 2. Summary of Significant Accounting Policies of Notes to Consolidated and Combined Financial Statements for a discussion of recent accounting pronouncements.

<s>[INST] The following Management’s Discussion and Analysis of Financial Condition and Results of Operations is intended to help you understand the results of operations and financial condition of Resideo Technologies, Inc. and its consolidated subsidiaries (“Resideo” or “the Company”, “we”, “us” or “our”) for the three years ended December 31, 2019 and should be read in conjunction with the Consolidated and Combined Financial Statements and the notes thereto contained elsewhere in this Form 10K. Overview and Business Trends We are a leading global provider of products, software solutions and technologies that help homeowners stay connected and in control of their comfort, security and energy use. We manage our business operations through two segments, Products & Solutions and ADI Global Distribution. Our Products & Solutions segment consists of solutions in Comfort, Residential Thermal Solutions (“RTS”) and Security categories and includes temperature and humidity control, thermal, water and air solutions as well as security panels, sensors, peripherals, wire and cable, communications devices, video cameras, awareness solutions, cloud infrastructure, installation and maintenance tools and related software. Our ADI Global Distribution business is the leading wholesale distributor of lowvoltage electronic and security products which include intrusion and smart home, fire, video surveillance, access control, power, audio and video, Pro AV, networking, communications, wire and cable, enterprise connectivity and structured wiring. Our Chief Operating Decision Maker evaluates segment performance based on Segment Adjusted EBITDA. Segment Adjusted EBITDA is defined as segment net income before income taxes, net interest expense (income), depreciation and amortization plus or minus environmental expense, Honeywell Reimbursement Agreement expense, stock compensation expense, restructuring charges, other expense, net and other costs not directly relating to future ongoing business of the segments, such as SpinOff related costs and consulting fees related to restructuring programs. We evaluate our results of operations on both an as reported and constant currency basis. The constant currency presentation, which is a nonGAAP financial measure, excludes the impact of fluctuations in foreign currency exchange rates. We believe providing constant currency information provides valuable supplemental information regarding our results of operations, thereby facilitating periodoverperiod comparisons of the Company’s business performance and is consistent with how management evaluates the Company’s performance. We calculate constant currency percentages by converting both our prior period local currency financial results and current period local currency financial results at a fixed exchange rate and comparing these adjusted amounts. These metrics should be considered in addition to, and not as replacements for, the most comparable measure in accordance with accounting principles generally accepted in the United States of America (“U.S. GAAP”). They should be read in connection with our financial statements presented in accordance with U.S. GAAP. Our financial performance is influenced by several macro factors such as repair and remodeling activity, residential and nonresidential construction, employment rates, and overall macro environment. During 2019, the Products & Solutions segment experienced flat revenue compared to 2018, with mixed results in the lines of businesses. Security maintained strong growth throughout the year, while Comfort and RTS results decelerated in the second half of the year. Segment adjusted EBITDA was impacted by negative product and channel mix, inventory writedowns, and high product rebates from a contract entered into prior to SpinOff. The RTS business experienced a slowdown across large original equipment manufacturers (“OEMs”) customers, which included impacts due to recent regulatory changes. The Comfort business revenue declines were primarily due to lower thermostat sales. Our ADI Global Distribution business has been further aided by increasing contractor needs for training and technical expertise and increasing demand for sameday ordering. Throughout 2019, the ADI Global Distribution business continued its strong performance, achieving constant currency growth across all regions and expansion in top product lines. ADI Global Distribution accelerated the adoption of digital tools, which is reflected in strong ecommerce growth. ADI Global Distribution continued to expand its footprint, including recent opening and remodeling of branches in Eastern Europe. RESIDEO TECHNOLOGIES, INC. Current Period Highlights Net revenues increased $161 million in [/INST] Positive. </s>

Garrett Motion Inc.

2019-03-01

2018-12-31

Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations The following discussion and analysis of our financial condition and results of operations, which we refer to as our “MD&A,” should be read in conjunction with our Consolidated and Combined Financial Statements and related notes thereto and other financial information appearing elsewhere in this Information Statement. Some of the information contained in this discussion and analysis or set forth elsewhere in this Annual Report on Form 10-K, including information with respect to our plans and strategy for our business, includes forward-looking statements that involve risks and uncertainties. As a result of many important factors, including those set forth in the "Risk Factors" section of this Annual Report on Form 10-K, our actual results could differ materially from the results described in, or implied, by these forward-looking statements. The following Management’s Discussion and Analysis of Financial Condition and Results of Operations is intended to help you understand the results of operations and financial condition of Garrett Motion Inc. for the years ended December 31, 2018, 2017 and 2016. Unless the context otherwise requires, references to “Garrett,” “we,” “us,” “our,” and “the Company” refer to (i) Honeywell’s Transportation Systems Business (the “Transportation Systems Business” or the “Business”) prior to our spin-off from Honeywell International Inc. (the “Spin-Off”) and (ii) Garrett Motion Inc. and its subsidiaries following the Spin-Off, as applicable. Overview and Business Trends Garrett designs, manufactures and sells highly engineered turbocharger and electric-boosting technologies for light and commercial vehicle OEMs and the global vehicle and independent aftermarket. These OEMs in turn ship to consumers globally. We are a global technology leader with significant expertise in delivering products across gasoline, diesel and electric (hybrid and fuel cell) powertrains. These products are key enablers for fuel economy and emission standards compliance. Market penetration of vehicles with a turbocharger is expected to increase from approximately 49% in 2018 to approximately 57% by 2022, according to IHS and other industry sources, which we believe will allow our business to grow at a faster rate than overall automobile production. The turbocharger market volume growth was particularly strong in China and other high-growth regions. The growth trajectory for turbochargers is expected to continue, as the technology is one of the most cost- effective solutions for OEMs to address strict constraints for vehicle fuel efficiency and emissions standards. As a result, OEMs are increasing their adoption of turbocharger technologies across gasoline and diesel engines as well as hybrid-electric and fuel cell vehicles. In recent years, we have also seen a shift in demand from diesel engines to gasoline engines. In particular, the commercial vehicle OEM market and light vehicle gasoline markets in China and other high-growth regions have increased due to favorable economic conditions and rising income levels which have led to an increase in automotive and vehicle content demand. While the respective growth rates may potentially decline as the local markets mature, we continue to expect an increase in future vehicle production utilizing turbocharger technologies as vehicle ownership remains well below ownership levels in developed markets. Separation from Honeywell On October 1, 2018, the Company became an independent publicly-traded company through a pro rata distribution by Honeywell of 100% of the then-outstanding shares of Garrett to Honeywell’s stockholders. Each Honeywell stockholder of record received one share of Garrett common stock for every 10 shares of Honeywell common stock held on the record date. Approximately 74 million shares of Garrett common stock were distributed on October 1, 2018 to Honeywell stockholders. In connection with the separation, Garrett´s common stock began trading “regular-way” under the ticker symbol “GTX” on the New York Stock Exchange on October 1, 2018. In connection with the separation, we entered into several agreements with Honeywell that govern the future relationship between us and Honeywell and impose certain obligations on us following the Spin-Off and which may cause us to incur new costs, including the following: • a Separation and Distribution Agreement; • a Transition Services Agreement; • an Employee Matters Agreement; • an Intellectual Property Agreement; and • a Trademark License Agreement. A description of each of these agreements is included in a Current Report on Form 8-K filed with the SEC on October 1, 2018. In addition, we entered into an Indemnification and Reimbursement Agreement (the “Indemnification and Reimbursement Agreement”) and a Tax Matters Agreement (the “Tax Matters Agreement”) with Honeywell on September 12, 2018, each of which is described in this MD&A. Basis of Presentation Prior to the Spin-Off on October 1, 2018, our historical financial statements were prepared on a stand-alone basis and derived from the consolidated financial statements and accounting records of Honeywell. Accordingly, for periods prior to October 1, 2018, our financial statements are presented on a combined basis and for the periods subsequent to October 1, 2018 are presented on a consolidated basis (collectively, the historical financial statements for all periods presented are referred to as “Consolidated and Combined Financial Statements”). The Consolidated and Combined Financial Statements have been prepared in accordance with accounting principles generally accepted in the United States of America (“U.S. GAAP”). The historical consolidated and combined financial information may not be indicative of our future performance and does not necessarily reflect what our consolidated and combined results of operations, financial condition and cash flows would have been had the Business operated as a separate, publicly traded company during the periods presented, particularly because of changes that we have experienced and expect to continue to experience in the future as a result of our separation from Honeywell, including changes in the financing, cash management, operations, cost structure and personnel needs of our business. For periods prior to the Spin-Off, the Consolidated and Combined Financial Statements include certain assets and liabilities that were held at the Honeywell corporate level prior to the Spin-Off but are specifically identifiable or otherwise allocable to the Business. Additionally, Honeywell provided certain services, such as legal, accounting, information technology, human resources and other infrastructure support, on behalf of the Business. The cost of these services has been allocated to the Business on the basis of the proportion of revenues. We consider these allocations to be a reasonable reflection of the benefits received by the Business. Actual costs that would have been incurred if the Business had been a stand-alone company would depend on multiple factors, including organizational structure and strategic decisions made in various areas, including information technology and infrastructure. We consider the basis on which the expenses have been allocated to be a reasonable reflection of the utilization of services provided to or the benefits received by the Business during the periods presented. Subsequent to the completion of the Spin-Off, we have incurred and continue to expect to incur expenditures consisting of employee-related costs, costs to start up certain stand-alone functions and information technology systems, and other one-time transaction related costs. Recurring stand-alone costs include establishing the internal audit, treasury, investor relations, tax and corporate secretary functions as well as the annual expenses associated with running an independent publicly traded company including listing fees, compensation of non-employee directors, related board of director fees and other fees and expenses related to insurance, legal and external audit. Recurring stand- alone costs that differ from historical allocations may have an impact on profitability and operating cash flows but we believe the impact will not be significant. As a stand-alone public company, we do not expect our recurring stand-alone corporate costs to be materially higher than the expenses historically allocated to us from Honeywell. Asbestos-Related and Environmental Liabilities For the periods prior to the Spin-Off, our Consolidated and Combined Financial Statements reflect an estimated liability for resolution of pending and future asbestos-related and environmental liabilities primarily related to the Bendix legacy Honeywell business, calculated as if we were responsible for 100% of the Bendix asbestos-liability payments. However, this recognition model differs from the recognition model applied subsequent to the Spin-Off. In periods subsequent to the Spin-Off, the accounting for the majority of our asbestos-related liability payments and accounts payable reflect the terms of the Indemnification and Reimbursement Agreement (the “Indemnification and Reimbursement Agreement”) with Honeywell entered into on September 12, 2018, under which we are required to make payments to Honeywell in amounts equal to 90% of Honeywell’s asbestos-related liability payments and accounts payable, primarily related to the Bendix business in the United States, as well as certain environmental-related liability payments and accounts payable and non-United States asbestos-related liability payments and accounts payable, in each case related to legacy elements of the Business, including the legal costs of defending and resolving such liabilities, less 90% of Honeywell’s net insurance receipts and, as may be applicable, certain other recoveries associated with such liabilities. The Indemnification and Reimbursement Agreement provides that the agreement will terminate upon the earlier of (x) December 31, 2048 or (y) December 31st of the third consecutive year during which certain amounts owed to Honeywell during each such year were less than $25 million as converted into Euros in accordance with the terms of the agreement. During the fourth quarter of 2018, we paid Honeywell the Euro-equivalent of $41 million in connection with the Indemnification and Reimbursement Agreement. On October 19, 2018, Honeywell disclosed in its Quarterly Report on Form 10-Q for the quarter ended September 30, 2018 (the “Honeywell Form 10-Q”) that the Division of Enforcement of the Securities and Exchange Commission (the “SEC”) has opened an investigation into Honeywell’s prior accounting for liability for unasserted Bendix-related asbestos claims. In addition, Honeywell noted that it revised certain previously-issued financial statements to correct the time period associated with the determination of appropriate accruals for legacy Bendix asbestos-related liability for unasserted claims. Our restated carve-out financial statements included in our Form 10 already contemplate these revisions, consistent with Honeywell’s previous disclosure in its Form 8-K filed with the SEC on August 23, 2018. These revisions are also contemplated in our Combined Interim Financial Statements for the three and nine months ended September 30, 2018. The Indemnification and Reimbursement Agreement has not been amended and otherwise remains unchanged. Prior to the filing of the Honeywell Form 10-Q with the SEC, our management was not aware of the SEC’s investigation into Honeywell’s prior accounting. Results of Operations for the Years Ended December 31, 2018, 2017 and 2016 Net Sales The change in net sales compared to the prior year period is attributable to the following: 2018 compared with 2017 Our net sales for 2018 were $3,375 million, an increase of $279 million, or 9.0% (5.6% excluding foreign currency translation), from $3,096 million in 2017, primarily driven by increases in sales volume partially offset by price reductions. The increase in sales volume, net of price reductions, was primarily driven by light vehicles OEM products growth of approximately $220 million, commercial vehicles OEM products growth of approximately $59 million and aftermarket products growth of approximately $8 million. Our light vehicles OEM product growth was primarily driven by increased gasoline volumes in Europe, China, North America, and South Korea, as a result of increased turbocharger penetration in gasoline engines and new product launches. Additionally, there were increased diesel volumes in China and Japan partially offset by lower diesel volumes to our OEM customers in Europe and South Korea. The commercial vehicles OEM product growth was primarily driven by volume increases in North America and Europe. Our slight aftermarket sales increase was primarily driven by higher volumes in Europe partially offset by lower volumes in Japan. 2017 compared with 2016 Our net sales for 2017 were $3,096 million, an increase of $99 million, or 3.3% (2.4% excluding foreign currency translation), from $2,997 million in 2016, primarily driven by increases in sales volume partially offset by price reductions. The increase in sales volume, net of price reductions, was primarily driven by commercial vehicles OEM products growth of approximately $124 million(1), partially offset by declines in our light vehicles OEM products of approximately $51 million. The commercial vehicles OEM product growth was primarily driven by volume increases in China, North America and Europe. Our light vehicles OEM product decline was primarily driven by lower diesel volumes to our OEM customers in Europe, North America and South Korea, partially offset by increased gasoline volumes in China and South Korea, as a result of increased turbocharger penetration in gasoline engines. Our aftermarket product sales were approximately flat, with volume increases in North America offset by a decrease in Europe. (1) The prior year amounts have been reclassified to conform to the current year presentation. Cost of Goods Sold 2018 compared with 2017 Cost of goods sold for 2018 was $2,599 million, an increase of $238 million, or 10.1%, from $2,361 million in 2017. This increase was primarily driven by an increase in direct material costs and labor of approximately $215 million, or 12%, (principally due to an increase in volume). Gross profit percentage decreased primarily due to unfavorable impacts from mix and price (approximately 3.1 percentage point impact) and inflation (approximately 1 percentage point impact), partially offset by higher productivity (approximately 3.0 percentage point impact) and net reductions in repositioning and other costs (approximately 0.6 percentage point impact). 2017 compared with 2016 Cost of goods sold for 2017 was $2,361 million, a decrease of $4 million, or 0.2%, from $2,365 million in 2016. This decrease was primarily driven by a reduction in repositioning costs of approximately $26 million. Direct material and labor costs were approximately flat in 2017 compared to 2016 (principally due to a favorable impact of productivity, net of inflation, partially offset by increased volume and foreign currency translation). R&D costs increased by $11 million. Gross profit percentage increased primarily due to higher productivity net of inflation (approximately 4.5 percentage point impact) and net reductions in repositioning and other costs (approximately 0.6 percentage point impact), partially offset by impacts from mix and price (approximately 2.1 percentage point impact) and unfavorable foreign currency translation (approximately 0.1 percentage point impact). Selling, General and Administrative Expenses 2018 compared with 2017 Selling, general and administrative expenses were flat for 2018 compared with 2017 leading to a decline in expenses as a percentage of sales. 2017 compared with 2016 Selling, general and administrative expense for 2017 was $249 million, an increase of $52 million, or 26.4%, from $197 million in 2016. This increase was primarily driven by a net increase in information technology (IT) costs of approximately $35 million, primarily due to higher corporate allocations from Honeywell. Allocations of corporate expenses from Honeywell are not necessarily indicative of future expenses and do not necessarily reflect the results that the Business would have experienced as an independent company for the periods presented. Additionally, selling costs increased by approximately $6 million related to investments for our software offerings. Other Expense, Net 2018 compared with 2017 For the periods prior to the Spin-Off, our Consolidated and Combined Financial Statements reflect an estimated liability for resolution of pending and future asbestos-related and environmental liabilities primarily related to the Bendix legacy Honeywell business, calculated as if we were responsible for 100% of the Bendix asbestos-liability payments. For the nine months ended September 30, 2018 prior to the Spin-Off over the same period in 2017, Other expense, net increased by $3 million due to a $6 million increase in environmental charges, partially offset by a $3 million decrease in asbestos charges. Following the Spin-Off in 2018, the accounting for the majority of our asbestos-related liability payments and accounts payable reflect the terms of the Indemnification and Reimbursement Agreement as described above in the Asbestos-Related and Environmental Liabilities section. During the fourth quarter of 2018, we recognized a $16 million benefit related to a reduction in Honeywell´s long-term estimate of asbestos claims experience, net of legal fees for the quarter, in connection to the Indemnification and Reimbursement Agreement, in comparison to a $1 million environmental charge in the same period of 2017. 2017 compared with 2016 Other expense, net for 2017, was $130 million, a decrease of $53 million, or 29.0%, from $183 million in 2016. This decrease was primarily driven by lower asbestos charges, net of insurance recoveries, in the year. Interest Expense (Dollars in millions) Interest Expense $ $ $ Following the Spin-Off, interest expense primarily relates to interest on our long-term debt. In connection with our long-term debt and revolving credit facility, we estimate that annual interest expense will be approximately $74 million for 2019. Prior to the Spin-Off, interest expense primarily related to related party notes cash pool arrangements with our Former Parent which were settled in cash prior to the Spin-Off. Interest expense for 2018, was $19 million, an increase of $11 million from $8 million in 2017. This increase was primarily driven by interest expense related to our long-term debt of $17 million partially offset by a decrease in related party notes interest expense of $5 million. Interest expense for 2017 increased by $1 million compared to 2016. See Note 3 Related Party Transactions with Honeywell and Note 14 Long-term Debt and Credit Agreements of Notes to Consolidated and Combined Financial Statements. Non-operating (income) expense (Dollars in millions) Non-operating (income) expense $ (8 ) $ (18 ) $ (5 ) 2018 compared with 2017 Non-operating (income) expense for 2018 decreased to income of ($8) million from income of ($18) million in 2017. This decrease was primarily driven by a decrease in interest income from bank accounts and marketable securities of $7 million and an increase in non-service related pension ongoing (income) expense of $3 million. 2017 compared with 2016 Non-operating (income) expense for 2017 increased to income of ($18) million from income of ($5) million in 2016 primarily driven by lower foreign exchange losses of $9 million. Tax (Benefit) Expense 2018 compared with 2017 The effective tax rate decreased by 566.6 percentage points in 2018 compared to 2017. The decrease was primarily attributable to the non-recurring impacts of U.S. tax reform from 2017 (see "The Tax Act" further below) and due to tax benefits from internal restructuring of Garrett’s business in advance of its Spin-Off which resulted in a decrease to the withholding tax deferred tax liability. The Company's non-U.S. effective tax rate was (197.6)% a decrease of approximately 417 percentage points compared to 2017. The year-over-year decrease in the non-U.S. effective tax rate was primarily driven by the Company's change in assertion regarding foreign unremitted earnings in connection with the Tax Act, decreased expense for tax reserves in various jurisdictions, and higher earnings taxed at lower rates. 2017 compared with 2016 The effective tax rate increased by 348.2 percentage points in 2017 compared to 2016. The increase was primarily attributable to the provisional impact of U.S. tax reform. On December 22, 2017, the U.S. enacted H.R.1, commonly known as the Tax Cuts and Jobs Act (“Tax Act”) that instituted fundamental changes to the U.S. tax system. The Tax Act included changes to the taxation of foreign earnings by implementing a dividend exemption system, expansion of the current anti-deferral rules, a minimum tax on low-taxed foreign earnings and new measures to deter base erosion. The Tax Act also permanently reduced the corporate tax rate from 35% to 21%, imposed a one-time mandatory transition tax on the historical earnings of foreign affiliates and implemented a territorial-style tax system. The impacts of these changes are reflected in the 2017 tax expense, which resulted in provisional charges of approximately $980 million due to the Company’s change in assertion regarding foreign unremitted earnings and $354 million due to the mandatory transition tax. These charges were subject to adjustment given the provisional nature of the charges. The Tax Act provisional charges were the primary driver of the increase in the effective tax rate in 2017, partially offset by increased tax benefits from the resolution of tax audits. The majority of the $980 million provisional charge described above relates to non-U.S. withholding taxes that would have been payable at the time of the actual cash transfer and is based on the legal entity structure that existed at December 31, 2017. However, as discussed above, this deferred tax liability was significantly reduced in 2018 as a result of internal restructuring in advance of the Spin-Off. Net Income (loss) (Dollars in millions) Net Income (loss) $ 1,180 $ (983 ) $ 2018 compared with 2017 As a result of the factors described above, net income was $1,180 million in 2018 as compared to net loss of $983 million in 2017. 2017 compared with 2016 As a result of the factors described above, net loss was $983 million in 2017 as compared to net income of $199 million in 2016. Liquidity and Capital Resources Historical Liquidity Prior to the Spin-Off, we generated positive cash flows from operations. Honeywell Central Treasury Function prior to the Spin-Off As part of the Former Parent for the periods prior to the Spin-Off, we were dependent upon Honeywell for all of our working capital and financing requirements. Honeywell uses a centralized approach to cash management and financing of its operations. The majority of the Business’s cash was transferred to Honeywell daily and Honeywell funded its operating and investing activities as needed. This arrangement is not reflective of the manner in which the Business would have been able to finance its operations had it been a stand-alone business separate from Honeywell during the entirety of the periods presented. Cash transfers to and from Honeywell’s cash management accounts are reflected within Invested deficit. For the periods prior to the Spin-Off, we operated a centralized non-interest-bearing cash pool in U.S. and regional interest-bearing cash pools outside of the U.S. As of December 31, 2017, we had non-interest-bearing cash pooling balances of $51 million, which are presented in Invested deficit within the Consolidated and Combined Balance Sheets. As part of the preparation for the Spin-Off, we delinked from U.S. and regional cash pools operated by Honeywell. All intracompany transactions have been eliminated. As described in Note 3 Related Party Transactions with Honeywell, all significant transactions between the Business and Honeywell prior to the Spin-Off have been included in the Consolidated and Combined Financial Statements and settled for cash prior to the Spin-Off with the exception of certain related party notes which were forgiven. These transactions are reflected in the Consolidated and Combined Balance Sheets as Due from related parties or Due to related parties for the periods prior to the Spin-Off. In the Consolidated and Combined Statements of Cash Flows, the cash flows related to related party notes receivables presented in the Consolidated and Combined Balance Sheets in Due from related parties are reflected as investing activities since these balances represent amounts loaned to Former Parent. The cash flows related to related party notes payables presented in the Consolidated and Combined Balance Sheets in Due to related parties are reflected as financing activities since these balances represent amounts financed by Former Parent. Following the Spin-Off, Honeywell is no longer considered a related party. For the periods prior to the Spin-Off, the cash and cash equivalents held by Honeywell at the corporate level were not specifically identifiable to the Business and therefore were not allocated for such periods. Honeywell third-party debt and the related interest expense have not been allocated for such periods, as Honeywell’s borrowings were not directly attributable to the Business. For the periods prior to the Spin-Off, we received interest income for related party notes receivables of $1 million, $1 million and $ 4 million, for the years ended December 31, 2018, 2017 and 2016, respectively. Additionally, we incurred interest expense for related party notes payable of $1 million, $6 million and $6 million, for the years ended December 31, 2018, 2017 and 2016, respectively. Senior Credit Facilities On September 27, 2018, we entered into a Credit Agreement, by and among us, Garrett LX I S.à r.l., Garrett LX II S.à r.l. (“Lux Guarantor”), Garrett LX III S.à r.l. (“Lux Borrower”), Garrett Borrowing LLC (in such capacity, the “US Co-Borrower”), and Honeywell Technologies Sàrl (“Swiss Borrower” and, together with Lux Borrower and US Co-Borrower, the “Borrowers”), the lenders and issuing banks party thereto and JPMorgan Chase Bank, N.A., as administrative agent (the “Credit Agreement”). The Credit Agreement provides for senior secured financing of approximately the Euro equivalent of $1,254 million, consisting of (i) a seven-year senior secured first-lien term B loan facility, which consists of a tranche denominated in Euro of €375 million and a tranche denominated in U.S. Dollars of $425 million (the “Term B Facility”), (ii) five-year senior secured first-lien term A loan facility in an aggregate principal amount of €330 million (the “Term A Facility” and, together with the Term B Facility, the “Term Loan Facilities”) and (iii) a five-year senior secured first-lien revolving credit facility in an aggregate principal amount of €430 million with revolving loans to Swiss Borrower, to be made available in a number of currencies including Australian Dollars, Euros, Pounds Sterling, Swiss Francs, U.S. Dollars and Yen (the “Revolving Facility” and, together with the Term Loan Facilities, the “Senior Credit Facilities”). Each of the Revolving Facility and the Term A Facility matures five years after the effective date of the Credit Agreement, in each case with certain extension rights in the discretion of each lender. The Term B Facility matures seven years after the effective date of the Credit Agreement, with certain extension rights in the discretion of each lender. The Senior Credit Facilities are subject to an interest rate, at our option, of either (a) base rate determined by reference to the highest of (1) the rate of interest last quoted by The Wall Street Journal as the “prime rate” in the United States, (2) the greater of the federal funds effective rate and the overnight bank funding rate, plus 0.5% and (3) the one month adjusted LIBOR rate, plus 1% per annum (“ABR”), (b) an adjusted LIBOR rate (“LIBOR”) (which shall not be less than zero), or (c) an adjusted EURIBOR rate (“EURIBOR”) (which shall not be less than zero), in each case, plus an applicable margin. The applicable margin for the U.S. Dollar tranche of the Term B Facility is currently 2.50% per annum (for LIBOR loans) and 1.50% per annum (for ABR loans) while that for the euro tranche of the Term B Facility is currently 2.75% per annum (for EURIBOR loans). The applicable margin for each of the Term A Facility and the Revolving Credit Facility varies based on our leverage ratio. Accordingly, the interest rates for the Senior Credit Facilities will fluctuate during the term of the Credit Agreement based on changes in the ABR, LIBOR, EURIBOR or future changes in our leverage ratio. Interest payments with respect to the Term Loan Facilities are required either on a quarterly basis (for ABR loans) or at the end of each interest period (for LIBOR and EURIBOR loans) or, if the duration of the applicable interest period exceeds three months, then every three months. We are obligated to make quarterly principal payments throughout the term of the Term Loan Facilities according to the amortization provisions in the Credit Agreement. Borrowings under the Credit Agreement are prepayable at our option without premium or penalty, subject to a 1.00% prepayment premium in connection with any repricing transaction with respect to the Term B Facility in the first six months after the effective date of the Credit Agreement. We may request to extend the maturity date of all or a portion of the Senior Credit Facilities subject to certain conditions customary for financings of this type. The Credit Agreement also contains certain mandatory prepayment provisions in the event that we incur certain types of indebtedness or receive net cash proceeds from certain non-ordinary course asset sales or other dispositions of property, in each case subject to terms and conditions customary for financings of this type. The Credit Agreement contains certain affirmative and negative covenants customary for financings of this type that, among other things, limit our and our subsidiaries’ ability to incur additional indebtedness or liens, to dispose of assets, to make certain fundamental changes, to enter into restrictive agreements, to make certain investments, loans, advances, guarantees and acquisitions, to prepay certain indebtedness and to pay dividends, to make other distributions or redemptions/ repurchases, in respect of the our and our subsidiaries’ equity interests, to engage in transactions with affiliates, amend certain material documents or to permit the International Financial Reporting Standards equity amount of Lux Borrower to decrease below a certain amount. The Credit Agreement also contains financial covenants requiring the maintenance of a consolidated total leverage ratio of not greater than 4.25 to 1.00 (with step-downs to (i) 4.00 to 1.00 in approximately 2019, (ii) 3.75 to 1.00 in approximately 2020 and (iii) 3.50 to 1.00 in approximately 2021), and a consolidated interest coverage ratio of not less than 2.75 to 1.00. We were in compliance with our financial covenants as of December 31, 2018. Senior Notes On September 27, 2018, we completed the offering of €350 million (approximately $400 million) in aggregate principal amount of 5.125% senior notes due 2026 (the “Senior Notes”). The Senior Notes bear interest at a fixed annual interest rate of 5.125% and mature on October 15, 2026. The Senior Notes were issued pursuant to an Indenture, dated September 27, 2018 (the “Indenture”), which, among other things and subject to certain limitations and exceptions, limits our ability and the ability of our restricted subsidiaries to: (i) incur, assume or guarantee additional indebtedness or issue certain disqualified equity interests and preferred shares, (ii) pay dividends or distributions on, or redeem or repurchase, capital stock and make other restricted payments, (iii) make investments, (iv) consummate certain asset sales or transfers, (v) engage in certain transactions with affiliates, (vi) grant or assume certain liens on assets to secure debt unless the notes are secured equally and ratably (vii) restrict dividends and other payments by certain of their subsidiaries and (vii) consolidate, merge, sell or otherwise dispose of all or substantially all of our or our restricted subsidiaries’ assets. Use of Proceeds from Senior Credit Facilities and Senior Notes In connection with the consummation of the Spin-Off, Lux Borrower used all of the net proceeds of the Term B Facility to make three unsecured intercompany loans to Swiss Borrower. In addition, the subsidiary that issued the Senior Notes used all of the net proceeds of the Senior Notes to make a secured intercompany loan to Swiss Borrower. Swiss Borrower used the proceeds of the intercompany loans, as well as the net proceeds of the Term A Facility, which equal, in the aggregate, the Euro-equivalent of approximately $1.621 billion, to repay certain Euro-denominated intercompany notes to Honeywell or a subsidiary of Honeywell. We used a portion of the gross proceeds from the Term Loan Facilities and the Senior Notes offering to pay fees, costs and expenses in connection with the entry into the Senior Credit Facilities and the consummation of the Senior Notes offering. Liquidity following the Spin-Off Following the Spin-Off, a treasury team was appointed and cash management structures were implemented, in order to manage the Company’s liquidity centrally and concentrate excess cash. Our capital structure and sources of liquidity have changed from our historical capital structure because we no longer participate in our Former Parent’s centralized cash management program. We expect that our primary cash requirements in 2019 will primarily be to fund operating activities, working capital, and capital expenditures, and to meet our obligations under the debt instruments and the Indemnification and Reimbursement Agreement described below, as well as the Tax Matters Agreement. In addition, we engage in repurchases of our debt and equity securities from time to time. We believe we will meet our known or reasonably likely future cash requirements through the combination of cash flows from operating activities, available cash balances and available borrowings through our debt agreements. If these sources of liquidity need to be augmented, additional cash requirements would likely be financed through the issuance of debt or equity securities; however, there can be no assurances that we will be able to obtain additional debt or equity financing on acceptable terms in the future. Based upon our history of generating strong cash flows, we believe we will be able to meet our short-term liquidity needs for at least the next twelve months. Indemnification and Reimbursement Agreement On September 12, 2018, we entered into the Indemnification and Reimbursement Agreement, under which we are required to make certain payments to Honeywell in amounts equal to 90% of Honeywell’s asbestos-related liability payments and accounts payable, primarily related to the Bendix business in the United States, as well as certain environmental-related liability payments and accounts payable and non-United States asbestos-related liability payments and accounts payable, in each case related to legacy elements of the Business, including the legal costs of defending and resolving such liabilities, less 90% of Honeywell’s net insurance receipts and, as may be applicable, certain other recoveries associated with such liabilities. Pursuant to the terms of the Indemnification and Reimbursement Agreement, we are responsible for paying to Honeywell such amounts, up to a cap of an amount equal to the Distribution Date Currency Exchange Rate (1.16977 USD = 1 EUR) equivalent of $175 million (exclusive of any late payment fees) in respect of such liabilities arising in any given calendar year. This Indemnification and Reimbursement Agreement may have material adverse effects on our liquidity and cash flows and on our results of operations, regardless of whether we experience a decline in net sales. See “We are subject to risks associated with the Indemnification and Reimbursement Agreement, pursuant to which we are required to make substantial cash payments to Honeywell, measured in substantial part by reference to estimates by Honeywell of certain of its liabilities.” The payments that we are required to make to Honeywell pursuant to the terms of the Indemnification and Reimbursement Agreement will not be deductible for U.S. federal income tax purposes. The Indemnification and Reimbursement Agreement provides that the agreement will terminate upon the earlier of (x) December 31, 2048 or (y) December 31st of the third consecutive year during which certain amounts owed to Honeywell during each such year were less than $25 million as converted into Euros in accordance with the terms of the agreement. During the fourth quarter of 2018, we paid Honeywell the Euro-equivalent of $41 million in connection with the Indemnification and Reimbursement Agreement. Tax Matters Agreement On September 12, 2018, we entered into a Tax Matters Agreement with Honeywell. The Tax Matters Agreement governs the respective rights, responsibilities and obligations of Honeywell and us after the Spin-Off with respect to all tax matters (including tax liabilities, tax attributes, tax returns and tax contests). The Tax Matters Agreement generally provides that we are responsible and will indemnify Honeywell for all taxes, including income taxes, sales taxes, VAT and payroll taxes, relating to Garrett for all periods, including periods prior to the completion date of the Spin-Off. Among other items, as a result of the mandatory transition tax imposed by the Tax Cuts and Jobs Act, one of our subsidiaries is required to make payments to a subsidiary of Honeywell in the amount representing the net tax liability of Honeywell under the mandatory transition tax attributable to us, as determined by Honeywell. We currently estimate that our aggregate payments to Honeywell with respect to the mandatory transition tax will be $240 million. Under the terms of the Tax Matters Agreement, we are required to pay this amount in Euros, without interest, in five annual installments, each equal to 8% of the aggregate amount, followed by three additional annual installments equal to 15%, 20% and 25% of the aggregate amount, respectively. In connection with this agreement, we paid Honeywell the Euro-equivalent of $19 million during the fourth quarter of 2018. In addition, the Tax Matters Agreement addresses the allocation of liability for taxes incurred as a result of restructuring activities undertaken to effectuate the Spin-Off. The Tax Matters Agreement also provides that we are required to indemnify Honeywell for certain taxes (and reasonable expenses) resulting from the failure of the Spin-Off and related internal transactions to qualify for their intended tax treatment under U.S. federal, state and local income tax law, as well as foreign tax law. The Tax Matters Agreement also imposes certain restrictions on us and our subsidiaries (including restrictions on share issuances, redemptions or repurchases, business combinations, sales of assets and similar transactions) that are designed to address compliance with Section 355 of the Internal Revenue Code of 1986, as amended, and are intended to preserve the tax-free nature of the Spin-Off. Cash Flow Summary for the Years Ended December 31, 2018, 2017 and 2016 Our cash flows from operating, investing and financing activities for the years ended December 31, 2018, 2017 and 2016, as reflected in the audited Consolidated and Combined Financial Statements included elsewhere in this Form 10-K, are summarized as follows: 2018 compared with 2017 Cash provided by operating activities increased by $302 million for 2018 in comparison to 2017, primarily due to a decrease in cash taxes paid of $354 million and favorable impacts from working capital of $35 million partially offset by an unfavorable impact from changes in Payables to related parties of $82 million. Cash provided by investing activities increased by $162 million for 2018 in comparison to 2017, primarily due to favorable net cash impacts from marketable securities investment activities year over year of $230 million, partially offset by a decrease in proceeds from related party notes receivables of $66 million. Cash used for financing activities increased by $718 million for 2018 in comparison to 2017 primarily due to a decrease in proceeds from related party notes payable year over year of $671 million. Additionally, there was $1,631 million in proceeds from issuance of long-term debt in 2018 partially offset by unfavorable impacts from changes in Invested deficit period over period of $1,474 million. 2017 compared with 2016 Cash provided by operating activities decreased by $234 million, primarily due to higher income taxes settled with our Former Parent of $357 million, mainly due to the provisional mandatory transition tax impact of the Tax Act. This was partially offset by higher Income before taxes of $116 million, favorable impacts from working capital of approximately $6 million and payables to related parties of $37 million. Cash provided by investing activities increased by $212 million, primarily due to lower issuances of related party notes receivables to the Former Parent of $63 million and favorable net cash impacts from marketable securities investment activities year over year of $145 million. Cash provided by financing activities increased by $209 million. The change was primarily due to a $133 million increase in cash received from the Former Parent’s cash pools and lower increase in Invested deficit of $76 million. Contractual Obligations and Probable Liability Payments The following is a summary of our significant contractual obligations and probable liability payments at December 31, 2018: _______________________ (1) Excludes legal fees which are expensed as incurred. For additional information, refer to “-Liquidity and Capital Resources-Indemnification and Reimbursement Agreement” section. (2) Excludes the indemnification obligation for uncertain tax positions for which timing of payment is uncertain. For additional information, refer to “-Liquidity and Capital Resources-Tax Matters Agreement” section. (3) Assumes all long-term debt is outstanding until scheduled maturity. Does not include expected utilization of our revolving credit facility. (4) Interest payments are estimated based on the interest rates applicable as of December 31, 2018. This does not include the impact of the cross currency interest rate swap nor the expected utilization of our revolving credit facility. (5) Purchase obligations are entered into with various vendors in the normal course of business and are consistent with our expected requirements. Capital Expenditures We believe our capital spending in recent years has been sufficient to maintain efficient production capacity, to implement important product and process redesigns and to expand capacity to meet increased demand. Productivity projects have freed up capacity in our manufacturing facilities and are expected to continue to do so. We expect to continue investing to expand and modernize our existing facilities and invest in our facilities to create capacity for new product development. Off-Balance Sheet Arrangements We do not engage in any off-balance sheet financial arrangements that have or are reasonably likely to have a material current or future effect on our financial condition, changes in financial condition, revenues or expenses, results of operations, liquidity, capital expenditures or capital resources. Critical Accounting Policies The preparation of our Consolidated and Combined Financial Statements in accordance with generally accepted accounting principles is based on the selection and application of accounting policies that require us to make significant estimates and assumptions about the effects of matters that are inherently uncertain. We consider the accounting policies discussed below to be critical to the understanding of our financial statements. Actual results could differ from our estimates and assumptions, and any such differences could be material to our Consolidated and Combined Financial Statements. Contingent Liabilities-We are subject to lawsuits, investigations and claims that arise out of the conduct of our global business operations or those of previously owned entities, including matters relating to commercial transactions, government contracts, product liability (including asbestos), prior acquisitions and divestitures, employee benefit plans, intellectual property, legal and environmental, health and safety matters. We continually assess the likelihood of any adverse judgments or outcomes to our contingencies, as well as potential amounts or ranges of probable losses, and recognize a liability, if any, for these contingencies based on a careful analysis of each matter with the assistance of outside legal counsel and, if applicable, other experts. Such analysis includes making judgments concerning matters such as the costs associated with environmental matters, the outcome of negotiations, the number and cost of pending and future asbestos claims, and the impact of evidentiary requirements. Because most contingencies are resolved over long periods of time, liabilities may change in the future due to new developments (including new discovery of facts, changes in legislation and outcomes of similar cases through the judicial system), changes in assumptions or changes in our settlement strategy. See Note 21, Commitments and Contingencies of Notes to Consolidated and Combined Financial Statements for a discussion of management’s judgment applied in the recognition and measurement of our environmental and asbestos liabilities which represent our most significant contingencies. Asbestos-Related Contingencies and Insurance Recoveries-Honeywell is subject to certain asbestos-related and environmental-related liabilities, primarily related to its legacy Bendix business. In conjunction with the Spin-Off, certain operations that were part of the Bendix business, along with the ownership of the Bendix trademark, as well as certain operations that were part of other legacy elements of the Business, were transferred to us. For periods prior to the Spin-Off, we reflect an estimated liability for resolution of pending and future asbestos-related and environmental liabilities primarily related to the Bendix legacy Honeywell business, calculated as if we were responsible for 100% of the Bendix asbestos-liability payments. We recognized a liability for any asbestos-related contingency that was probable of occurrence and reasonably estimable. In connection with the recognition of liabilities for asbestos-related matters, we recorded asbestos-related insurance recoveries that are deemed probable. Asbestos-related expenses, net of probable insurance recoveries, are presented within Other expense, net in the Consolidated and Combined Statement of Operations. In periods subsequent to the Spin-Off, the accounting for the majority of our asbestos-related liability payments and accounts payable reflect the terms of the Indemnification and Reimbursement Agreement with Honeywell entered into on September 12, 2018, under which we are required to make payments to Honeywell in amounts equal to 90% of Honeywell’s asbestos-related liability payments and accounts payable, primarily related to the Bendix business in the United States, as well as certain environmental-related liability payments and accounts payable and non-United States asbestos-related liability payments and accounts payable, in each case related to legacy elements of the Business, including the legal costs of defending and resolving such liabilities, less 90% of Honeywell’s net insurance receipts and, as may be applicable, certain other recoveries associated with such liabilities. The Indemnification and Reimbursement Agreement provides that the agreement will terminate upon the earlier of (x) December 31, 2048 or (y) December 31st of the third consecutive year during which certain amounts owed to Honeywell during each such year were less than $25 million as converted into Euros in accordance with the terms of the agreement. Warranties and Guarantees-Expected warranty costs for products sold are recognized based on an estimate of the amount that eventually will be required to settle such obligations. These accruals are based on factors such as past experience, length of the warranty and various other considerations. Costs of product recalls, which may include the cost of the product being replaced as well as the customer’s cost of the recall, including labor to remove and replace the recalled part, are accrued as part of our warranty accrual at the time an obligation becomes probable and can be reasonably estimated. These estimates are adjusted from time to time based on facts and circumstances that impact the status of existing claims. See Note 21, Commitments and Contingencies of Notes to Consolidated and Combined Financial Statements included herein for additional information. Pension Benefits-We sponsor defined benefit pension plans covering certain employees, primarily in Switzerland, the US and Ireland. For such plans, we recognize net actuarial gains or losses in excess of 10% of the greater of the fair value of plan assets or the plans’ projected benefit obligation (the corridor) annually in the fourth quarter each year (“MTM Adjustment”), and, if applicable, in any quarter in which an interim remeasurement is triggered. The remaining components of pension expense, primarily service and interest costs and assumed return on plan assets, are recognized on a quarterly basis. On January 1, 2018, we retrospectively adopted the new accounting guidance on presentation of net periodic pension costs. That guidance requires that we disaggregate the service cost component of net benefit costs and report those costs in the same line item or items in the Consolidated Statement of Operations as other compensation costs arising from services rendered by the pertinent employees during the period. The other nonservice components of net benefit costs are required to be presented separately from the service cost component. Following the adoption of this guidance, we continue to record the service cost component of Pension ongoing (income) expense in Costs of goods sold. The remaining components of net benefit costs within Pension ongoing (income) expense, primarily interest costs and assumed return on plan assets, are now recorded in Non-operating (income) expense. We will continue to recognize net actuarial gains or losses in excess of 10% of the greater of the fair value of plan assets or the plans’ projected benefit obligation (the corridor) annually in the fourth quarter of each year (MTM Adjustment). The MTM Adjustment will also be reported in Non-operating (income) expense. The key assumptions used in developing our 2018 net periodic pension (income) expense included the following: The MTM Adjustment represents the recognition of net actuarial gains or losses in excess of 10% of the greater of the fair value of plan assets or the plans’ projected benefit obligation (the corridor). Net actuarial gains and losses occur when the actual experience differs from any of the various assumptions used to value our pension plans or when assumptions change. The primary factors contributing to actuarial gains and losses are changes in the discount rate used to value pension obligations as of the measurement date each year and the difference between expected and actual returns on plan assets. The mark-to-market accounting method results in the potential for volatile and difficult to forecast MTM Adjustments. MTM charges were $0 for our U.S. Plans and $3 million for our non-U.S. Plans for the year ended December 31, 2018. We determine the expected long-term rate of return on plan assets utilizing historical plan asset returns over varying long-term periods combined with our expectations of future market conditions and asset mix considerations (see Note 22 Defined Benefit Pension Plan of Notes to Consolidated and Combined Financial Statements for details on the actual various asset classes and targeted asset allocation percentages for our pension plans). We plan to continue to use an expected rate of return on plan assets of 5.8% for our U.S. Plans and 3.34% for our non-U.S. Plans for 2019 as this is a long-term rate based on historical plan asset returns over varying long-term periods combined with our expectations of future market conditions and the asset mix of the plan’s investments. The discount rate reflects the market rate on December 31 (measurement date) for high-quality fixed-income investments with maturities corresponding to our benefit obligations and is subject to change each year. The discount rate can be volatile from year to year as it is determined based upon prevailing interest rates as of the measurement date. We used a 4.33% discount rate to determine benefit obligations for our U.S. Plans and 1.50% for our non-U.S. Plans as of December 31, 2018. Pension ongoing expense for all of our pension plans is expected to be approximately $2 million in 2019 compared with pension ongoing expense of $2 million in 2018. Also, if required, an MTM Adjustment will be recorded in the fourth quarter of 2019 in accordance with our pension accounting method as previously described. It is difficult to reliably forecast or predict whether there will be an MTM Adjustment in 2019, and if one is required, what the magnitude of such adjustment will be. MTM Adjustments are primarily driven by events and circumstances beyond the control of the Company such as changes in interest rates and the performance of the financial markets. For periods prior to the Spin-off, certain Garrett employees participated in defined benefit pension plans (the “Shared Plans”) sponsored by Honeywell which includes participants of other Honeywell subsidiaries and operations. We account for our participation in the Shared Plans as a multiemployer benefit plan. Accordingly, we do not record an asset or liability to recognize the funded status of the Shared Plans. The related pension expense is based on annual service cost of active Garrett participants and reported within Cost of goods sold in the Consolidated and Combined Statements of Operations. The pension expense specifically identified for the active Garrett participants in the Shared Plans for the years ended December 31, 2018, 2017 and 2016 was $5 million, $7 million and $6 million, respectively. Inventories-Inventories are stated at the lower of cost, determined on a first-in, first-out basis, including direct material costs and direct and indirect manufacturing costs, or net realizable value. Obsolete inventory is identified based on analysis of inventory for known obsolescence issues. The original equipment inventory on hand in excess of one year’s forecasted usage is fully reserved. Goodwill-Goodwill is subject to impairment testing annually as of March 31, and whenever events or changes in circumstances indicate that the carrying amount may not be fully recoverable. This testing compares carrying value to fair value of our single reporting unit. The Company recognizes an impairment charge for the amount by which the carrying value of the reporting unit exceeds the reporting unit´s fair value. However, any impairment should not exceed the amount of goodwill allocated to the reporting unit. We completed our annual goodwill impairment test as of March 31, 2018, as well as an interim impairment test immediately following the Spin-Off and determined that there was no impairment as of these dates. Income Taxes-We account for income taxes pursuant to the asset and liability method which requires us to recognize current tax liabilities or receivables for the amount of taxes we estimate are payable or refundable for the current year and deferred tax assets and liabilities for the expected future tax consequences attributable to temporary differences between the financial statement carrying amounts and their respective tax bases of assets and liabilities and the expected benefits of net operating loss and credit carryforwards. Deferred tax assets and liabilities are measured using enacted tax rates expected to apply to taxable income in the years in which those temporary differences are expected to be recovered or settled. The effect on deferred tax assets and liabilities of a change in tax rates is recognized in operations in the period enacted. A valuation allowance is provided when it is more likely than not that a portion or all of a deferred tax asset will not be realized. The ultimate realization of deferred tax assets is dependent upon the generation of future taxable income and the reversal of deferred tax liabilities during the period in which related temporary differences become deductible. Our pre-Spin-Off activity in the U.S. will be reported in Honeywell’s U.S. consolidated income tax return and certain foreign activity will be reported in Honeywell tax paying entities in those jurisdictions. For periods prior to the Spin-Off, the income tax provision included in the Consolidated and Combined Financial Statements related to domestic and certain foreign operations was calculated on a separate return basis, as if Garrett was a separate taxpayer and the resulting current tax receivable or liability, including any liabilities related to uncertain tax positions, was settled with Honeywell through equity at the time of the Spin-Off. In other foreign taxing jurisdictions, the operations of Garrett were always conducted through discrete legal entities, each of which filed separate tax returns, and all resulting income tax assets and liabilities, including liabilities related to uncertain tax positions, are reflected in the Consolidated and Combined Balance Sheets of Garrett. Other Matters Litigation and Environmental Matters See Note 21, Commitments and Contingencies of Notes to Consolidated and Combined Financial Statements for a discussion of environmental, asbestos and other litigation matters. Recent Accounting Pronouncements See Note 2 Summary of Significant Accounting Policies of Notes to the Consolidated and Combined Financial Statements for a discussion of recent accounting pronouncements.

<s>[INST] The following Management’s Discussion and Analysis of Financial Condition and Results of Operations is intended to help you understand the results of operations and financial condition of Garrett Motion Inc. for the years ended December 31, 2018, 2017 and 2016. Unless the context otherwise requires, references to “Garrett,” “we,” “us,” “our,” and “the Company” refer to (i) Honeywell’s Transportation Systems Business (the “Transportation Systems Business” or the “Business”) prior to our spinoff from Honeywell International Inc. (the “SpinOff”) and (ii) Garrett Motion Inc. and its subsidiaries following the SpinOff, as applicable. Overview and Business Trends Garrett designs, manufactures and sells highly engineered turbocharger and electricboosting technologies for light and commercial vehicle OEMs and the global vehicle and independent aftermarket. These OEMs in turn ship to consumers globally. We are a global technology leader with significant expertise in delivering products across gasoline, diesel and electric (hybrid and fuel cell) powertrains. These products are key enablers for fuel economy and emission standards compliance. Market penetration of vehicles with a turbocharger is expected to increase from approximately 49% in 2018 to approximately 57% by 2022, according to IHS and other industry sources, which we believe will allow our business to grow at a faster rate than overall automobile production. The turbocharger market volume growth was particularly strong in China and other highgrowth regions. The growth trajectory for turbochargers is expected to continue, as the technology is one of the most cost effective solutions for OEMs to address strict constraints for vehicle fuel efficiency and emissions standards. As a result, OEMs are increasing their adoption of turbocharger technologies across gasoline and diesel engines as well as hybridelectric and fuel cell vehicles. In recent years, we have also seen a shift in demand from diesel engines to gasoline engines. In particular, the commercial vehicle OEM market and light vehicle gasoline markets in China and other highgrowth regions have increased due to favorable economic conditions and rising income levels which have led to an increase in automotive and vehicle content demand. While the respective growth rates may potentially decline as the local markets mature, we continue to expect an increase in future vehicle production utilizing turbocharger technologies as vehicle ownership remains well below ownership levels in developed markets. Separation from Honeywell On October 1, 2018, the Company became an independent publiclytraded company through a pro rata distribution by Honeywell of 100% of the thenoutstanding shares of Garrett to Honeywell’s stockholders. Each Honeywell stockholder of record received one share of Garrett common stock for every 10 shares of Honeywell common stock held on the record date. Approximately 74 million shares of Garrett common stock were distributed on October 1, 2018 to Honeywell stockholders. In connection with the separation, Garrett´s common stock began trading “regularway” under the ticker symbol “GTX” on the New York Stock Exchange on October 1, 2018. In connection with the separation, we entered into several agreements with Honeywell that govern the future relationship between us and Honeywell and impose certain obligations on us following the SpinOff and which may cause us to incur new costs, including the following: a Separation and Distribution Agreement; a Transition Services Agreement; an Employee Matters Agreement; an Intellectual Property Agreement; and a Trademark License Agreement. A description of each of these agreements is included in a Current Report on Form 8K filed with the SEC on October 1, 2018. In addition, we entered into an Indemnification and Reimbursement Agreement (the “Indemnification and Reimbursement Agreement”) and a Tax Matters Agreement (the “Tax Matters Agreement”) with Honeywell on September 12, 2018, each of which is described in this MD&A. Basis of Presentation Prior to the SpinOff on October 1, 2018, our historical financial statements [/INST] Negative. </s>

Garrett Motion Inc.

2020-02-27

2019-12-31

Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations The following discussion and analysis of our financial condition and results of operations, which we refer to as our “MD&A,” should be read in conjunction with our Consolidated and Combined Financial Statements and related notes thereto and other financial information appearing elsewhere in this Information Statement. Some of the information contained in this discussion and analysis or set forth elsewhere in this Annual Report on Form 10-K, including information with respect to our plans and strategy for our business, includes forward-looking statements that involve risks and uncertainties. As a result of many important factors, including those set forth in the "Risk Factors" section of this Annual Report on Form 10-K, our actual results could differ materially from the results described in, or implied, by these forward-looking statements. The following Management’s Discussion and Analysis of Financial Condition and Results of Operations is intended to help you understand the results of operations and financial condition of Garrett Motion Inc. for the years ended December 31, 2019, 2018 and 2017. Certain amounts as of and for the year ended December 31, 2018 have been revised to correct for errors that were immaterial to our previously issued Consolidated and Combined Financial Statements for the year ended December 31, 2018 as described in Note 8 -Revision of Previously Issued Financial Statements in Part II, Item 8 of this Form 10-K. Unless the context otherwise requires, references to “Garrett,” “we,” “us,” “our,” and “the Company” refer to (i) Honeywell’s Transportation Systems Business (the “Transportation Systems Business” or the “Business”) prior to our spin-off from Honeywell International Inc. (the “Spin-Off”) and (ii) Garrett Motion Inc. and its subsidiaries following the Spin-Off, as applicable. Overview and Business Trends Garrett designs, manufactures and sells highly engineered turbocharger and electric-boosting technologies for light and commercial vehicle original equipment manufacturers (“OEMs”) and the global vehicle and independent aftermarket. These OEMs in turn ship to consumers globally. We are a global technology leader with significant expertise in delivering products across gasoline, diesel and electric (hybrid and fuel cell) powertrains. These products are key enablers for fuel economy and emission standards compliance. Market penetration of vehicles with a turbocharger is expected to increase from approximately 51% in 2019 to approximately 56% by 2023, according to IHS and other industry sources, which we believe will allow our business to grow at a faster rate than overall automobile production. The turbocharger market volume growth was particularly strong in China and other high-growth regions. The growth trajectory for turbochargers is expected to continue, as the technology is one of the most cost- effective solutions for OEMs to address strict constraints for vehicle fuel efficiency and emissions standards. As a result, OEMs are increasing their adoption of turbocharger technologies across gasoline and diesel engines as well as hybrid-electric and fuel cell vehicles. In recent years, we have also seen a shift in demand from diesel engines to gasoline engines. In particular, the commercial vehicle OEM market and light vehicle gasoline markets in China and other high-growth regions have increased due to favorable economic conditions and rising income levels which have led to an increase in automotive and vehicle content demand. While the respective growth rates may potentially decline as the local markets mature, we continue to expect an increase in future vehicle production utilizing turbocharger technologies as vehicle ownership remains well below ownership levels in developed markets. We are closely monitoring the current novel coronavirus outbreak and its implications for the auto industry both within and outside China. We expect this outbreak to affect the auto industry primarily in 2020. We currently do not expect a long-term impact on industry demand beyond 2021. Separation from Honeywell On October 1, 2018, the Company became an independent publicly-traded company through a pro rata distribution by Honeywell of 100% of the then-outstanding shares of Garrett to Honeywell’s stockholders. Each Honeywell stockholder of record received one share of Garrett common stock for every 10 shares of Honeywell common stock held on the record date. Approximately 74 million shares of Garrett common stock were distributed on October 1, 2018 to Honeywell stockholders. In connection with the separation, Garrett´s common stock began trading “regular-way” under the ticker symbol “GTX” on the New York Stock Exchange on October 1, 2018. In connection with the Spin-Off, we entered into an Indemnification and Reimbursement Agreement (the “Indemnification and Reimbursement Agreement”) and a Tax Matters Agreement (the “Tax Matters Agreement”) with Honeywell on September 12, 2018, each of which is described in this MD&A. In December 2019, we commenced a lawsuit against Honeywell in connection with the Indemnification and Reimbursement Agreement, as described below. Basis of Presentation Prior to the Spin-Off on October 1, 2018, our historical financial statements were prepared on a stand-alone basis and derived from the consolidated financial statements and accounting records of Honeywell. Accordingly, for periods prior to October 1, 2018, our financial statements are presented on a combined basis and for the periods subsequent to October 1, 2018 are presented on a consolidated basis (collectively, the historical financial statements for all periods presented are referred to as “Consolidated and Combined Financial Statements”). The Consolidated and Combined Financial Statements have been prepared in accordance with accounting principles generally accepted in the United States of America (“U.S. GAAP”). The historical consolidated and combined financial information may not be indicative of our future performance and does not necessarily reflect what our consolidated and combined results of operations, financial condition and cash flows would have been had the Business operated as a separate, publicly traded company during the periods presented, particularly because of changes that we have experienced and expect to continue to experience in the future as a result of our separation from Honeywell, including changes in the financing, cash management, operations, cost structure and personnel needs of our business. For periods prior to the Spin-Off, the Consolidated and Combined Financial Statements include certain assets and liabilities that were held at the Honeywell corporate level prior to the Spin-Off but are specifically identifiable or otherwise allocable to the Business. Additionally, Honeywell provided certain services, such as legal, accounting, information technology, human resources and other infrastructure support, on behalf of the Business. The cost of these services has been allocated to the Business on the basis of the proportion of revenues. We consider these allocations to be a reasonable reflection of the benefits received by the Business. Actual costs that would have been incurred if the Business had been a stand-alone company would depend on multiple factors, including organizational structure and strategic decisions made in various areas, including information technology and infrastructure. We consider the basis on which the expenses have been allocated to be a reasonable reflection of the utilization of services provided to or the benefits received by the Business during the periods presented. Subsequent to the completion of the Spin-Off, we have incurred and continue to expect to incur expenditures consisting of employee-related costs, costs to start up certain stand-alone functions and information technology systems, and other one-time transaction related costs. Recurring stand-alone costs include establishing the internal audit, treasury, investor relations, tax and corporate secretary functions as well as the annual expenses associated with running an independent publicly traded company including listing fees, compensation of non-employee directors, related board of director fees and other fees and expenses related to insurance, legal and external audit. Recurring stand- alone costs that differ from historical allocations may have an impact on profitability and operating cash flows but we believe the impact will not be significant. As a stand-alone public company, we do not expect our recurring stand-alone corporate costs to be materially higher than the expenses historically allocated to us from Honeywell. Asbestos-Related and Environmental Liabilities For the periods prior to the Spin-Off, our Consolidated and Combined Financial Statements reflect an estimated liability for resolution of pending and future asbestos-related and environmental liabilities primarily related to the Bendix legacy Honeywell business, calculated as if we were responsible for 100% of the Bendix asbestos-liability payments. However, this recognition model differs from the recognition model applied subsequent to the Spin-Off. In periods subsequent to the Spin-Off, the accounting for the majority of our asbestos-related liability payments and accounts payable reflect the terms of the Indemnification and Reimbursement Agreement with Honeywell entered into on September 12, 2018, under which we are required to make payments to Honeywell in amounts equal to 90% of Honeywell’s asbestos-related liability payments and accounts payable, primarily related to the Bendix business in the United States, as well as certain environmental-related liability payments and accounts payable and non-United States asbestos-related liability payments and accounts payable, in each case related to legacy elements of the Business, including the legal costs of defending and resolving such liabilities, less 90% of Honeywell’s net insurance receipts and, as may be applicable, certain other recoveries associated with such liabilities. The Indemnification and Reimbursement Agreement provides that the agreement will terminate upon the earlier of (x) December 31, 2048 or (y) December 31st of the third consecutive year during which certain amounts owed to Honeywell during each such year were less than $25 million as converted into Euros in accordance with the terms of the agreement. During the year ended December 31, 2019 and in the fourth quarter of 2018, we paid Honeywell the Euro-equivalent of $153 million and $41million, respectively, in connection with the Indemnification and Reimbursement Agreement. Garrett has made all payments under the Indemnification and Reimbursement Agreement under protest, as described below. On October 19, 2018, Honeywell disclosed in its Quarterly Report on Form 10-Q for the quarter ended September 30, 2018 (the “Honeywell Form 10-Q”) that the Division of Enforcement of the Securities and Exchange Commission (the “SEC”) opened an investigation into Honeywell’s prior accounting for liability for unasserted Bendix-related asbestos claims. In addition, Honeywell noted that it revised certain previously-issued financial statements to correct the time period associated with the determination of appropriate accruals for legacy Bendix asbestos-related liability for unasserted claims. As disclosed, in Honeywell’s Current Report on Form 8-K filed on August 28, 2019, the SEC informed Honeywell that it had concluded its investigation and that it does not intend to recommend any enforcement action against Honeywell. On December 2, 2019, we filed a Summons with Notice in the Commercial Division of the Supreme Court of the State of New York, County of New York (“NY Supreme Court”) commencing an action (the “Action”) against Honeywell for declaratory judgment, breach of contract, breach of fiduciary duties, aiding and abetting breach of fiduciary duties, corporate waste, breach of implied covenant of good faith and fair dealing, and unjust enrichment. On January 15, 2020, we filed a Complaint in the NY Supreme Court in connection with the Action. The lawsuit arises from the Indemnification and Reimbursement agreement, which was not negotiated at arm’s - length, and purports to obligate Garrett to compensate Honeywell for payments relating to asbestos exposure arising from Honeywell’s legacy Bendix automotive brake business, including payments relating to punitive damages and defense costs. Our lawsuit seeks to establish that the Indemnification and Reimbursement Agreement is unenforceable in whole or part and that Honeywell has breached its obligations under this agreement by filing to provide us with information as to the underlying claims to which it is entitled. There can be no assurance as to the time and recourses that will be required to pursue these claims or the ultimate outcome of the lawsuit, but we intend to press these claims aggressively. Among other claims, Garrett asserts that Honeywell is not entitled to indemnification because it improperly seeks indemnification for amounts attributable to punitive damages and intentional misconduct, and because it has failed to establish other prerequisites for indemnification under New York law. Specifically, the claim asserts that Honeywell has failed to establish its right to indemnity for each and every asbestos settlement of the thousands for which it seeks indemnification. The Action seeks to establish that the Indemnification and Reimbursement Agreement is not enforceable, in whole or in part. Results of Operations for the Years Ended December 31, 2019, 2018 and 2017 Net Sales The change in net sales compared to the prior year period is attributable to the following: 2019 compared with 2018 Our net sales for 2019 were $3,248 million, a decrease of $127 million or 3.8% (including a negative impact of 4.0% due to foreign currency translation), from $3,375 million in 2018. The decrease in sales was primarily driven by light vehicles OEM products decline of $57 million, commercial vehicles OEM products decline of $39 million, aftermarket products decline of $20 million and other products decline of $10 million. Our light vehicles OEM product decline was primarily driven by lower diesel volumes in Europe and Asia, partially offset by higher gasoline volumes as a result of increased turbocharger penetration in gasoline engines and new product launches. The decrease in net sales for commercial vehicles is mainly driven by lower volumes in Europe and North America. The decrease in aftermarket product sales was primarily driven by a volume decrease in Europe. 2018 compared with 2017 Our net sales for 2018 were $3,375 million, an increase of $279 million, or 9.0% (including a favorable impact of 3.4% due to foreign currency translation), from $3,096 million in 2017, primarily driven by increases in sales volume partially offset by price reductions. The increase in sales volume, net of price reductions, was primarily driven by light vehicles OEM products growth of $220 million, commercial vehicles OEM products growth of $59 million and aftermarket products growth of $8 million. Our light vehicles OEM product growth was primarily driven by increased gasoline volumes in Europe, China, North America, and South Korea, as a result of increased turbocharger penetration in gasoline engines and new product launches. Additionally, there were increased diesel volumes in China and Japan partially offset by lower diesel volumes to our OEM customers in Europe and South Korea. The commercial vehicles OEM product growth was primarily driven by volume increases in North America and Europe. Our slight aftermarket sales increase was primarily driven by higher volumes in Europe partially offset by lower volumes in Japan. Cost of Goods Sold 2019 compared with 2018 Cost of goods sold for 2019 was $2,537 million, a decrease of $62 million or 2.4% from $2,599 million in 2018. The decrease was primarily due to a decrease in direct material costs and labor costs of $113 million primarily due to changes in foreign exchange rates and increases in productivity of $98 million, partially offset by unfavorable impacts from volume and mix of $141 million and other impacts of $8 million. Gross profit percentage decreased primarily due to unfavorable impacts from mix (2.8 percentage points), price (0.9 percentage points) and the unfavorable impacts from inflation (0.7 percentage points), partially offset by the favorable impact of productivity (3.1 percentage points) and the favorable impact of foreign exchange rates (0.2 percentage points). 2018 compared with 2017 Cost of goods sold for 2018 was $2,599 million, an increase of $238 million, or 10.1%, from $2,361 million in 2017. This increase was primarily driven by an increase in direct material costs and labor of $215 million, or 12%, (principally due to an increase in volume). Gross profit percentage decreased primarily due to unfavorable impacts from mix and price (3.1 percentage point impact) and inflation (1 percentage point impact), partially offset by higher productivity (3.0 percentage point impact) and net reductions in repositioning and other costs (0.6 percentage point impact). Selling, General and Administrative Expenses 2019 compared with 2018 Selling, general and administrative expenses were flat for 2019 compared to 2018 leading to an increase in expenses as a percentage of sales. 2018 compared with 2017 Selling, general and administrative expenses were flat for 2018 compared with 2017 leading to a decline in expenses as a percentage of sales. Other Expense, Net 2019 compared with 2018 Other expense, net decreased in 2019 by $80 million compared to 2018. For 2019, Other expense, net of $40 million primarily reflects $28 million of legal fees incurred in connection with the Indemnification and Reimbursement Agreement, $11 million of litigation legal fees in connection with the pending litigation against Honeywell, and $1 million in factoring and notes receivables discount fees. For 2018, Other expense, net of $120 million was primarily driven by asbestos-related charges, net of probable insurance recoveries of $131 million. 2018 compared with 2017 For the periods prior to the Spin-Off, our Consolidated and Combined Financial Statements reflect an estimated liability for resolution of pending and future asbestos-related and environmental liabilities primarily related to the Bendix legacy Honeywell business, calculated as if we were responsible for 100% of the Bendix asbestos-liability payments. For the nine months ended September 30, 2018, compared to the same period in 2017, Other expense, net increased by $3 million due to a $6 million increase in environmental charges, partially offset by a $3 million decrease in asbestos charges. Following the Spin-Off in 2018, the accounting for the majority of our asbestos-related liability payments and accounts payable reflect the terms of the Indemnification and Reimbursement Agreement as described above in the Asbestos-Related and Environmental Liabilities section. During the fourth quarter of 2018, we recognized a $16 million benefit related to a reduction in Honeywell´s long-term estimate of asbestos claims experience, net of legal fees for the quarter, in connection to the Indemnification and Reimbursement Agreement, in comparison to a $1 million environmental charge in the same period of 2017. Interest Expense (Dollars in millions) Interest Expense $ $ $ 2019 compared with 2018 Interest expense in 2019, was $68 million, an increase of $49 million from $19 million in 2018. The increase was primarily driven by interest expense related to our long-term debt. Prior to the Spin-Off, interest expense was primarily related to related party notes from cash pool arrangements with our Former Parent which were settled in cash prior to the Spin-Off. 2018 compared with 2017 Following the Spin-Off, interest expense primarily relates to interest on our long-term debt. Prior to the Spin-Off, interest expense primarily related to related party notes from cash pool arrangements with our Former Parent which were settled in cash prior to the Spin-Off. Interest expense for 2018, was $19 million, an increase of $11 million from $8 million in 2017. This increase was primarily driven by interest expense related to our long-term debt of $17 million partially offset by a decrease in related party notes interest expense of $5 million. See Note 3 Related Party Transactions with Honeywell and Note 16 Long-term Debt and Credit Agreements of Notes to Consolidated and Combined Financial Statements. Non-operating expense (income) (Dollars in millions) Non-operating expense (income) $ $ (8 ) $ (18 ) 2019 compared with 2018 Non-operating expense (income) in 2019 decreased to an expense of $8 million from an income of ($8) million in the prior year period, primarily driven by $6 million of marked to market pension costs and other non-service components of pension costs, $7 million of foreign exchange costs, net of hedging and a $4 million decrease in interest income from bank accounts and marketable securities. 2018 compared with 2017 Non-operating (income) expense for 2018 decreased to income of ($8) million from income of ($18) million in 2017. This decrease was primarily driven by a decrease in interest income from bank accounts and marketable securities of $7 million and an increase in non-service related pension ongoing (income) expense of $3 million. Tax Expense (Benefit) 2019 compared with 2018 The effective tax rate increased by 214.0 percentage points in 2019 compared to 2018. The increase was primarily attributable to the absence of approximately $910 million of non-recurring tax benefits in 2018 because of a reduction in withholding taxes incurred as part of an internal restructuring of Garrett’s business in advance of the Spin-Off. The increase was partially offset by approximately $60 million of tax benefits related to the remeasurement of deferred tax assets and liabilities for tax law changes enacted during 2019, primarily in Switzerland. 2018 compared with 2017 The effective tax rate decreased by 573.1 percentage points in 2018 compared to 2017. The decrease was primarily attributable to the absence of approximately $1,335 million of expense related to the Tax Act incurred during 2017 and approximately $910 million of tax benefits from a reduction of withholding taxes incurred as part of an internal restructuring of Garrett’s business in advance of the Spin-Off. The impacts of the Tax Act during 2017 primarily consisted of a tax charge of $354 million related to the imposition of the one-time mandatory transition tax on the Company’s undistributed foreign earnings (see below for amounts payable to Honeywell) and a $980 million tax charge because of a change in the Company’s intent to no longer permanently reinvest its undistributed foreign earnings outside the US. The $980 million tax charge primarily consisted of withholding taxes on future distributions which were subsequently reduced to approximately $50 million during 2018 primarily in connection with an internal restructuring. Net Income (loss) (Dollars in millions) Net Income (loss) $ $ 1,206 $ (983 ) 2019 compared with 2018 As a result of the factors described above, net income was $313 million in 2019 as compared to net income of $1,206 million in 2018. Net income for 2018 includes an $879 million tax benefit from reduced withholding taxes on undistributed earnings and no interest expense related to our long-term debt raised at the time of the Spin-Off. 2018 compared with 2017 As a result of the factors described above, net income was $1,206 million in 2018 as compared to net loss of $983 million in 2017. Liquidity and Capital Resources We expect that our primary cash requirements in 2020 will primarily be to fund operating activities, working capital, and capital expenditures, and to meet our obligations under the debt instruments and the Indemnification and Reimbursement Agreement described below, as well as the Tax Matters Agreement. In addition, we may engage in repurchases of our debt and equity securities from time to time. We believe we will meet our known or reasonably likely future cash requirements through the combination of cash flows from operating activities, available cash balances and available borrowings through our debt agreements. If these sources of liquidity need to be augmented, additional cash requirements would likely be financed through the issuance of debt or equity securities; however, there can be no assurances that we will be able to obtain additional debt or equity financing on acceptable terms in the future. Based upon our history of generating strong cash flows, we believe we will be able to meet our short-term liquidity needs for at least the next twelve months. Senior Credit Facilities On September 27, 2018, we entered into a Credit Agreement, by and among us, Garrett LX I S.à r.l., Garrett LX II S.à r.l. (“Lux Guarantor”), Garrett LX III S.à r.l. (“Lux Borrower”), Garrett Borrowing LLC (in such capacity, the “US Co-Borrower”), and Honeywell Technologies Sàrl (“Swiss Borrower” and, together with Lux Borrower and US Co-Borrower, the “Borrowers”), the lenders and issuing banks party thereto and JPMorgan Chase Bank, N.A., as administrative agent (the “Credit Agreement”). The Credit Agreement provides for senior secured financing of approximately the Euro equivalent of $1,254 million, consisting of (i) a seven-year senior secured first-lien term B loan facility, which consists of a tranche denominated in Euro of €375 million and a tranche denominated in U.S. Dollars of $425 million (the “Term B Facility”), (ii) five-year senior secured first-lien term A loan facility in an aggregate principal amount of €330 million (the “Term A Facility” and, together with the Term B Facility, the “Term Loan Facilities”) and (iii) a five-year senior secured first-lien revolving credit facility in an aggregate principal amount of €430 million with revolving loans to Swiss Borrower, to be made available in a number of currencies including Australian Dollars, Euros, Pounds Sterling, Swiss Francs, U.S. Dollars and Yen (the “Revolving Facility” and, together with the Term Loan Facilities, the “Senior Credit Facilities”). Each of the Revolving Facility and the Term A Facility matures five years after the effective date of the Credit Agreement, in each case with certain extension rights in the discretion of each lender. The Term B Facility matures seven years after the effective date of the Credit Agreement, with certain extension rights in the discretion of each lender. The Senior Credit Facilities are subject to an interest rate, at our option, of either (a) base rate determined by reference to the highest of (1) the rate of interest last quoted by The Wall Street Journal as the “prime rate” in the United States, (2) the greater of the federal funds effective rate and the overnight bank funding rate, plus 0.5% and (3) the one month adjusted LIBOR rate, plus 1% per annum (“ABR”), (b) an adjusted LIBOR rate (“LIBOR”) (which shall not be less than zero), or (c) an adjusted EURIBOR rate (“EURIBOR”) (which shall not be less than zero), in each case, plus an applicable margin. The applicable margin for the U.S. Dollar tranche of the Term B Facility is currently 2.50% per annum (for LIBOR loans) and 1.50% per annum (for ABR loans) while that for the euro tranche of the Term B Facility is currently 2.75% per annum (for EURIBOR loans). The applicable margin for each of the Term A Facility and the Revolving Credit Facility varies based on our leverage ratio. Accordingly, the interest rates for the Senior Credit Facilities will fluctuate during the term of the Credit Agreement based on changes in the ABR, LIBOR, EURIBOR or future changes in our leverage ratio. Interest payments with respect to the Term Loan Facilities are required either on a quarterly basis (for ABR loans) or at the end of each interest period (for LIBOR and EURIBOR loans) or, if the duration of the applicable interest period exceeds three months, then every three months. We are obligated to make quarterly principal payments throughout the term of the Term Loan Facilities according to the amortization provisions in the Credit Agreement. Borrowings under the Credit Agreement are prepayable at our option without premium or penalty. We may request to extend the maturity date of all or a portion of the Senior Credit Facilities subject to certain conditions customary for financings of this type. The Credit Agreement also contains certain mandatory prepayment provisions in the event that we incur certain types of indebtedness or receive net cash proceeds from certain non-ordinary course asset sales or other dispositions of property, in each case subject to terms and conditions customary for financings of this type. The Credit Agreement contains certain affirmative and negative covenants customary for financings of this type that, among other things, limit our and our subsidiaries’ ability to incur additional indebtedness or liens, to dispose of assets, to make certain fundamental changes, to enter into restrictive agreements, to make certain investments, loans, advances, guarantees and acquisitions, to prepay certain indebtedness and to pay dividends, to make other distributions or redemptions/ repurchases, in respect of the our and our subsidiaries’ equity interests, to engage in transactions with affiliates, amend certain material documents or to permit the International Financial Reporting Standards equity amount of Lux Borrower to decrease below a certain amount. The Credit Agreement also contains financial covenants requiring the maintenance of a consolidated total leverage ratio of not greater than 4.00 to 1.00 (with step-downs to (i) 3.75 to 1.00 in September 2020 and (ii) 3.50 to 1.00 in September 2021), and a consolidated interest coverage ratio of not less than 2.75 to 1.00. We were in compliance with our financial covenants as of December 31, 2019. Senior Notes On September 27, 2018, we completed the offering of €350 million (approximately $410 million based on exchange rates as of September 27, 2018) in aggregate principal amount of 5.125% senior notes due 2026 (the “Senior Notes”). The Senior Notes bear interest at a fixed annual interest rate of 5.125% and mature on October 15, 2026. The Senior Notes were issued pursuant to an Indenture, dated September 27, 2018 (the “Indenture”), which, among other things and subject to certain limitations and exceptions, limits our ability and the ability of our restricted subsidiaries to: (i) incur, assume or guarantee additional indebtedness or issue certain disqualified equity interests and preferred shares, (ii) pay dividends or distributions on, or redeem or repurchase, capital stock and make other restricted payments, (iii) make investments, (iv) consummate certain asset sales or transfers, (v) engage in certain transactions with affiliates, (vi) grant or assume certain liens on assets to secure debt unless the notes are secured equally and ratably (vii) restrict dividends and other payments by certain of their subsidiaries and (vii) consolidate, merge, sell or otherwise dispose of all or substantially all of our or our restricted subsidiaries’ assets. Indemnification and Reimbursement Agreement On September 12, 2018, we entered into the Indemnification and Reimbursement Agreement, under which we are required to make certain payments to Honeywell in amounts equal to 90% of Honeywell’s asbestos-related liability payments and accounts payable, primarily related to the Bendix business in the United States, as well as certain environmental-related liability payments and accounts payable and non-United States asbestos-related liability payments and accounts payable, in each case related to legacy elements of the Business, including the legal costs of defending and resolving such liabilities, less 90% of Honeywell’s net insurance receipts and, as may be applicable, certain other recoveries associated with such liabilities. Pursuant to the terms of the Indemnification and Reimbursement Agreement, we are responsible for paying to Honeywell such amounts, up to a cap equal to the Distribution Date Currency Exchange Rate (1.16977 USD = 1 EUR) equivalent of $175 million (exclusive of any late payment fees) in respect of such liabilities arising in any given calendar year. This Indemnification and Reimbursement Agreement may have material adverse effects on our liquidity and cash flows and on our results of operations, regardless of whether we experience a decline in net sales. See “We are subject to risks associated with the Indemnification and Reimbursement Agreement, pursuant to which we are required to make substantial cash payments to Honeywell, measured in substantial part by reference to estimates by Honeywell of certain of its liabilities.” The payments that we are required to make to Honeywell pursuant to the terms of the Indemnification and Reimbursement Agreement will not be deductible for U.S. federal income tax purposes. The Indemnification and Reimbursement Agreement provides that the agreement will terminate upon the earlier of (x) December 31, 2048 or (y) December 31st of the third consecutive year during which certain amounts owed to Honeywell during each such year were less than $25 million as converted into Euros in accordance with the terms of the agreement. During the year ended December 31, 2019 and in the fourth quarter of 2018, we paid Honeywell, under protest, the Euro-equivalent of $153 million and $41 million, respectively, in connection with the Indemnification and Reimbursement Agreement. Based on information received related to indemnifiable payments made by Honeywell, we estimate that the 2019 payment includes approximately $34 million of overpayments which, if confirmed by Honeywell in the Prior Year Aggregate Loss Statement (as defined in the Indemnification and Reimbursement Agreement), will be deducted from the indemnity payment for the second quarter of 2020 in accordance with the Indemnification and Reimbursement Agreement. We are currently engaged in litigation against Honeywell in connection with the Indemnification and Reimbursement Agreement. For additional information, see Part I, Item 3. Legal Proceedings. Tax Matters Agreement On September 12, 2018, we entered into a Tax Matters Agreement with Honeywell. The Tax Matters Agreement governs the respective rights, responsibilities and obligations of Honeywell and us after the Spin-Off with respect to all tax matters (including tax liabilities, tax attributes, tax returns and tax contests). The Tax Matters Agreement generally provides that we are responsible and will indemnify Honeywell for all taxes, including income taxes, sales taxes, VAT and payroll taxes, relating to Garrett for all periods, including periods prior to the completion date of the Spin-Off. Among other items, as a result of the mandatory transition tax imposed by the Tax Cuts and Jobs Act, one of our subsidiaries is required to make payments to a subsidiary of Honeywell in the amount representing the net tax liability of Honeywell under the mandatory transition tax attributable to us, as determined by Honeywell. We estimate that our total aggregate payments to Honeywell with respect to the mandatory transition tax will be $240 million with $193 million in payments remaining as of December 31, 2019. Under the terms of the Tax Matters Agreement, we are required to pay this amount in Euros, without interest, in five annual installments, each equal to 8% of the aggregate amount, followed by three additional annual installments equal to 15%, 20% and 25% of the aggregate amount, respectively. In connection with this agreement, we paid Honeywell the Euro-equivalent of $18 million and $19 million during the year ended December 31, 2019 and the fourth quarter of 2018, respectively. In addition, the Tax Matters Agreement addresses the allocation of liability for taxes incurred as a result of restructuring activities undertaken to effectuate the Spin-Off. The Tax Matters Agreement also provides that we are required to indemnify Honeywell for certain taxes (and reasonable expenses) resulting from the failure of the Spin-Off and related internal transactions to qualify for their intended tax treatment under U.S. federal, state and local income tax law, as well as foreign tax law. The Tax Matters Agreement also imposes certain restrictions on us and our subsidiaries (including restrictions on share issuances, redemptions or repurchases, business combinations, sales of assets and similar transactions) that are designed to address compliance with Section 355 of the Internal Revenue Code of 1986, as amended, and are intended to preserve the tax-free nature of the Spin-Off. Cash Flow Summary for the Years Ended December 31, 2019, 2018 and 2017 Our cash flows from operating, investing and financing activities for the years ended December 31, 2019, 2018 and 2017, as reflected in the audited Consolidated and Combined Financial Statements included elsewhere in this Form 10-K, are summarized as follows: 2019 compared with 2018 Cash provided by operating activities decreased by $131 million for 2019 in comparison to 2018, primarily due to a a decrease in Obligations to Honeywell of $67 million, higher cash interest payments of $46 million, a decrease in net income, net of deferred taxes of $3 million and a decrease of $39 million in other items (accrued liabilities and other assets), partially offset by a favorable impact from working capital of $24 million. Cash provided by investing activities decreased by $278 million in 2019 compared to 2018, primarily due to unfavorable net cash impacts from marketable securities investments activities year over year of $291 million and unfavorable impact from Expenditures for property, plant and equipment of $7 million, partially offset by a favorable impact from the cash settlement received on the re-couponing of our cross currency swap contract of $19 million. Cash used for financing activities decreased by $495 million in 2019, as compared to 2018. The change was driven by payments for related party notes payable of $493 million, net changes to cash pooling and short-term notes of $300 million and the net decrease in invested deficit of $1,493 million during 2018 that did not recur during 2019. This was partially offset by the $1,631 million of proceeds from issuance of long-term debt during 2018 that did not recur during 2019 and payments of long-term debt during 2019 of $163 million, as compared to $6 million during 2018. 2018 compared with 2017 Cash provided by operating activities increased by $302 million for 2018 in comparison to 2017, primarily due to a decrease in cash taxes paid of $354 million and favorable impacts from working capital of $35 million partially offset by an unfavorable impact from changes in Payables to related parties of $82 million. Cash provided by investing activities increased by $162 million for 2018 in comparison to 2017, primarily due to favorable net cash impacts from marketable securities investment activities year over year of $230 million, partially offset by a decrease in proceeds from related party notes receivables of $66 million. Cash used for financing activities increased by $718 million for 2018 in comparison to 2017 primarily due to a decrease in proceeds from related party notes payable year over year of $671 million. Additionally, there was $1,631 million in proceeds from issuance of long-term debt in 2018 partially offset by unfavorable impacts from changes in Invested deficit period over period of $1,474 million. Contractual Obligations and Probable Liability Payments The following is a summary of our significant contractual obligations and probable liability payments at December 31, 2019: (1) Excludes legal fees which are expensed as incurred. For additional information, refer to “-Liquidity and Capital Resources-Indemnification and Reimbursement Agreement” section. (2) Excludes the indemnification obligation for uncertain tax positions for which timing of payment is uncertain. For additional information, refer to “-Liquidity and Capital Resources-Tax Matters Agreement” section. (3) Assumes all long-term debt is outstanding until scheduled maturity. Does not include expected utilization of our revolving credit facility. (4) Interest payments are estimated based on the interest rates applicable as of December 31, 2019. This includes the impact of the cross currency interest rate swap and the interest rate swaps. This does not include the expected utilization of our revolving credit facility. (5) Purchase obligations are entered into with various vendors in the normal course of business and are consistent with our expected requirements. Capital Expenditures We believe our capital spending in recent years has been sufficient to maintain efficient production capacity, to implement important product and process redesigns and to expand capacity to meet increased demand. Productivity projects have freed up capacity in our manufacturing facilities and are expected to continue to do so. We expect to continue investing to expand and modernize our existing facilities and invest in our facilities to create capacity for new product development. Off-Balance Sheet Arrangements We do not engage in any off-balance sheet financial arrangements that have or are reasonably likely to have a material current or future effect on our financial condition, changes in financial condition, revenues or expenses, results of operations, liquidity, capital expenditures or capital resources. Critical Accounting Policies The preparation of our Consolidated and Combined Financial Statements in accordance with generally accepted accounting principles is based on the selection and application of accounting policies that require us to make significant estimates and assumptions about the effects of matters that are inherently uncertain. We consider the accounting policies discussed below to be critical to the understanding of our financial statements. Actual results could differ from our estimates and assumptions, and any such differences could be material to our Consolidated and Combined Financial Statements. Contingent Liabilities-We are subject to lawsuits, investigations and claims that arise out of the conduct of our global business operations or those of previously owned entities, including matters relating to commercial transactions, government contracts, product liability (including asbestos), prior acquisitions and divestitures, employee benefit plans, intellectual property, legal and environmental, health and safety matters. We continually assess the likelihood of any adverse judgments or outcomes to our contingencies, as well as potential amounts or ranges of probable losses, and recognize a liability, if any, for these contingencies based on a careful analysis of each matter with the assistance of outside legal counsel and, if applicable, other experts. Such analysis includes making judgments concerning matters such as the costs associated with environmental matters, the outcome of negotiations, the number and cost of pending and future asbestos claims, and the impact of evidentiary requirements. Because most contingencies are resolved over long periods of time, liabilities may change in the future due to new developments (including new discovery of facts, changes in legislation and outcomes of similar cases through the judicial system), changes in assumptions or changes in our settlement strategy. See Note 23, Commitments and Contingencies of Notes to Consolidated and Combined Financial Statements for a discussion of management’s judgment applied in the recognition and measurement of our environmental and asbestos liabilities which represent our most significant contingencies. Asbestos-Related Contingencies and Insurance Recoveries-Honeywell is subject to certain asbestos-related and environmental-related liabilities, primarily related to its legacy Bendix business. In conjunction with the Spin-Off, certain operations that were part of the Bendix business, along with the ownership of the Bendix trademark, as well as certain operations that were part of other legacy elements of the Business, were transferred to us. For periods prior to the Spin-Off, we reflect an estimated liability for resolution of pending and future asbestos-related and environmental liabilities primarily related to the Bendix legacy Honeywell business, calculated as if we were responsible for 100% of the Bendix asbestos-liability payments. We recognized a liability for any asbestos-related contingency that was probable of occurrence and reasonably estimable. In connection with the recognition of liabilities for asbestos-related matters, we recorded asbestos-related insurance recoveries that are deemed probable. Asbestos-related expenses, net of probable insurance recoveries, are presented within Other expense, net in the Consolidated and Combined Statement of Operations. In periods subsequent to the Spin-Off, the accounting for the majority of our asbestos-related liability payments and accounts payable reflect the terms of the Indemnification and Reimbursement Agreement with Honeywell entered into on September 12, 2018, under which we are required to make payments to Honeywell in amounts equal to 90% of Honeywell’s asbestos-related liability payments and accounts payable, primarily related to the Bendix business in the United States, as well as certain environmental-related liability payments and accounts payable and non-United States asbestos-related liability payments and accounts payable, in each case related to legacy elements of the Business, including the legal costs of defending and resolving such liabilities, less 90% of Honeywell’s net insurance receipts and, as may be applicable, certain other recoveries associated with such liabilities. The Indemnification and Reimbursement Agreement provides that the agreement will terminate upon the earlier of (x) December 31, 2048 or (y) December 31st of the third consecutive year during which certain amounts owed to Honeywell during each such year were less than $25 million as converted into Euros in accordance with the terms of the agreement. We are currently engaged in litigation against Honeywell in connection with the Indemnification and Reimbursement Agreement. For additional information, see Item 3. Legal Proceedings. Warranties and Guarantees-Expected warranty costs for products sold are recognized based on an estimate of the amount that eventually will be required to settle such obligations. These accruals are based on factors such as past experience, length of the warranty and various other considerations. Costs of product recalls, which may include the cost of the product being replaced as well as the customer’s cost of the recall, including labor to remove and replace the recalled part, are accrued as part of our warranty accrual at the time an obligation becomes probable and can be reasonably estimated. These estimates are adjusted from time to time based on facts and circumstances that impact the status of existing claims. See Note 23, Commitments and Contingencies of Notes to Consolidated and Combined Financial Statements included herein for additional information. Pension Benefits-We sponsor defined benefit pension plans covering certain employees, primarily in Switzerland, the U.S. and Ireland. For such plans, we are required to disaggregate the service cost component of net benefit costs and report those costs in the same line item or items in the Consolidated and Combined Statements of Operations as other compensation costs arising from services rendered by the pertinent employees during the period. The other nonservice components of net benefit costs are required to be presented separately from the service cost component. We record the service cost component of Pension ongoing (income) expense in Cost of goods sold or Selling, general and administrative expenses. The remaining components of net benefit costs within Pension ongoing (income) expense, primarily interest costs and assumed return on plan assets, are recorded in Non-operating expense (income). We recognize net actuarial gains or losses in excess of 10% of the greater of the fair value of plan assets or the plans’ projected benefit obligation (the corridor) annually in the fourth quarter each year (“MTM Adjustment”). The MTM Adjustment is recorded in Non-operating expense (income). The key assumptions used in developing our 2019 net periodic pension (income) expense included the following: The MTM Adjustment represents the recognition of net actuarial gains or losses in excess of 10% of the greater of the fair value of plan assets or the plans’ projected benefit obligation (the corridor). Net actuarial gains and losses occur when the actual experience differs from any of the various assumptions used to value our pension plans or when assumptions change. The primary factors contributing to actuarial gains and losses are changes in the discount rate used to value pension obligations as of the measurement date each year and the difference between expected and actual returns on plan assets. The mark-to-market accounting method results in the potential for volatile and difficult to forecast MTM Adjustments. MTM charges were $0 for our U.S. Plans and $13 million for our non-U.S. Plans for the year ended December 31, 2019. We determine the expected long-term rate of return on plan assets utilizing historical plan asset returns over varying long-term periods combined with our expectations of future market conditions and asset mix considerations (see Note 24 Defined Benefit Pension Plan of Notes to Consolidated and Combined Financial Statements for details on the actual various asset classes and targeted asset allocation percentages for our pension plans). We plan to use an expected rate of return on plan assets of 5.49% for our U.S. Plans and 3.79% for our non-U.S. Plans for 2020 as this is a long-term rate based on historical plan asset returns over varying long-term periods combined with our expectations of future market conditions and the asset mix of the plan’s investments. The discount rate reflects the market rate on December 31 (measurement date) for high-quality fixed-income investments with maturities corresponding to our benefit obligations and is subject to change each year. The discount rate can be volatile from year to year as it is determined based upon prevailing interest rates as of the measurement date. We used a 3.30% discount rate to determine benefit obligations for our U.S. Plans and 0.79% for our non-U.S. Plans as of December 31, 2019. Pension ongoing expense for all of our pension plans is expected to be $1 million in 2020 compared with pension ongoing expense of $2 million in 2019. Also, if required, an MTM Adjustment will be recorded in the fourth quarter of 2020 in accordance with our pension accounting method as previously described. It is difficult to reliably forecast or predict whether there will be an MTM Adjustment in 2020, and if one is required, what the magnitude of such adjustment will be. MTM Adjustments are primarily driven by events and circumstances beyond the control of the Company such as changes in interest rates and the performance of the financial markets. For periods prior to the Spin-off, certain Garrett employees participated in defined benefit pension plans (the “Shared Plans”) sponsored by Honeywell which includes participants of other Honeywell subsidiaries and operations. We account for our participation in the Shared Plans as a multiemployer benefit plan. Accordingly, we do not record an asset or liability to recognize the funded status of the Shared Plans. The related pension expense is based on annual service cost of active Garrett participants and reported within Cost of goods sold in the Consolidated and Combined Statements of Operations. The pension expense specifically identified for the active Garrett participants in the Shared Plans for the years ended December 31, 2018 and 2017 was $5 million and $7 million, respectively. Income Taxes-We account for income taxes pursuant to the asset and liability method which requires us to recognize current tax liabilities or receivables for the amount of taxes we estimate are payable or refundable for the current year and deferred tax assets and liabilities for the expected future tax consequences attributable to temporary differences between the financial statement carrying amounts and their respective tax bases of assets and liabilities and the expected benefits of net operating loss and credit carryforwards. Deferred tax assets and liabilities are measured using enacted tax rates expected to apply to taxable income in the years in which those temporary differences are expected to be recovered or settled. The effect on deferred tax assets and liabilities of a change in tax rates is recognized in operations in the period enacted. A valuation allowance is provided when it is more likely than not that a portion or all of a deferred tax asset will not be realized. The ultimate realization of deferred tax assets is dependent upon the generation of future taxable income and the reversal of deferred tax liabilities during the period in which related temporary differences become deductible. Our pre-Spin-Off activity in the U.S. will be reported in Honeywell’s U.S. consolidated income tax return and certain foreign activity will be reported in Honeywell tax paying entities in those jurisdictions. For periods prior to the Spin-Off, the income tax provision included in the Consolidated and Combined Financial Statements related to domestic and certain foreign operations was calculated on a separate return basis, as if Garrett was a separate taxpayer and the resulting current tax receivable or liability, including any liabilities related to uncertain tax positions, was settled with Honeywell through equity at the time of the Spin-Off. In other foreign taxing jurisdictions, the operations of Garrett were always conducted through discrete legal entities, each of which filed separate tax returns, and all resulting income tax assets and liabilities, including liabilities related to uncertain tax positions, are reflected in the Consolidated and Combined Balance Sheets of Garrett. Other Matters Litigation and Environmental Matters See Note 23. Commitments and Contingencies of Notes to Consolidated and Combined Financial Statements for a discussion of environmental, asbestos and other litigation matters. Recent Accounting Pronouncements See Note 2. Summary of Significant Accounting Policies of Notes to the Consolidated and Combined Financial Statements for a discussion of recent accounting pronouncements.

<s>[INST] The following Management’s Discussion and Analysis of Financial Condition and Results of Operations is intended to help you understand the results of operations and financial condition of Garrett Motion Inc. for the years ended December 31, 2019, 2018 and 2017. Certain amounts as of and for the year ended December 31, 2018 have been revised to correct for errors that were immaterial to our previously issued Consolidated and Combined Financial Statements for the year ended December 31, 2018 as described in Note 8 Revision of Previously Issued Financial Statements in Part II, Item 8 of this Form 10K. Unless the context otherwise requires, references to “Garrett,” “we,” “us,” “our,” and “the Company” refer to (i) Honeywell’s Transportation Systems Business (the “Transportation Systems Business” or the “Business”) prior to our spinoff from Honeywell International Inc. (the “SpinOff”) and (ii) Garrett Motion Inc. and its subsidiaries following the SpinOff, as applicable. Overview and Business Trends Garrett designs, manufactures and sells highly engineered turbocharger and electricboosting technologies for light and commercial vehicle original equipment manufacturers (“OEMs”) and the global vehicle and independent aftermarket. These OEMs in turn ship to consumers globally. We are a global technology leader with significant expertise in delivering products across gasoline, diesel and electric (hybrid and fuel cell) powertrains. These products are key enablers for fuel economy and emission standards compliance. Market penetration of vehicles with a turbocharger is expected to increase from approximately 51% in 2019 to approximately 56% by 2023, according to IHS and other industry sources, which we believe will allow our business to grow at a faster rate than overall automobile production. The turbocharger market volume growth was particularly strong in China and other highgrowth regions. The growth trajectory for turbochargers is expected to continue, as the technology is one of the most cost effective solutions for OEMs to address strict constraints for vehicle fuel efficiency and emissions standards. As a result, OEMs are increasing their adoption of turbocharger technologies across gasoline and diesel engines as well as hybridelectric and fuel cell vehicles. In recent years, we have also seen a shift in demand from diesel engines to gasoline engines. In particular, the commercial vehicle OEM market and light vehicle gasoline markets in China and other highgrowth regions have increased due to favorable economic conditions and rising income levels which have led to an increase in automotive and vehicle content demand. While the respective growth rates may potentially decline as the local markets mature, we continue to expect an increase in future vehicle production utilizing turbocharger technologies as vehicle ownership remains well below ownership levels in developed markets. We are closely monitoring the current novel coronavirus outbreak and its implications for the auto industry both within and outside China. We expect this outbreak to affect the auto industry primarily in 2020. We currently do not expect a longterm impact on industry demand beyond 2021. Separation from Honeywell On October 1, 2018, the Company became an independent publiclytraded company through a pro rata distribution by Honeywell of 100% of the thenoutstanding shares of Garrett to Honeywell’s stockholders. Each Honeywell stockholder of record received one share of Garrett common stock for every 10 shares of Honeywell common stock held on the record date. Approximately 74 million shares of Garrett common stock were distributed on October 1, 2018 to Honeywell stockholders. In connection with the separation, Garrett´s common stock began trading “regularway” under the ticker symbol “GTX” on the New York Stock Exchange on October 1, 2018. In connection with the SpinOff, we entered into an Indemnification and Reimbursement Agreement (the “Indemnification and Reimbursement Agreement”) and a Tax Matters Agreement (the “Tax Matters Agreement”) with Honeywell on September 12, 2018, each of which is described in this MD&A. [/INST] Positive. </s>

Spirit MTA REIT

2019-03-22

2018-12-31

Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations The following discussion relates to our consolidated financial statements and should be read in conjunction with the consolidated financial statements and notes thereto appearing elsewhere in this Annual Report on Form 10-K. Statements contained in Item 7. “Management’s Discussion and Analysis of Financial Condition and Results of Operations”, and elsewhere in this report, that are not historical facts may be forward-looking statements. Such statements are subject to certain risks and uncertainties, which could cause actual results to differ materially. Some of the financial and other information presented is forward-looking in nature, including information concerning projected future occupancy rates, rental rate increases, property development timing and investment amounts. Although the information is based on our current expectations, actual results could vary from expectations stated in this report. Numerous factors will affect our actual results, some of which are beyond our control. These include the breadth and duration of the current economic environment and its impact on our tenants, particularly Shopko, which filed for bankruptcy protection and recently announced that it intends to liquidate its operations, the strength of commercial and industrial real estate markets, market conditions affecting tenants, competitive market conditions, interest rate levels, volatility in our share price, capital markets conditions and our ability to execute on our strategic plans. You are cautioned not to place undue reliance on this information, which speaks only as of the date of this report. We assume no obligation to update publicly any forward-looking information, whether as a result of new information, future events, or otherwise, except to the extent required by law. For a discussion of important risks related to our business, financial condition and results of operations and related to investing in our securities, including risks that could cause actual results and events to differ materially from results and events referred to in the forward-looking information, see Item 1A. and Item 7. - "Liquidity and Capital Resources.” OVERVIEW SMTA was formed for the purpose of receiving, via contribution from Spirit, the legal entities which held (i) Master Trust 2014, an asset-backed securitization trust which issues non-recourse asset-back securities collateralized by commercial real estate, net-leases and mortgage loans, (ii) all of Spirit's properties leased to Shopko, (iii) a single distribution center property leased to a sporting goods tenant encumbered with CMBS debt, and (iv) a portfolio of unencumbered properties, as well as a $35.0 million B-1 Term Loan with Shopko as borrower, and a cash contribution of $3.0 million. The activities of the newly formed legal entities are not reflected in the accompanying financial statements balances or results of operations prior to May 31, 2018, but the ten additional properties, the B-1 Term Loan and cash are reflected as contributions as of their respective legal dates of transfer. On May 31, 2018, the distribution date, Spirit completed the Spin-Off of SMTA. On the distribution date, Spirit distributed on a pro rata basis one SMTA common share for every ten shares of Spirit common stock held by each of Spirit's stockholders as of May 18, 2018, the record date. As a result, 42,851,010 shares of SMTA common were issued on May 31, 2018. In conjunction with the Spin-Off, we and our Manager, a wholly-owned subsidiary of Spirit, entered into an Asset Management Agreement under which our Manager provides various services including, but not limited to: active portfolio management (including underwriting and risk management), financial reporting, and SEC compliance. The fees for these services are a flat rate of $20 million per annum. Additionally, Spirit Realty, L.P. continues as the property manager and special servicer of Master Trust 2014, under which Spirit Realty, L.P. receives property management fees which accrue daily at 0.25% per annum of the collateral value of the Master Trust 2014 Collateral Pool less any specially serviced assets, and special servicing fees which accrue daily at 0.75% per annum of the collateral value of any assets deemed to be specially serviced per the terms of the Property Management and Servicing Agreement. SMTA and Spirit also entered into a Separation and Distribution Agreement, an Insurance-Sharing Agreement, a Tax Matters Agreement, and a Registration Rights Agreement in connection with the Spin-Off. SMTA expects to operate in a manner intended to enable it to qualify as a REIT under the applicable provisions of the Internal Revenue Code of 1986, as amended. To maintain REIT status, SMTA must meet a number of organizational and operational requirements, including a requirement to distribute annually to shareholders at least 90% of SMTA’s REIT taxable income, determined without regard to the dividends paid deduction and excluding any net capital gains. Management believes the Company has qualified and will continue to qualify as a REIT and therefore, no provision has been made for federal income taxes for the period presented subsequent to the Spin-Off. For the period presented prior to the Spin-Off, the Company was disregarded for federal income tax purposes, so no provision for federal income tax was made. SMTA is subject to certain other taxes, including state taxes, which have been reflected as income tax expense in the consolidated statements of operations and comprehensive income (loss). The accompanying financial statements include the consolidated accounts of the Company and its wholly-owned subsidiaries for the period subsequent to the Spin-Off on May 31, 2018. The pre-spin financial statements were prepared on a carve-out basis and reflect the combined net assets and operations of the predecessor legal entities which formed the Company at the time of the Spin-Off. GAAP requires us to make estimates and assumptions that affect the reported amounts of assets and liabilities, and revenues and expenses during the reporting periods. Actual results could differ from these estimates. The historical financial results prior to the Spin-Off include allocated expenses for certain corporate costs which we believe are reasonable. These expenses were based on either actual costs incurred or a proportion of costs estimated to be allocable to SMTA based on the relative property count of the Company to those owned by Spirit as a whole. Such costs do not necessarily reflect what the actual costs would have been if SMTA had been operating as a separate standalone public company. These expenses are discussed further in Note 11 of the accompanying financial statements. Recent Developments Shopko Bankruptcy Filing On January 16, 2019, Shopko, the Company's largest tenant, filed for relief under the Bankruptcy Code. As of December 31, 2018, we received $42.1 million in annualized Contractual Rent from Shopko, which represented 17.9% of our total annualized Contractual Rent. On January 16, 2019, our indirect wholly-owned subsidiaries as borrowers under the Shopko CMBS Loan Agreements defaulted on the loans when those entities ceased to make interest payments as a result of Shopko ceasing to pay its rent obligations following its bankruptcy filing. The full outstanding principal amount of $157.4 million outstanding under the Shopko CMBS Loan Agreements immediately became due and payable, and interest is accruing at the default rate of LIBOR plus 12.5% on the original loan portion and LIBOR plus 18.0% on the mezzanine loan portion. On March 1, 2019, the Shopko Lenders foreclosed on the equity of the entity that owns the four property-owning subsidiaries. We also hold the Shopko B-1 Term Loan, with principal outstanding of $34.4 million as of December 31, 2018. While the outcome of the Shopko bankruptcy filing is uncertain and there can be no assurances that we will recover any amounts due to us under the Shopko B-1 Term Loan, we intend to pursue all of our rights and remedies in connection with the bankruptcy proceedings, with the goal of maximizing the receipt of amounts due to us under the the Shopko B-1 Term loan. As a consequence of the bankruptcy filing and the subsequent foreclosure by the Shopko Lenders on the equity of the entity that indirectly holds the majority of our Shopko assets, we do not expect to receive any additional cash flow going forward from any of the assets leased to Shopko, nor bear further meaningful expenses related to those assets. On March 18, 2019, Shopko announced that it would seek to liquidate its operations. On January 16, 2019, in connection with the Shopko bankruptcy filing, the Company announced that its Board of Trustees had elected to accelerate its strategic plan by engaging advisors to explore strategic alternatives focused on maximizing shareholder value. Strategic alternatives to be considered may include, but are not limited to, a sale of the Company or Master Trust 2014, a merger, the sale of other assets, and the maximizing of recoveries in connection with the Shopko bankruptcy. The Company has not set a timetable for completion of the execution of any portion of this strategic plan, and there can be no assurance that the exploration of strategic alternatives will result in any transaction or other alternative. Common Dividend Declared On March 5, 2019, the Board of Trustees declared a special cash dividend of $0.33 per common share for the first quarter ended March 31, 2019. The dividend will be paid on April 15, 2019 to holders of record as of March 29, 2019. CRITICAL ACCOUNTING POLICIES AND ESTIMATES Our accounting policies are determined in accordance with GAAP. The preparation of our financial statements requires us to make estimates and assumptions that are subjective in nature and, as a result, our actual results could differ materially from our estimates. Estimates and assumptions include, among other things, subjective judgments regarding the fair values and useful lives of our properties for depreciation and lease classification purposes, the collectability of receivables and asset impairment analysis. Set forth below are the more critical accounting policies that require management judgment and estimates in the preparation of our consolidated financial statements. See Notes 2 and 8 to the consolidated financial statements for further details. Purchase Accounting and Acquisition of Real Estate; Lease Intangibles We use a number of sources to estimate fair value of real estate acquisitions, including building age, building location, building condition, rent comparables from similar properties, and terms of in-place leases, if any. Lease intangibles, if any, acquired in conjunction with the purchase of real estate represent the value of in-place leases and above or below-market leases. In-place lease intangibles are valued based on our estimates of costs related to tenant acquisition and the carrying costs that would be incurred during the time it would take to locate a tenant if the property were vacant, considering current market conditions and costs to execute similar leases at the time of the acquisition. We then allocate the purchase price (including acquisition and closing costs) to land, building, improvements and equipment based on their relative fair values. For properties acquired with in-place leases, we allocate the purchase price of real estate to the tangible and intangible assets and liabilities acquired based on their estimated fair values. Above and below-market lease intangibles are recorded based on the present value of the difference between the contractual amounts to be paid pursuant to the leases at the time of acquisition of the real estate and our estimate of current market lease rates for the property, measured over a period equal to the remaining initial term of the lease. Impairment We review our real estate investments and related lease intangibles periodically for indicators of impairment, including the asset being held for sale, vacant or non-operating, tenant bankruptcy or delinquency, and leases expiring in 60 days or less. For assets with indicators of impairment, we then evaluate if its carrying amount may not be recoverable. We consider factors such as expected future undiscounted cash flows, estimated residual value, market trends (such as the effects of leasing demand and competition) and other factors in making this assessment. An asset is considered impaired if its carrying value exceeds its estimated undiscounted cash flows. Impairment is then calculated as the amount by which the carrying value exceeds the estimated fair value, or for assets held for sale, as the amount by which the carrying value exceeds fair value less costs to sell. Estimating future cash flows and fair values is highly subjective and such estimates could differ materially from actual results. Key assumptions used in estimating future cash flows and fair values include, but are not limited to, revenue growth rates, interest rates, discount rates, capitalization rates, lease renewal probabilities, tenant vacancy rates and other factors. Impairment and Allowance for Loan Losses We periodically evaluate the collectability of our loans receivable, including accrued interest, by analyzing the underlying property-level economics and trends, collateral value and quality, and other relevant factors in determining the adequacy of its allowance for loan losses. A loan is determined to be impaired when, in management’s judgment based on current information and events, it is probable that we will be unable to collect all amounts due according to the contractual terms of the loan agreement. Specific allowances for loan losses are provided for impaired loans on an individual loan basis in the amount by which the carrying value exceeds the estimated fair value of the underlying collateral less disposition costs. Delinquent loans receivable are written off against the allowance when all possible means of collection have been exhausted. A loan is placed on non-accrual status when the loan has become 60 days past due, or earlier if management determines that full recovery of the contractually specified payments of principal and interest is doubtful. While on non-accrual status, interest income is recognized only when received. REIT Status We will elect to be taxed as a REIT for federal income tax purposes commencing with our taxable year ended December 31, 2018. We believe that we have been organized and have operated in a manner that has allowed us to qualify as a REIT commencing with such taxable year. To maintain our REIT status, we are required to annually distribute to our shareholders at least 90% of our REIT taxable income, determined without regard to the dividends paid deduction and excluding any net capital gain, and meet the various other requirements imposed by the Code relating to such matters as operating results, asset holdings, distribution levels and diversity of share ownership. Provided that we qualify for taxation as a REIT, we are generally not subject to corporate level federal income tax on the earnings distributed to our shareholders that we derive from our REIT qualifying activities. We are still subject to state and local income and franchise taxes and to federal income and excise tax on our undistributed income. If we fail to qualify as a REIT in any taxable year, or we elect not to maintain our REIT status, and are unable to avail ourselves of certain savings provisions set forth in the Code, all of our taxable income would be subject to federal income tax at regular corporate rates. Unless entitled to relief under specific statutory provisions, we would be ineligible to elect to be treated as a REIT for the four taxable years following the year for which we lose our qualification. It is not possible to state whether in all circumstances we would be entitled to this statutory relief. RESULTS OF OPERATIONS: COMPARISON OF THE YEARS ENDED DECEMBER 31, 2018 AND 2017 NM-Percentages over 100% are not displayed. Revenues Rental income Rental income for the comparative period increased primarily due to SMTA being a net acquirer during 2018, based on the following activity: • Acquisitions/Contributions: ◦ Nine properties acquired into the Master Trust 2014 segment, with a Real Estate Investment Value of $112.6 million ◦ Ten properties contributed from Spirit in conjunction with the Spin-Off into the Other Properties segment, with a Real Estate Investment Value of $54.2 million • Dispositions/Distributions: ◦ 35 properties disposed from the Master Trust 2014 segment, with a Real Estate Investment Value of $45.0 million, of which ten properties were Vacant ◦ 12 properties disposed from the Other Properties segment, with a Real Estate Investment Value of $59.9 million, of which two properties were Vacant ◦ Three properties distributed to Spirit in conjunction with the Spin-Off from the Other Properties segment, with a Real Estate Investment Value of $3.2 million As of December 31, 2018 and 2017, respectively, 25 and six of our properties were Vacant, representing approximately 2.9% and 0.7% of our owned properties, respectively. Also included in rental income are tenant reimbursements, where our tenants are obligated under the lease agreement to reimburse us for certain property costs we incur, and non-cash rental income. Tenant reimbursement income is driven by the tenant reimbursable property costs described below and comprised 0.8% and 1.0% of rental income for the years ended December 31, 2018 and 2017, respectively. Non-cash rental income primarily consists of straight-line rental revenue and amortization of above- and below-market lease intangibles. During the years ended December 31, 2018 and 2017, non-cash rentals were $3.1 million and $5.2 million, respectively, representing approximately 1.3% and 2.3%, respectively, of total rental income. On January 16, 2019, Shopko filed for bankruptcy, and subsequently announced that it intends to liquidate its operations. As a result of Shopko's bankruptcy filing and the subsequent foreclosure by the Shopko Lenders on the equity of the entity that indirectly owns the majority of our assets leased to Shopko, we do not expect to receive any significant future cash flows from Shopko. Shopko contributed 19.1% of our contractual rent for the year ended December 31, 2018, almost all of which was attributable to our Other Properties segment. Interest income on loans receivable The increase in interest income on loans receivable is a result of the contribution from Spirit of the $35.0 million B-1 12% term loan with Shopko as borrower prior to the completion of the Spin-Off. Interest income on mortgage loans remained relatively flat period-over-period. In connection with Shopko’s bankruptcy filing, Shopko has filed pleadings asserting that any recovery under the Shopko B-1 Term Loan will be limited and may be impaired in full. Therefore, the Company has recorded an allowance for loan losses of $33.8 million in relation to the Shopko B-1 Term Loan, the remaining amount of the Shopko B-1 Term Loan as of the date hereof. While the outcome of the Shopko bankruptcy filing is uncertain and there can be no assurances that we will recover any amounts due to us under the Shopko B-1 Term Loan, we intend to pursue all of our rights and remedies in connection with the bankruptcy proceedings, with the goal of maximizing the receipt of amounts due to us under the the Shopko B-1 Term Loan. Shopko contributed 86.8% of our interest income on loans receivable for the year ended December 31, 2018, all of which was attributable to our Other Properties segment. Other income Period-over-period other income decreased primarily due to a decrease in lease termination fees received. For the year ended December 31, 2018, we received $0.5 million in lease termination fees primarily received from eight properties with tenants in the restaurant - casual dining industry, compared to $3.6 million in lease termination fees received primarily from one property with a tenant in the medical/other office industry and nine properties with tenants in the restaurant - casual dining industry during the year ended December 31, 2017. Expenses General and administrative and Transaction costs For periods prior to the Spin-Off, general administrative expenses and transaction costs are comprised of amounts specifically identified and amounts allocated from Spirit's financial statements. Specifically identified expenses: General and administrative expenses of $5.0 million and $0.7 million during the year ended December 31, 2018 and 2017, respectively, were specifically identified based on direct usage or benefit. Transaction costs are the expenses associated with the Spin-Off and, for the year ended December 31, 2018, $4.7 million were specifically identified based on direct usage or benefit. For year ended December 31, 2017, $3.2 million of transaction costs were specifically identified. As such, specifically identified expenses increased period-over-period, primarily as a result of professional costs incurred in 2018 subsequent to the Spin-Off in conjunction with operating as a separate publicly-traded company. Allocated expenses: The increase from specifically identified expenses was offset by a decrease in allocated general and administrative expenses and transaction costs period-over-period. These have been allocated from Spirit’s financial statements for the periods prior to the completion of the Spin-Off, based on SMTA's property count relative to Spirit’s property count. SMTA’s property count decreased from 920 properties at December 31, 2017 compared to 893 properties at May 31, 2018. Spirit’s property count also decreased from 2,525 properties to 2,432 for the same period. As such, the allocation percentage year over year remained relatively flat. Therefore, the net decrease in allocated expenses is a direct result of there being only five months of allocated expenses in 2018 compared to a full year of allocated expenses in 2017. Related party fees In conjunction with the Spin-Off, SMTA entered into the Asset Management Agreement with Spirit Realty, L.P. for a $20 million flat fee per annum, plus a promoted interest fee based on the total shareholder return of SMTA's common shares during the relevant period if certain conditions are met. Therefore, asset management fees of $11.7 million were incurred and a promoted interest fee of $0.8 million was recognized for the seven months subsequent to the Spin-Off, which was the primary driver of the increase in related party fees period-over-period. Additionally, property management fees for Master Trust 2014 accrue daily at 0.25% per annum of the collateral value of the Master Trust 2014 Collateral Pool less any specially serviced assets and special servicing fees which accrue daily at 0.75% per annum of the collateral value of any assets deemed to be specially serviced per the terms of the Property Management and Servicing Agreement. Collateral value of Master Trust 2014 increased from $2.0 billion at December 31, 2016 to $2.6 billion at December 31, 2017 as a result of the December 2017 issuance, and then remained flat at $2.6 billion until December 31, 2018. As a result, property management and special servicing fees paid to our Manager increased $1.5 million period-over-period. Property costs (including reimbursable) For the year ended December 31, 2018, property costs excluding bad debt expense were $12.3 million (including $2.8 million of tenant reimbursable expenses) compared to $9.1 million (including $2.8 million of tenant reimbursable expenses) for the same period in 2017. The increase in non-reimbursable costs of $3.2 million was driven primarily by $4.9 million of non-reimbursable property tax expenses recorded to the Other Properties segment in conjunction with Shopko's bankruptcy, offset by a decrease in other non-reimbursable property tax expense year-over-year. Bad debt expense for the year ended December 31, 2017 was $3.4 million, which reflects the write-off of straight-line rent receivables deemed to be uncollectible, compared to $0.5 million of bad debt expense for the year ended December 31, 2018. Interest The increase in interest expense is primarily related to the new issuance of Master Trust 2014 notes in December 2017 and the two CMBS loans, both in the Other Properties segment, entered into in January 2018 and November 2018, respectively. See Note 4 to the financial statements herein. The following table summarizes our interest expense: Depreciation and amortization During the year ended December 31, 2018, we acquired or received through contribution 19 properties, representing a Real Estate Investment Value of $166.8 million, and we disposed of or contributed 50 properties with a Real Estate Investment Value of $108.1 million. Therefore, as a net acquirer during the period based on Real Estate Investment Value, depreciation and amortization increased year-over-year. This increase was attributable to the Master Trust 2014 segment, as this segment was a net acquirer of depreciable real estate, partially offset by a slight decrease in depreciation and amortization in the Other Properties segment, at this segment was a net disposer of decpreciable real estate year-over-year. The following table summarizes our depreciation and amortization expenses: Impairment and allowance for loan losses During the year ended December 31, 2018, we recorded impairment and allowance for loan losses of $221.3 million. This primarily consisted of $202.3 million of impairment charges and allowance for loan losses related to tangible and intangible assets due to the Shopko bankruptcy filing, including $6.5 million of impairment charges recorded on the Other Properties segment's goodwill and a $33.8 million allowance for loan losses in relation to the Shopko B-1 Term Loan. During the year ended December 31, 2017, we recorded impairment charges of $33.5 million, of which $25.2 million of the impairment was recorded on vacant properties, comprised of $21.4 million on 19 vacant held for use properties and $3.8 million on eight vacant held for sale properties. $8.0 million of impairment was recorded on underperforming properties, comprised of $8.5 million recorded on 11 underperforming held for sale properties, offset by $0.5 million recoveries recorded on 14 underperforming held for use properties as a result of the write-off of intangible lease liabilities. The remaining $0.3 million of impairment charges related to unrecoverable amounts from loans receivable. Loss on debt extinguishment During the year ended December 31, 2018, we extinguished $6.3 million of Master Trust 2014 debt, resulting in approximately $0.4 million in losses on debt extinguishment related to pre-payment premiums paid. During the same period in 2017, we extinguished the full outstanding balance of Master Trust 2014 Series 2014-1 Class A1 notes of $43.1 million. The loss on the extinguishment was primarily attributable to the $1.6 million pre-payment premium paid in conjunction with this voluntary pre-payment. Gain on disposition of assets During the year ended December 31, 2018, we disposed of 47 properties and recorded net gains totaling $9.5 million. There were $8.8 million in net gains on the sale of 35 active properties, including the sale of 10 properties operated by Shopko. There were additionally $0.7 million in net gains from the sale of 12 vacant properties. For the same period in 2017, we disposed of 76 properties and recorded net gains totaling $22.4 million. There were $23.6 million in net gains on the sale of 32 active properties, including the sale of 12 properties operated by Shopko. This was partially offset by $1.2 million in net losses from the sale of 44 vacant properties. RESULTS OF OPERATIONS: COMPARISON OF THE YEARS ENDED DECEMBER 31, 2017 AND 2016 NM-Percentages over 100% are not displayed. Revenues Rental income Rental income for the comparative period decreased primarily due to a decrease in contractual rental revenue resulting from the timing of real estate transactions subsequent to December 31, 2016. While Real Estate Investment Value increased by $265.5 million for the year ended December 31, 2017 through the acquisition of two properties and Spirit’s contribution of 10 properties in conjunction with the Master Trust 2014 issuance, the 10 properties were not contributed until December 2017. During the same period, 76 properties were disposed with a Real Estate Investment Value of $145.7 million. As of December 31, 2017 and 2016, respectively, six and 18 of our properties were Vacant, representing approximately 0.7% and 1.8% of our owned properties. Of the six Vacant properties, none were held for sale as of December 31, 2017. Also included in rental income are tenant reimbursements, where our tenants are obligated under the lease agreement to reimburse us for certain property costs we incur, and non-cash rental income. Tenant reimbursement income is driven by the tenant reimbursable property costs described below and comprised 1.0% and 0.9% of rental income for the years ended December 31, 2017 and 2016, respectively. Non-cash rental income primarily consists of straight-line rental revenue and amortization of above- and below-market lease intangibles. During the years ended December 31, 2017 and 2016, non-cash rentals were $5.2 million and $4.1 million, respectively, representing approximately 2.3% and 1.7%, respectively, of total rental income. Interest income on loans receivable The decrease in interest income on loans receivable year over year primarily relates to the timing of change in outstanding loans during the year ended December 31, 2016, where mortgage loans receivable decreased from 79 loans collateralized by 81 properties at the beginning of 2016 to nine loans collateralized by 11 properties at December 31, 2016. Mortgage loans receivable then remained flat, with nine loans collateralized by 11 properties still outstanding at December 31, 2017. Other income Year-over-year other income decreased primarily due to a decrease in lease termination fees received. For the year ended December 31, 2017, other income is primarily attributable to $3.6 million in lease termination fees received from one property with a tenant in the medical office industry and nine properties with tenants in the restaurant - casual dining industry. For the year ended December 31, 2016, other income is primarily attributable to $5.4 million in lease termination fees received from three properties with a tenant in the education industry. Expenses General and administrative, Restructuring charges and Transaction costs General and administrative expenses of $0.7 million and $1.4 million during the years ended December 31, 2017 and 2016, respectively, were specifically identified based on direct usage or benefit. The change in specifically identified expenses is a result of internalization of certain property servicing functions in 2017, resulting in the elimination of certain servicing fees. Transaction costs are the expenses associated with the spin-off, and there were no transaction costs incurred for the year ended 2016. For the transaction costs incurred during the year ended December 31, 2017, $3.2 million were specifically identified based on direct usage or benefit. The remaining general and administrative expenses, restructuring charges and transaction costs have been allocated from Spirit’s financial statements, based on SMTA's property count relative to Spirit’s property count. SMTA's property count decreased from 982 properties at December 31, 2016 to 918 properties at December 31, 2017. Spirit’s property count also decreased from 2,615 properties to 2,480 for the same period. As such, the allocation percentage year over year remained relatively flat. Therefore, the increase in general and administrative expenses is a direct result of Spirit’s increased expenses year-over-year. The relocation of Spirit’s headquarters from Scottsdale, Arizona to Dallas, Texas was completed in 2016 and therefore there were no restructuring charges recognized at Spirit for the year ended December 31, 2017. Related party fees Spirit Realty, L.P., a wholly-owned subsidiary of Spirit, is the property manager and special servicer of Master Trust 2014, under which Spirit Realty, L.P. receives property management fees which accrue daily at 0.25% per annum of the collateral value of the Master Trust 2014 collateral pool less any specially serviced assets and special servicing fees which accrue daily at 0.75% per annum of the collateral value of any assets deemed to be specially serviced per the terms of the Property Management and Servicing Agreement. Collateral value remained relatively flat from $2.0 billion at December 31, 2016 to $1.9 billion at November 31, 2017. In conjunction with the issuance completed in December 2017, collateral value increased to $2.6 billion at December 31, 2017. However, due to the timing of the issuance, the increase in collateral value had little impact on the related party fees for the year ended December 31, 2017, resulting in relatively flat related party fees year-over-year. Property costs (including reimbursable) For the year ended December 31, 2017, property costs excluding bad debt expense were $9.1 million (including $2.8 million of tenant reimbursable expenses) compared to $5.3 million (including $2.0 million of tenant reimbursable expenses) for the same period in 2016. The increase was driven primarily by an increase in non-reimbursable property taxes on operating properties of $2.4 million, which relates primarily to the timing of dispositions of vacant properties during 2017, as well as an increase in tenant credit issues year-over-year. Bad debt expense for the year ended December 31, 2017 was $3.4 million, which reflects the write-off of straight-line rent receivables deemed to be uncollectible, compared to no bad debt expense for the year ended December 31, 2016. Interest Interest expense decreased slightly year-over year, primarily due to the timing of debt extinguishment in both 2016 and 2017. For the year ended December 31, 2016, $119.3 million of CMBS debt was extinguished with a weighted average interest rate of 6.0%; however, most of the debt was extinguished in the first half of 2016. For the year ended December 31, 2017, $43.1 million of Master Trust 2014 debt was extinguished with an interest rate of 5.1%, however, it was not extinguished until November 2017. The following table summarizes our interest expense: Depreciation and amortization Depreciation and amortization expense relates to the commercial buildings and improvements we own and to amortization of the related lease intangibles. The year-over-year decrease is primarily due to the disposition of 76 properties with a depreciable basis of $145.7 million, during the year ended December 31, 2017. The decrease was partially offset by acquisitions of 12 properties during 2017 with a depreciable basis of $265.5 million; however, 10 of these properties were contributed to the Predecessor Entities in conjunction with the Master Trust 2014 issuance in December 2017 and therefore did not contribute significantly to depreciation and amortization expenses for the year ended 2017. The decline in depreciable basis was furthered by impairment charges recorded in 2017 on properties that remain in our portfolio. The following table summarizes our depreciation and amortization expenses: Impairment and allowance for loan losses During the year ended December 31, 2017, we recorded impairment charges of $33.5 million, of which $25.2 million of the impairment was recorded on vacant properties, comprised of $21.4 million on 19 vacant held for use properties and $3.8 million on eight vacant held for sale properties. $8.0 million of impairment was recorded on underperforming properties, comprised of $8.5 million recorded on 11 underperforming held for sale properties, offset by $0.5 million recoveries recorded on 14 underperforming held for use properties as a result of the write-off of intangible lease liabilities. The remaining $0.3 million of impairment charges related to unrecoverable amounts from loans receivable. During the year ended December 31, 2016, we recorded impairment charges of $26.6 million, of which $9.3 million of the impairment was recorded on vacant properties, comprised of $6.4 million recorded on 15 vacant held for use properties and $2.9 million recorded on three vacant held for sale properties. The remaining $17.3 million of impairment was recorded on underperforming properties, comprised of $8.5 million recorded on 12 underperforming held for sale properties and $8.8 million recorded on 28 underperforming held for use properties. Loss on debt extinguishment During the year ended December 31, 2017, we extinguished the full outstanding balance of Master Trust 2014 Series 2014-1 Class A1 note of $43.1 million. The loss on the extinguishment was primarily attributable to the $1.6 million pre-payment premium paid in conjunction with this voluntary pre-payment. During the same period in 2016, we extinguished $119.3 million of CMBS debt and recognized a loss on debt extinguishment of $1.4 million. The CMBS debt related to three fixed rate loans collateralized by 56 properties with a weighted average interest rate of 6.0%. Gain on disposition of assets During the year ended December 31, 2017, we disposed of 76 properties and recorded net gains totaling $22.4 million. There were $23.6 million in net gains on the sale of 32 active properties, including the sale of 12 properties operated by Shopko. This was partially offset by $1.2 million in net losses from the sale of 44 vacant properties. For the same period in 2016, we disposed of 48 properties and recorded net gains totaling $26.5 million. There were $25.5 million in net gains on the sale of 37 active properties, including the sale of nine properties operated by Shopko. The remaining $1.0 million was primarily comprised of net gains on the sale of 11 vacant properties and a partial taking. LIQUIDITY AND CAPITAL RESOURCES Short-term Liquidity and Capital Resources On a short-term basis, our principal demands for funds will be for operating expenses, as well as distributions to shareholders and interest and principal on our debt financings. We expect to fund our operating expenses and other short-term liquidity requirements, capital expenditures, payment of principal and interest on our outstanding indebtedness, property improvements, re-leasing costs and cash distributions to common and preferred shareholders, primarily through cash provided by operating activities, from refinancings within Master Trust 2014, and continued dispositions of assets within our Other Properties segment. Long-term Liquidity and Capital Resources On January 16, 2019, in connection with the Shopko bankruptcy filing, we announced that our Board of Trustees had elected to accelerate our strategic plan by identifying and engaging advisors to explore strategic alternatives focused on maximizing shareholder value. Strategic alternatives to be considered may include, but are not limited to, a sale of the Company or the Master Trust 2014, a merger, the sale of the single distribution center property and other non-core assets, and the maximizing of recoveries in connection with the Shopko bankruptcy. The execution of strategic alternatives may materially impact our long-term capital needs and plan to meet those needs. Currently, we plan to meet our long-term capital needs, including long-term financing of debt maturities, by issuing bonds using the Master Trust 2014 program discussed below or by issuing debt or equity securities. We will continually evaluate and seek to obtain alternative financing, but we cannot assure you that we will have access to the capital markets at times and on terms that are acceptable to us. We expect that our primary uses of capital will be for the payment of tenant improvements, operating expenses, including debt service payments on any outstanding indebtedness, and distributions to our shareholders. We believe that cash on hand and other available borrowings are sufficient to meet these obligations over the next 12 months. Description of Certain Debt The following descriptions of debt should be read in conjunction with Note 4 to the consolidated financial statements herein. Master Trust 2014 Master Trust 2014 is an asset-backed securitization platform through which we raise capital by issuing non-recourse asset-backed securities collateralized by commercial real estate, net leases and mortgage loans. The Master Trust 2014 Collateral Pool is managed by Spirit Realty, L.P., a related party, in its capacity as property manager and special servicer. In general, monthly rental and mortgage receipts are deposited with the indenture trustee, who first utilizes these funds to satisfy the debt service requirements on the notes and any fees and costs associated with the administration of Master Trust 2014. Any remaining funds are remitted to SMTA monthly on the note payment date. Upon satisfaction of certain conditions, we may, from time to time, sell or exchange real estate properties or mortgage loans from the Collateral Pool. Proceeds from these transactions are held on deposit by the indenture trustee in the Release Account until a qualifying substitution is made or the amounts are distributed as an early repayment of principal. At December 31, 2018, $16.1 million and $5.6 million were held on deposit in the Release Account and Liquidity Reserve Account, respectively, and classified as restricted cash within deferred costs and other assets, net in the consolidated balance sheet. All outstanding series of Master Trust 2014 were rated investment grade as of December 31, 2018. As of December 31, 2018, the Master Trust 2014 notes were secured by 784 owned and financed properties. The notes issued under Master Trust 2014 are cross-collateralized by the assets of all issuers (each its own special purpose entity) within this trust. The assets of these special purpose entities are not available to pay, or otherwise satisfy obligations to, the creditors of any affiliate or owner of another entity unless the special purpose entities have expressly agreed and are permitted under their governing documents. As of December 31, 2018, total assets of $1.91 billion were held by the Master Trust 2014 special purpose entities. The Master Trust 2014 debt is summarized below: (1) Represents the individual series stated interest rates as of December 31, 2018 and the weighted average stated rate of the total Master Trust 2014 notes, based on the collective series outstanding principal balances as of December 31, 2018. Academy CMBS On January 22, 2018, we entered into a new non-recourse loan agreement, which is collateralized by a single distribution center property located in Katy, Texas. The loan has a fixed interest rate of 5.14%. As a result of the issuance, we received approximately $84.0 million in proceeds, all of which was distributed to Spirit. This CMBS loan and its collateral are held in special purpose entities, which are separate legal entities, and are the sole owner of their assets and responsible for their liabilities. The assets of the special purpose entities are not available to pay, or otherwise satisfy obligations to, the creditors of any affiliate or owner of another entity unless the special purpose entities have expressly agreed and are permitted to do so under their governing documents. As of December 31, 2018, total assets of $101.4 million were held by the CMBS special purpose entities, and the loan had an outstanding principal balance of $83.0 million with a remaining maturity of 9.1 years. Shopko CMBS On November 1, 2018, four indirectly wholly-owned, property-owning subsidiaries of the Company entered into a non-recourse mortgage loan agreement with the Shopko Lenders, in an aggregate amount of $165.0 million. The Company received net proceeds from this loan agreement of approximately $141.9 million after the payment of fees, expenses and required reserves. The loan was secured by a pledge of the equity in the four subsidiaries, which collectively hold 85 assets (83 owned properties and two seller-financed notes on properties) that are leased to Shopko. On November 27, 2018, SMTA, through the indirectly wholly-owned subsidiary that owns the four property-owning subsidiaries, entered into a non-recourse mezzanine loan agreement with the Shopko Lenders, pursuant to which $40.0 million of the original $165.0 million was carved out, resulting in no additional proceeds to SMTA (such mezzanine loan agreement, together with the original loan agreement, the “Shopko CMBS Loan Agreements”). The mezzanine loan was secured by an equity pledge of the indirect wholly-owned subsidiary that owns the four property-owning subsidiaries. On January 16, 2019, our indirect wholly-owned subsidiaries as borrowers under the Shopko CMBS Loan Agreements defaulted on the loans when those entities ceased to make interest payments as a result of Shopko ceasing to pay its rent obligations following its bankruptcy filing. The full outstanding principal amount of $157.4 million outstanding under the Shopko CMBS Loan Agreements immediately became due and payable, and interest is accruing at the default rate of LIBOR plus 12.5% on the original loan portion and LIBOR plus 18.0% on the mezzanine loan portion. On March 1, 2019, the Shopko Lenders foreclosed on the equity of the entity that owns the four property-owning subsidiaries. Debt Maturities Future principal payments due on our Master Trust 2014 and CMBS debt outstanding as of December 31, 2018: (1) $157.4 million of the CMBS principal balance is attributable to the Shopko CMBS Loan Agreements, which was relieved on March 1, 2019 as a result of the Shopko Lenders foreclosing on the equity of the entity that indirectly owns the Shopko assets that secured the loan. Contractual Obligations Our commitments, based on period in which payment is due, as of December 31, 2018: (1) $157.4 million of the CMBS principal balance for less than one year is attributable to the Shopko CMBS Loan Agreements, which was relieved on March 1, 2019 as a result of the Shopko Lenders foreclosing on the equity of the entity that indirectly owns the Shopko assets that secured the loan. (2) Debt - Interest has been calculated based on outstanding balances as of December 31, 2018 through their respective maturity dates and excludes unamortized non-cash deferred financing costs of $21.9 million and unamortized debt discount, net of $21.2 million as of December 31, 2018. Distribution Policy Distributions from our current or accumulated earnings are generally classified as ordinary income, whereas distributions in excess of our current and accumulated earnings, to the extent of a shareholder’s federal income tax basis in our common shares, are generally classified as a return of capital. Under the 2017 Tax Legislation, U.S. shareholders that are individuals, trusts and estates generally may deduct up to 20% of the ordinary dividends (e.g., dividends not designated as capital gain dividends or qualified dividend income) received from a REIT for taxable years beginning after December 31, 2017 and before January 1, 2026. Distributions in excess of a shareholder’s federal income tax basis in our common shares are generally characterized as capital gain. We are required to distribute 90% of our taxable income (subject to certain adjustments and excluding net capital gains) on an annual basis to maintain qualification as a REIT for federal income tax purposes and are required to pay federal income tax at regular corporate rates to the extent we distribute less than 100% of our taxable income (including capital gains). We currently intend to make distributions that will enable us to meet the distribution requirements applicable to REITs and to eliminate or minimize our obligation to pay corporate-level federal income and excise taxes. Any distributions made to our shareholders will be at the sole discretion of our Board of Trustees, and their form, timing and amount, if any, will depend upon a number of factors, including our actual and projected results of operations, FFO, liquidity, cash flows and financial condition, the revenue we actually receive from our properties, our operating expenses, our debt service requirements, our capital expenditures, prohibitions and other limitations under our financing arrangements, our REIT taxable income, the annual REIT distribution requirements, applicable law and such other factors as our Board of Trustees deems relevant. CASH FLOWS: COMPARISON OF THE YEARS ENDED DECEMBER 31, 2018 AND 2017 The following table presents a summary of our cash flows for the year ended December 31, 2018 and 2017: As of December 31, 2018, we had $205.1 million in cash, cash equivalents and restricted cash as compared to $66.5 million as of December 31, 2017. Operating Activities Our cash flows from operating activities are primarily dependent upon the occupancy level of our portfolio, the rental rates specified in our leases, the collectability of rent and the level of our operating expenses and other general and administrative costs. The net decrease in cash provided by operating activities was primarily attributable to an increase in cash interest expense of $32.0 million, an increase in related party fees of $14.0 million and an increase in transaction costs of $4.3 million. The net decrease in cash provided by operating activities was partially offset by an increase in cash rental revenue totaling $15.9 million. Investing Activities Cash used in investing activities is generally used to fund property acquisitions, for investments in loans receivable and, to a limited extent, for capital expenditures. Cash provided by investing activities generally relates to the disposition of real estate and other assets. Net cash used in investing activities during the year ended December 31, 2018 included the use of $112.6 million to fund the acquisition of nine properties and capitalized real estate expenditures of $3.1 million, partially offset by the receipt of $76.9 million in net proceeds from the disposition of 47 properties and collections of principal on loans receivable totaling $5.1 million. During the same period in 2017, net cash provided by investing activities included cash proceeds of $146.6 million from the disposition of 76 properties, partially offset by $26.0 million of cash used to fund the acquisition of two properties (of which one was a related party purchase from Spirit as discussed in Note 11: Related Party Transactions). Net cash provided by investing activities also included collections on loans receivable during the year ended December 31, 2017 of $8.8 million. Financing Activities Generally, our net cash used in financing activities is impacted by our contributions/distributions to Spirit for the period prior to the Spin-Off and our net borrowings under Master Trust 2014 and CMBS. Net cash provided by financing activities during the year ended December 31, 2018 was attributable to borrowings under mortgages and notes payable of $257.7 million as a result of entering into new CMBS debt agreements. This was partially offset by cash used in financing activities primarily related to net distributions to Spirit of $106.4 million, repayments under mortgages and notes payable of $42.2 million, payments of common share dividends totaling $14.2 million, payments of preferred dividends totaling $9.3 million, and deferred financing costs of $9.6 million. During the same period in 2017, net cash used in financing activities was primarily attributable to net distributions to Spirit of $749.3 million, repayments under Master Trust 2014 of $61.1 million, and deferred financing costs of $11.2 million. Net cash used in financing activities also included borrowings under Master Trust 2014 of $618.1 million. CASH FLOWS: COMPARISON OF THE YEARS ENDED DECEMBER 31, 2017 AND 2016 As of December 31, 2017, we had $66.5 million in cash, cash equivalents and restricted cash as compared to $12.7 million as of December 31, 2016. Operating Activities Our cash flows from operating activities are primarily dependent upon the occupancy level of our portfolio, the rental rates specified in our leases, the collectability of rent and the level of our operating expenses and other general and administrative costs. The decrease in net cash provided by operating activities was primarily attributable to a decrease in cash rental revenue and interest income on loans receivable of $13.0 million, due to the disposition of 76 properties during 2017 with a Real Estate Investment value of $145.7 million and the payoff of one loan receivable with a principal balance of $2.9 million, which was partially offset by the acquisition of two properties during the same period with a Real Estate Investment Value of $25.0 million. Additionally, there was a $2.4 million decrease in cash interest expense as a result of principal repayments of $53.9 million of Master Trust 2014 during the year ended December 31, 2017. Investing Activities Cash used in investing activities is generally used to fund property acquisitions, for investments in loans receivable and, to a limited extent, for capital expenditures. Cash provided by investing activities generally relates to the disposition of real estate and other assets. Net cash provided by investing activities during 2017 included cash proceeds of $146.6 million from the disposition of 76 properties, partially offset by $26.0 million of cash used to fund the acquisition of two properties (of which one was a related party purchase from Spirit as discussed in Note 11: Related Party Transactions). Net cash provided by investing activities also included collections on loans receivable during the year ended December 31, 2017 of $8.8 million. During the same period in 2016, net cash provided by investing activities included cash proceeds of $141.3 million from the disposition of 48 properties, partially offset by $62.7 million of cash used to fund the acquisition of 17 properties (of which seven were related party purchases from Spirit as discussed in Note 11: Related Party Transactions). Net cash provided by investing activities also included collections on loans receivable during the year ended December 31, 2016 of $6.9 million. Financing Activities Generally, our net cash used in financing activities is impacted by our contributions/distributions to Spirit and net borrowings under Master Trust 2014 and CMBS. Net cash used in financing activities during 2017 was primarily attributable to net distributions to Spirit of $749.3 million, repayments under Master Trust 2014 of $61.1 million, and deferred financing costs of $11.2 million. Net cash provided by financing activities also included borrowings under Master Trust 2014 of $618.1 million. For the same period in 2016, net cash used in financing activities was primarily attributable to net distributions to Spirit of $81.6 million, repayments under Master Trust 2014 of $15.1 million and repayments under CMBS of $119.5 million. Off-Balance Sheet Arrangements As of December 31, 2018, we did not have any off-balance sheet financing arrangements.

<s>[INST] OVERVIEW SMTA was formed for the purpose of receiving, via contribution from Spirit, the legal entities which held (i) Master Trust 2014, an assetbacked securitization trust which issues nonrecourse assetback securities collateralized by commercial real estate, netleases and mortgage loans, (ii) all of Spirit's properties leased to Shopko, (iii) a single distribution center property leased to a sporting goods tenant encumbered with CMBS debt, and (iv) a portfolio of unencumbered properties, as well as a $35.0 million B1 Term Loan with Shopko as borrower, and a cash contribution of $3.0 million. The activities of the newly formed legal entities are not reflected in the accompanying financial statements balances or results of operations prior to May 31, 2018, but the ten additional properties, the B1 Term Loan and cash are reflected as contributions as of their respective legal dates of transfer. On May 31, 2018, the distribution date, Spirit completed the SpinOff of SMTA. On the distribution date, Spirit distributed on a pro rata basis one SMTA common share for every ten shares of Spirit common stock held by each of Spirit's stockholders as of May 18, 2018, the record date. As a result, 42,851,010 shares of SMTA common were issued on May 31, 2018. In conjunction with the SpinOff, we and our Manager, a whollyowned subsidiary of Spirit, entered into an Asset Management Agreement under which our Manager provides various services including, but not limited to: active portfolio management (including underwriting and risk management), financial reporting, and SEC compliance. The fees for these services are a flat rate of $20 million per annum. Additionally, Spirit Realty, L.P. continues as the property manager and special servicer of Master Trust 2014, under which Spirit Realty, L.P. receives property management fees which accrue daily at 0.25% per annum of the collateral value of the Master Trust 2014 Collateral Pool less any specially serviced assets, and special servicing fees which accrue daily at 0.75% per annum of the collateral value of any assets deemed to be specially serviced per the terms of the Property Management and Servicing Agreement. SMTA and Spirit also entered into a Separation and Distribution Agreement, an InsuranceSharing Agreement, a Tax Matters Agreement, and a Registration Rights Agreement in connection with the SpinOff. SMTA expects to operate in a manner intended to enable it to qualify as a REIT under the applicable provisions of the Internal Revenue Code of 1986, as amended. To maintain REIT status, SMTA must meet a number of organizational and operational requirements, including a requirement to distribute annually to shareholders at least 90% of SMTA’s REIT taxable income, determined without regard to the dividends paid deduction and excluding any net capital gains. Management believes the Company has qualified and will continue to qualify as a REIT and therefore, no provision has been made for federal income taxes for the period presented subsequent to the SpinOff. For the period presented prior to the SpinOff, the Company was disregarded for federal income tax purposes, so no provision for federal income tax was made. SMTA is subject to certain other taxes, including state taxes, which have been reflected as income tax expense in the consolidated statements of operations and comprehensive income (loss). The accompanying financial statements include the consolidated accounts of the Company and its whollyowned subsidiaries for the period subsequent to the SpinOff on May 31, 2018. The prespin financial statements were prepared on a carveout basis and reflect the combined net assets and operations of the predecessor legal entities which formed the Company at the time of the SpinOff. GAAP requires us to make estimates and assumptions that affect the reported amounts of assets and liabilities, and revenues and expenses during the reporting periods. Actual results could differ from these estimates. The historical financial results prior to the SpinOff include allocated expenses for certain corporate costs which we believe are reasonable. These expenses were based on either actual costs in [/INST] Negative. </s>

AgeX Therapeutics, Inc.

2019-04-01

2018-12-31

Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations The following Management’s Discussion and Analysis of Financial Condition and Results of Operations is intended to provide information necessary to understand our audited consolidated financial statements for the years ended December 31, 2018 and 2017, and highlight certain other information which, in the opinion of management, will enhance a reader’s understanding of our financial condition, changes in financial condition and results of operations. These historical financial statements may not be indicative of our future performance. This Management’s Discussion and Analysis of Financial Condition and Results of Operations contains a number of forward-looking statements, all of which are based on our current expectations and could be affected by the uncertainties and risks described throughout this filing, particularly in “Risk Factors.” Emerging Growth Company Status The Jumpstart our Business Startups Act of 2012 (“JOBS Act”) permits an “emerging growth company” such as AgeX to take advantage of an extended transition period to comply with new or revised accounting standards applicable to public companies. However, we elected to comply with newly adopted or revised accounting standards when they become applicable to public companies because our financial statements were consolidated with those of BioTime, which is not an emerging growth company under the JOBS Act and is therefore not permitted to delay the adoption of new or revised accounting standards that become applicable to public companies. This election under the JOBS Act to not delay the adoption of new or revised accounting standards is irrevocable. Overview We were incorporated in January 2017 in the state of Delaware as a subsidiary of BioTime, a publicly traded, clinical-stage biotechnology company targeting degenerative diseases. BioTime common stock trades on the NYSE American and Tel Aviv Stock Exchange under the symbol “BTX”. We are a biotechnology company focused on the development and commercialization of novel therapeutics targeting human aging. Our initial discovery and preclinical programs focus on utilizing brown adipose tissue in targeting diabetes, obesity, and heart disease; and induced tissue regeneration in utilizing the human body’s own abilities to scarlessly regenerate tissues damaged from age or trauma. We may also pursue other early-stage pre-clinical programs. On August 17, 2017, we completed an asset acquisition and stock sale pursuant to which we received certain assets from BioTime for use in our research and development programs and raised $10.0 million in cash from investors to finance our operations. From February 28, 2018 to July 10, 2018, we sold warrants to purchase 2,000,000 shares of AgeX common stock (the “Warrants”) for $0.50 per warrant for aggregate cash proceeds of $1,000,000. The Warrants were exercisable at $2.50 per share. Pursuant to the Warrant Agreement governing the Warrants, we set March 18, 2019 as the expiration date of the Warrants and by that date Warrant holders purchased 1.8 million shares of common stock through the exercise of the Warrants for $4.5 million in the aggregate. The Warrants were classified as equity since, among other factors, they were not redeemable, could not be settled in cash or other assets and required settlement by issuing a fixed number of shares of AgeX common stock. The Warrants were sold at fair value determined using the Binomial Lattice option pricing model on the issuance date, with certain management assumptions, which included the timing of an initial public offering of AgeX common stock, peer-group volatility, term to maturity, price cap and AgeX current and future stock prices. On June 7, 2018, we sold 2.0 million shares of common stock for $2.50 per share to Juvenescence for aggregate cash proceeds to us of $5.0 million. These financings have allowed us to focus our resources on our pre-clinical programs. On August 30, 2018, BioTime consummated the secondary sale of 14.4 million of its shares of AgeX common stock to Juvenescence pursuant to a stock purchase agreement. Upon completion of the transaction, BioTime’s ownership in us was reduced from 80.4% to 40.2% of our issued and outstanding shares of common stock, and Juvenescence’s ownership in AgeX was increased from 5.6% to 45.8% of our issued and outstanding shares of common stock. As a result, beginning on August 30, 2018, we are no longer considered a subsidiary of BioTime because, on that date, BioTime experienced a “loss of control” of a subsidiary, as defined by generally accepted accounting principles in the United States. Loss of control is deemed to have occurred when, among other things, a parent company owns less than a majority of the outstanding common stock in a subsidiary, lacks a controlling financial interest in the subsidiary, and is unable to unilaterally control the subsidiary through other means such as having, or being able to obtain, the power to elect a majority of the subsidiary’s Board of Directors based solely on contractual rights or ownership of shares holding a majority of the voting power of the subsidiary’s voting securities. All of these loss-of-control factors were present with respect to BioTime’s ownership interest in us as of August 30, 2018. Accordingly, BioTime deconsolidated our consolidated financial statements and results from its consolidated financial statements and results beginning on August 30, 2018. On November 28, 2018, BioTime owned 14,416,000 shares of our common stock, representing approximately 40.2% of the shares of the common stock issued and outstanding on the Distribution Date. On the Distribution Date, BioTime distributed to its shareholders, on a pro rata basis, 12,697,028 shares of the AgeX common stock it then held. Immediately after the Distribution, BioTime retained 1,718,972 shares of AgeX common stock, representing approximately 4.8% of the common stock then issued and outstanding. Following the Distribution, our common stock began publicly trading on the NYSE American under the symbol “AGE”. Since inception, our operations have focused on building our technology platform, identifying potential product candidates, establishing and protecting our intellectual property and raising capital. Our revenues have been principally derived from subscription and advertising revenue from LifeMap Sciences’ online databases based upon applicable subscription or advertising periods. We do not have any products approved for sale and have not generated any revenue from product sales. We believe we have sufficient capital to carry out our current research and development programs and other operations through at least twelve months from the issuance date of our consolidated financial statements included elsewhere in this Report. We will need to obtain additional financing in order to continue our research and development programs after that date. See “Liquidity and Capital Resources” for a discussion of our available capital resources, our need for future financing. Since inception, we have incurred significant operating losses. Our operating losses were $11.2 million and $6.7 million, for the years ended December 31, 2018 and 2017, respectively. As of December 31, 2018, we had an accumulated deficit of $74.1 million. We expect to continue to incur significant expenses and operating losses over the next several years. We anticipate that our expenses will increase significantly in connection with our ongoing activities, if we: ● commence clinical development of our product candidates; ● continue activities to discover, validate and develop additional product candidates; ● maintain, expand and protect our intellectual property portfolio; ● hire research, development and general and administrative personnel as we begin operations as a standalone, publicly-traded company; and ● incur additional costs associated with operating as a public company. Critical Accounting Policies The preparation of financial statements in conformity with accounting principles generally accepted in the United States (“GAAP”), requires management to make estimates and assumptions that affect the reported amounts in our consolidated financial statements and related notes. Our significant accounting policies are described in Note 2 to our consolidated financial statements included elsewhere in this Report. We have identified below our critical accounting policies and estimates that we believe require the greatest amount of judgment. On an ongoing basis, we evaluate our estimates that are subject to significant judgment including those related to going concern assessment of consolidated financial statements, allocations and adjustments necessary for carve-out basis of presentation, including the separate return method for income taxes, useful lives associated with long-lived assets, including evaluation of asset impairment, allowances for uncollectible accounts receivables, loss contingencies, deferred income taxes and tax reserves, including valuation allowances related to deferred income taxes, and assumptions used to value stock-based awards, or other equity instruments. Actual results could differ materially from those estimates. On an ongoing basis, we evaluate our estimates compared to historical experience and trends, which form the basis for making judgments about the carrying value of assets and liabilities. To the extent that there are material differences between our estimates and our actual results, our future consolidated financial statement presentation, financial condition, results of operations and cash flows will be affected. We believe the assumptions and estimates associated with the following have the greatest potential impact on our consolidated financial statements. Principles of consolidation - AgeX’s consolidated financial statements include the accounts of its subsidiaries and certain research and development departments, including former BioTime personnel, transferred from BioTime to AgeX in connection with the Asset Contribution Agreement described in Note 4 to our consolidated financial statements. AgeX consolidated its direct and indirect wholly-owned or majority-owned subsidiaries because AgeX has the ability to control their operating and financial decisions and policies through its ownership, and the noncontrolling interest is reflected as a separate element of stockholders’ equity on AgeX’s consolidated balance sheets. As of, and for the year ended, December 31, 2018, AgeX consolidated ReCyte Therapeutics, LifeMap Sciences, Inc. (“LifeMap Sciences”), and LifeMap Sciences, Ltd. (Israel) and included the historical expenses of certain former BioTime research and development departments (see Note 4 to our consolidated financial statements). For periods prior to the year ended December 31, 2018, AgeX also consolidated LifeMap Solutions, Inc., a subsidiary of LifeMap Sciences that was transferred to BioTime during June 2017 and subsequently ceased operations and was dissolved. Going concern assessment - We assess going concern uncertainty for our consolidated financial statements to determine if we have sufficient cash and cash equivalents on hand and working capital to operate for a period of at least one year from the date our consolidated financial statements are issued or are available to be issued, which is referred to as the “look-forward period” as defined by FASB’s ASU No. 2014-15. As part of this assessment, based on conditions that are known and reasonably knowable to us, we consider various scenarios, forecasts, projections, and estimates, and we make certain key assumptions, including the timing and nature of projected cash expenditures or programs, among other factors, and our ability to delay or curtail those expenditures or programs within the look-forward period in accordance with ASU No. 2014-15, if necessary. Related party transactions - Shared Facilities and Services Agreement - As more fully described in Note 4 to our consolidated financial statements included elsewhere in this Report, to the extent we do not have our own employees, human resources or facilities for our operations, BioTime provides certain employees for administrative or operational services, including laboratory space and administrative facilities, as necessary, for our benefit, under the Shared Facilities Agreement. Accordingly, BioTime allocates expenses such as salaries and payroll related expenses incurred and paid on our behalf based on the amount of time that particular employees devote to AgeX affairs. Other expenses such as legal, accounting and financial reporting, marketing, and travel expenses are allocated to us to the extent that those expenses are incurred by or on behalf of AgeX. BioTime also allocates certain overhead expenses such as rent and utilities, property taxes, insurance, laboratory expenses and supplies, telecommunications and other indirect expenses. These allocations are made based upon activity-based allocation drivers such as time spent, percentage of square feet of office or laboratory space used, headcount and percentage of personnel devoted to our operations or management. Management evaluates the appropriateness of the allocations on a periodic basis and believes that this basis for allocation is reasonable. Related party transactions - allocated expenses from BioTime - Consistent with the principles of carve-out financial statements and presentation discussed in Note 2 to our consolidated financial statements, certain expenses have been allocated by BioTime and included in our consolidated statements of operations and consolidated statements of stockholders’ equity as a contribution by BioTime. Research and development expenses include allocations from BioTime primarily attributable to certain former BioTime research departments contributed to us. Those expenses are primarily comprised of former BioTime personnel and related expenses, including stock-based compensation, and other outside expenses relevant to the nature of the research projects that were contributed to us pursuant to the Asset Contribution Agreement discussed in Note 4 to our consolidated financial statements included elsewhere in this Report. Management considers the allocation methodologies used to allocate expenses as reasonable and appropriate based on historical BioTime expenses attributable to us and our operations for purposes of the standalone, carve-out consolidated financial statements included elsewhere in this Report. The expenses reflected in the consolidated financial statements may not be indicative of expenses that we will incur as an independent, publicly-traded company and should not be relied upon as an indicator of our future results. Research and development - Research and development expenses include both direct expenses incurred by us or our subsidiaries and indirect overhead costs allocated by BioTime that benefit or support our research and development functions. Direct research and development expenses consist primarily of personnel costs and related benefits, including stock-based compensation, amortization of intangible assets, outside consultants and suppliers, and license fees paid to third parties to acquire patents or licenses to use patents and other technology. Direct research and development expenses also include allocations for carve-out presentation purposes from certain former BioTime research departments discussed above under Related party transactions - allocated expenses from BioTime. Indirect research and development expenses include overhead expenses allocated to us by BioTime discussed under Related party transactions - Shared Facilities and Services Agreement above. Research and development costs are expensed as incurred. Research and development expenses incurred and reimbursed by grants from third parties or governmental agencies, including service revenues from co-development projects with customers, if any and as applicable, approximate the respective revenues recognized in the consolidated statements of operations. General and administrative - General and administrative expenses include both direct expenses incurred by us and indirect overhead costs allocated by BioTime that benefit or support our general and administrative functions. Direct general and administrative expenses consist primarily of compensation and related benefits, including stock-based compensation, for executive and corporate personnel, and professional and consulting fees. Direct general and administrative expenses also include allocations for carve-out presentation purposes discussed above under Related party transactions - allocated expenses from BioTime. Indirect general and administrative expenses include overhead expenses allocated to us by BioTime discussed under Related party transactions - Shared Facilities and Services Agreement above. Income taxes - For Federal and California purposes, AgeX’s activity through August 30, 2018 and for 2017 will be or was included in BioTime’s federal consolidated and California combined tax returns. For those periods, the income tax provision was prepared in accordance with ASC 740, Income Taxes, using the separate return method to determine the tax provision of AgeX for carve-out presentation purposes of its consolidated financial statements. The separate return method, amongst other things, requires that the amount of current and deferred tax expense for a group that files a consolidated income tax return be allocated among the members of that group as if each group member were a separate taxpayer. As a result, the provision for income taxes has been presented as if AgeX had filed a separate federal consolidated tax return and a California combined tax return for the periods presented. In using the separate return method, the sum of the amounts allocated to the members of the income tax return group may not equal the consolidated amount. If tax attributes recorded in the carve-out consolidated financial statements are materially different from the actual tax attributes pertaining to us or our legal entities and our subsidiaries, or to BioTime and its subsidiaries, those differences are identified and disclosed in Note 7 to our consolidated financial statements included elsewhere in the Report. Accordingly, depending on our future legal structure and related tax elections that may be taken by us, our effective tax rate in future years could vary materially from our historical effective tax rates. The historical deferred tax assets, including the operating losses and credit carryforwards generated by certain research and development departments that operated within BioTime and were transferred to us on August 17, 2017, have been presented as our tax attributes consistent with the principles of the separate return method described above. As of December 31, 2018, the deferred tax assets and liabilities presented in Note 7 included elsewhere in this Report, including net operating loss carryforwards and research and development credits, represent the tax attributes of AgeX and its subsidiaries. However, the net operating losses and research and development credits generated before August 17, 2017 with respect to BioTime research departments that were transferred to us on that date will remain as tax attributes of BioTime. In general, net operating losses and other tax credit carryforwards generated by legal entities in a consolidated federal tax group or a combined state tax group, collectively “the tax group”, are available to other members of the tax group depending on the nature of the transaction that a member may enter into while still in the tax group. However, under the Tax Matters Agreement between BioTime and AgeX entered into on August 17, 2017, any use of a member’s net operating loss and other tax credit carryforwards by the other member is subject to reimbursement by the benefiting member for the actual tax benefit realized. Since the August 30, 2018 deconsolidation of AgeX and to date, neither BioTime nor AgeX has used the tax attributes of the other. We account for income taxes in accordance with ASC 740, which prescribes the use of the asset and liability method, whereby deferred tax asset or liability account balances are calculated at the balance sheet date using current tax laws and enacted rates in effect. Valuation allowances are established when necessary to reduce deferred tax assets when it is more likely than not that a portion or all of the deferred tax assets will not be realized. Our judgments, estimates and projections regarding future taxable income may change over time due to changes, among other factors, in market conditions, changes in tax laws, and tax planning strategies. If our assumptions and consequently our estimates change in the future, the valuation allowance may be increased or decreased, which may have a material impact on our consolidated financial statements. The guidance also prescribes a recognition threshold and a measurement attribute for the financial statement recognition and measurement of tax positions taken or expected to be taken in a tax return. For those benefits to be recognized, a tax position must be more-likely-than-not sustainable upon examination by taxing authorities. We recognize accrued interest and penalties related to unrecognized tax benefits as income tax expense. No amounts were accrued for the payment of interest and penalties as of December 31, 2018 and 2017. We are not aware of any uncertain tax positions that could result in significant additional payments, accruals, or other material adjustments for the years ended December 31, 2018 and 2017. We are currently unaware of any tax issues under review. On December 22, 2017, the United States enacted major federal tax reform legislation, Public Law No. 115-97, commonly referred to as the 2017 Tax Cuts and Jobs Act (“2017 Tax Act”), which enacted a broad range of changes to the Internal Revenue Code. Changes to taxes on corporations impacted by the 2017 Tax Act include, but not limited to, lowering the U.S. federal tax rates to a 21 percent flat tax rate, eliminating the corporate alternative minimum tax (“AMT”), imposing additional limitations on the deductibility of interest and net operating losses, allowing any net operating loss (“NOLs”) generated in tax years ending after December 31, 2017 to be carried forward indefinitely and generally repealing carrybacks, reducing the maximum deduction for NOL carryforwards arising in tax years beginning after 2017 to a percentage of the taxpayer’s taxable income, and allowing for additional expensing of certain capital expenditures. The 2017 Tax Act also puts into effect a number of changes impacting operations outside of the United States including, but not limited to, the imposition of a one-time tax “deemed repatriation” on accumulated offshore earnings not previously subject to U.S. tax, and shifts the U.S taxation of multinational corporations from a worldwide system of taxation to a territorial system. ASC 740 requires the effects of changes in tax rates and laws on deferred tax balances (including the effects of the one-time transition tax) to be recognized in the period in which the legislation is enacted. On December 22, 2017, the SEC staff issued Staff Accounting Bulletin No. 118 (“SAB 118”) to provide guidance for companies that are not able to complete their accounting for the income tax effects of the 2017 Tax Act in the period of enactment. SAB 118 allows us to record provisional amounts during a measurement period not to extend beyond one year of the enactment date. We applied the guidance in SAB 118 when accounting for the enactment-date effects of the 2017 Tax Act during the years ended December 31, 2018 and 2017. As of December 31, 2018, we completed the accounting for all the enactment-date income tax effects of the 2017 Tax Act as further discussed in Note 7 to our consolidated financial statements included elsewhere in this Report. Stock-based compensation - We recognize compensation expense related to employee stock option grants and other equity based awards, if any, in accordance with FASB ASC 718, Compensation - Stock Compensation (“ASC 718”). We estimate the fair value of employee stock-based payment awards on the grant-date and recognize the resulting fair value, net of estimated forfeitures for grants prior to 2017, over the requisite service period. Upon adoption of Accounting Standards Update (“ASU”) 2016-09 on January 1, 2017, forfeitures are accounted for as they occur instead of based on the number of awards that were expected to vest prior to adoption of ASU 2016-09. We use the Black-Scholes option pricing model for estimating the fair value of options granted under our 2017 Equity Incentive Plan (the “Plan”). The fair value of each restricted stock or restricted stock unit grant, if any, is determined based on the value of the common stock granted or sold. We have elected to treat stock-based awards with time-based service conditions as a single award and recognize stock-based compensation on a straight-line basis over the requisite service period. Compensation expense for non-employee stock-based awards is recognized in accordance with ASC 718 and FASB ASC 505-50, Equity-Based Payments to Non-Employees. Stock option awards issued to non-employees, principally consultants or outside contractors, as applicable, are accounted for at fair value using the Black-Scholes option pricing model. Management believes that the fair value of the stock options can more reliably be measured than the fair value of services received. We record compensation expense based on the then-current fair values of the stock options at each financial reporting date. Compensation expense recorded during the service period is adjusted in subsequent periods for changes in the fair value of the stock options until the earlier of the date at which the non-employee’s performance is complete or a performance commitment is reached, which is generally when the stock option award vests. Compensation expense for non-employee grants is recorded on a straight-line basis in the consolidated statements of operations. The Black-Scholes option pricing model requires us to make certain assumptions including the fair value of the underlying common stock, the expected term, the expected volatility, the risk-free interest rate and the dividend yield. The fair value of the shares of common stock underlying the stock options has historically been determined by our Board of Directors. Because there was no public market for our common stock prior to November 29, 2018, our Board of Directors determined the fair value of the common stock at the time of the grant of options by considering a number of objective and subjective factors including contemporaneous sales of our common stock to investors, valuation of comparable companies, operating and financial performance and general and industry-specific economic outlook, amongst other factors. The fair value was determined in accordance with applicable elements of the practice aid issued by the American Institute of Certified Public Accountants titled Valuation of Privately Held Company Equity Securities Issued as Compensation. Since our common stock began publicly trading on the NYSE American, the fair value of our common stock underlying stock options has been valued based on prevailing market prices. The expected term of employee stock options represents the weighted-average period that the stock options are expected to remain outstanding. We estimate the expected term of options granted based upon the “simplified method” provided under Staff Accounting Bulletin, Topic 14, or SAB Topic 14. Because our common stock has no publicly traded history prior to November 29, 2018, for the year ended December 31, 2017 we estimated the expected volatility of the awards from the historical volatility of selected public companies within the biotechnology industry with comparable characteristics to us, including similarity in size, lines of business, market capitalization, revenue and financial leverage. We determined the expected volatility assumption using the frequency of daily historical prices of comparable public company’s common stock for a period equal to the expected term of the options. For the year ended December 31, 2018, we estimated the expected volatility using its own stock price volatility to the extent applicable or a combination of our stock price volatility and the stock price volatility of stock of peer companies, for a period equal to the expected term of the options. The risk-free interest rate assumption is based upon observed interest rates on the United States government securities appropriate for the expected term of our stock options. The dividend yield assumption is based on our history and expectation of dividend payouts. We have never declared or paid any cash dividends on our common stock, and we do not anticipate paying any cash dividends in the foreseeable future. All excess tax benefits and tax deficiencies from stock-based compensation awards accounted for under ASC 718 are recognized as an income tax benefit or expense, respectively, in the consolidated statements of operations. Prior to the adoption of ASU 2016-09, AgeX recognized excess tax benefits, if any, in additional paid-in capital only if the tax deduction reduced cash income taxes payable, and excess tax deficiencies were recognized as an offset to accumulated excess tax benefits, if any, on AgeX’s consolidated statements of operations. An excess income tax benefit arises when the tax deduction of a share-based award for income tax purposes exceeds the compensation cost recognized for financial reporting purposes, and a tax deficiency arises when the compensation cost exceeds the tax deduction. Because AgeX had no stock option exercises during the years ended December 31, 2018 and 2017, and because of AgeX’s full valuation allowance as of December 31, 2018 and 2017, there was no impact to AgeX’s consolidated financial statements from the adoption of 2016-09. Stock-based compensation expense for the years ended December 31, 2018 and 2017 consists of stock-based compensation under the AgeX 2017 Equity Incentive Plan, stock-based compensation allocated from BioTime, and stock-based compensation of AgeX’s subsidiaries that have their own stock option plans. As discussed above, certain of our consolidated subsidiaries have their own share-based compensation plans. For share-based compensation awards granted by those privately-held consolidated subsidiaries under their respective equity plans, we determine the fair value of the options granted under those plans using similar methodologies and assumptions we used for our stock options discussed above. Although the fair value of stock options is determined in accordance with FASB guidance, changes in the assumptions and allocations can materially affect the estimated value and therefore the amount of compensation expense recognized in the consolidated financial statements. Long-lived intangible assets - Long-lived intangible assets, consisting primarily of acquired patents, acquired in-process research and development (“IPR&D”) with alternative future uses, patent applications, and licenses to use certain patents, are stated at acquired cost, less accumulated amortization. Amortization expense is computed using the straight-line method over the estimated useful lives of the assets, generally over 10 years. Impairment of long-lived assets - Long-lived assets, including long-lived intangible assets, are reviewed for impairment whenever events or changes in circumstances indicate that the carrying amount of an asset may not be fully recoverable. If an impairment indicator is present, we evaluate recoverability by a comparison of the carrying amount of the assets to future undiscounted net cash flows expected to be generated by the assets. If the assets are impaired, the impairment recognized is measured by the amount by which the carrying amount exceeds the estimated fair value of the assets. Through December 31, 2018, there have been no such impairment losses. Adoption of ASU 2014-09, Revenues from Contracts with Customers (Topic 606). During May 2014, the FASB issued ASU 2014-09 (“Topic 606”) Revenue from Contracts with Customers which supersedes the revenue recognition requirements in Topic 605 Revenue Recognition (“Topic 605”). Topic 606 describes principles an entity must apply to measure and recognize revenue and the related cash flows, using the following five steps: (i) identify the contract(s) with a customer; (ii) identify the performance obligations in the contract; (iii) determine the transaction price; (iv) allocate the transaction price to the performance obligation(s) in the contract; and (v) recognize revenue when (or as) the entity satisfies a performance obligation. Topic 606 core principle is that it requires entities to recognize revenue when control of the promised goods or services is transferred to customers at an amount that reflects the consideration to which the entity expects to be entitled to in exchange for those goods or services. We adopted Topic 606 as of January 1, 2018 using the modified retrospective transition method applied to those contracts which were not completed as of the adoption date. Results for reporting periods beginning on January 1, 2018 and thereafter are presented under Topic 606, while prior period amounts are not adjusted and continue to be reported in accordance with our historic revenue recognition accounting under Topic 605. On January 1, 2018, the impact of the adoption and application of Topic 606 was immaterial, and no cumulative effect adjustment was made as of that date. In the applicable paragraphs below, we have summarized our revenue recognition policies for various revenue sources in accordance with Topic 606. Subscription and advertisement revenues. LifeMap Sciences, our direct majority-owned subsidiary, sells subscription-based products, including research databases and software tools, for biomedical, gene, and disease research. LifeMap Sciences sells these subscriptions primarily through the internet to biotech and pharmaceutical companies worldwide. LifeMap Sciences’ principal subscription product is the GeneCards® Suite, which includes the GeneCards® human gene database, and the MalaCards human disease database. LifeMap Sciences’ performance obligations for subscriptions include a license of intellectual property related to its genetic information packages and premium genetic information tools. These licenses are deemed functional licenses that provide customers with a “right to access” to LifeMap Sciences’ intellectual property during the subscription period and, accordingly, revenue is recognized over a period of time, which is generally the subscription period. Payments are typically received at the beginning of a subscription period and revenue is recognized according to the type of subscription sold. For subscription contracts in which the subscription term commences before a payment is due, LifeMap Sciences records an accounts receivable as the subscription is earned over time and bills the customer according to the contract terms. LifeMap Sciences continuously monitors collections and payments from customers and maintains a provision for estimated credit losses and uncollectible accounts based upon its historical experience and any specific customer collection issues that have been identified. Amounts determined to be uncollectible are written off against the allowance for doubtful accounts. LifeMap Sciences has not historically provided significant discounts, credits, concessions, or other incentives from the stated price in the contract as the prices are offered on a fixed fee basis for the type of subscription package being purchased. LifeMap Sciences may issue refunds only if the packages cease to be available for reasons beyond its control. In such an event, the customer will get a refund on a pro-rata basis. Both the customer and LifeMap Sciences expect the subscription packages to be available during the entire subscription period, and LifeMap Sciences has not experienced any significant issues with the availability of the product and has not issued any material refunds. Using the most likely amount method for estimating refunds under Topic 606, including historical experience, LifeMap Sciences determined that the single most likely amount of variable consideration for refunds is immaterial as LifeMap Sciences does not expect to pay any refunds. LifeMap Sciences performance obligations for advertising are overall advertising services and represent a series of distinct services. Contracts are typically less than a year in duration and the fees charged may include a combination of fixed and variable fees with the variable fees tied to click throughs to the customer’s products on their website. LifeMap Sciences allocates the variable consideration to each month the click through services occur and allocates the annual fee to the performance obligation period of the initial term of the contract because those amounts correspond to the value provided to the customer each month. For click-through advertising services, at the time the variable compensation is known and determinable, the service has been rendered and revenue is recognized at that time. LifeMap Sciences deferred subscription revenues primarily represent subscriptions for which cash payment has been received for the subscription term, but the subscription term has not been completed as of the balance sheet date reported. For the years ended December 31, 2018 and 2017, LifeMap Sciences recognized $1.2 million and $1.4 million in subscription and advertisement revenues. As of December 31, 2018, there was $0.3 million included in deferred revenues in the consolidated balance sheets which is expected to be recognized as subscription revenue over the next twelve months. LifeMap Sciences has licensed from third parties the databases and software it commercializes and has a contractual obligation to pay royalties to the licensor on subscriptions sold. These costs are included in cost of sales on the consolidated statements of operations when the cash is received and the royalty obligation is incurred as the royalty payments do not qualify for capitalization of costs to fulfill a contract under ASC 340-40, Other Assets and Deferred Costs - Contracts with Customers. Grant revenues. In applying the provisions of Topic 606, we have determined that government grants are out of the scope of Topic 606 because the government entities do not meet the definition of a “customer”, as defined by Topic 606, as there is not considered to be a transfer of control of good or services to the government entities funding the grant. We have, and will continue to, account for grants received to perform research and development services in accordance with ASC 730-20, Research and Development Arrangements, which requires an assessment, at the inception of the grant, of whether the grant is a liability or a contract to perform research and development services for others. If we or a subsidiary receiving the grant are obligated to repay the grant funds to the grantor regardless of the outcome of the research and development activities, then we are required to estimate and recognize that liability. Alternatively, if we or a subsidiary receiving the grant are not required to repay, or if we are required to repay the grant funds only if the research and development activities are successful, then the grant agreement is accounted for as a contract to perform research and development services for others, in which case, grant revenue is recognized when the related research and development expenses are incurred. In September 2018, we were awarded a grant of up to approximately $225,000 from the NIH. The NIH grant provides funding for continued development of our technologies for treating osteoporosis. The grant funds will be made available to AgeX by the NIH as allowable expenses are incurred. For the year ended December 31, 2018, we incurred approximately $20,000 of allowable expenses under the NIH grant and recognized corresponding grant revenues for that period. On April 5, 2018, our subsidiary ReCyte Therapeutics was awarded a grant of up to approximately $386,000 from the NIH. The NIH grant provides funding for continued development of our technologies for treating stroke. The grant funds will be made available to ReCyte Therapeutics by the NIH as allowable expenses are incurred. As of December 31, 2018, ReCyte Therapeutics had not incurred any allowable expenses or recognized any grant revenues under the NIH grant. Arrangements with multiple performance obligations. Future contracts with customers may include multiple performance obligations. For such arrangements, we will allocate revenue to each performance obligation based on its relative standalone selling price. We will generally determine or estimate standalone selling prices based on the prices charged, or that would be charged, to customers for that product or service. As of, and for the year ended, December 31, 2018, we did not have significant arrangements with multiple performance obligations. Financial Operations Overview To date, our revenues have been principally derived from subscription and advertising revenue from LifeMap Sciences’ online databases based upon applicable subscription or advertising periods. We do not have any products approved for sale and have not generated any revenue from commercialized product sales, and we do not expect to generate any revenue from product sales for the foreseeable future. Our operating expenses consist of research and development expenses primarily from our pre-clinical programs and general and administrative expenses, including a significant amount of operating expenses allocated to us from BioTime, either incurred directly for our benefit or indirect overhead costs, as described under “-Critical Accounting Policies.” We expect to continue to incur significant expenses and operating losses over the next several years. We anticipate that our expenses will increase significantly in connection with our ongoing activities, if we: ● commence clinical development of our product candidates; ● continue activities to discover, validate and develop additional product candidates; ● maintain, expand and protect our intellectual property portfolio; ● hire research, development and general and administrative personnel as we begin operations as a standalone, publicly-traded company; ● enter into our own leases for laboratory and administrative facilities; and ● incur additional costs associated with operating as a public company. Results of Operations Comparison of Years Ended December 31, 2018 and 2017 Revenues and Cost of Sales The amounts in the table below show our consolidated revenues by source and cost of sales for the years ended December 31, 2018 and 2017 (in thousands). * Not meaningful. Our revenues were primarily generated by LifeMap Sciences, as subscription and advertising revenues from its GeneCards® online database. Subscription and advertising revenues amounted to $1.2 million and $1.4 million for the years ended December 31, 2018 and 2017. During the year ended December 31, 2018, LifeMap Sciences also generated $115,000 of revenues from performing services under contracts, which we do not expect will be recurring revenues for LifeMap Sciences, while service revenues were insignificant during 2017. During 2018 we recognized income of approximately $20,000 from a grant from the NIH. We had no grant revenue in 2017. Cost of sales for the year ended December 31, 2018 as compared to 2017 increased primarily due to an increase in the royalty payments made or incurred by LifeMap Sciences due to a long-term increase in the royalty rate for its subscriptions products and due to the timing of cash received and the related royalty obligation incurred. Operating Expenses The following table shows our consolidated operating expenses for the years ended December 31, 2018 and 2017 (in thousands). * Not meaningful. Research and development expenses Research and development expenses and acquired IPR&D increased by $0.8 million to $6.6 million in 2018 as compared to $5.8 million in 2017. The increase was primarily attributable to an increase of $0.5 million for programs utilizing PureStem® cell lines and iTR technology. Additionally, on March 23, 2018, we purchased certain in-process research and development assets, primarily related to stem cell derived cardiomyocytes (heart muscle cells) to be developed by us, for a total cash consideration of $0.8 million. The transaction was considered an asset acquisition rather than a business combination. Accordingly, the $0.8 million was expensed on the acquisition date as acquired in-process research and development as those assets have no alternative future uses. These increases were partially offset by the LifeMap Sciences’ disposition of its ownership of LifeMap Solutions which accounted for $0.5 million of the decrease in research and development expenses as shown in the table below. The following table shows the amounts and percentages of our total research and development expenses of $6.6 million and $5.8 million, including acquired in-process research and development incurred during 2018, allocated to our primary research and development programs, during the years ended December 31, 2018 and 2017, respectively (amounts in thousands). (1) Amount includes research and development expenses incurred both directly by us or the named subsidiary and indirect overhead costs allocated by BioTime that benefit or support our research and development programs. Direct research and development expenses attributable to us also include allocations for carve-out presentation purposes from certain former BioTime general research departments contributed to us primarily comprised of former BioTime personnel and related expenses, including stock-based compensation, transferred to us, and other outside expenses relevant to the nature of the research projects being conducted that were contributed to us pursuant to the Asset Contribution Agreement described in Note 4 to our consolidated financial statements. Amount also includes indirect expenses allocated from BioTime for certain general research and development expenses, such as lab supplies, lab expenses, rent and insurance allocated to research and development expenses, incurred directly by BioTime on behalf of the subsidiary and allocated to the subsidiary. See Notes 2 and 4 to our consolidated financial statements included elsewhere in this Report. (2) Includes approximately $185,000 and $769,000 from ReCyte Therapeutics for the years ended December 31, 2018 and 2017, respectively. (3) LifeMap Sciences is a subsidiary of AgeX. See Notes 2 and 4 to our consolidated financial statements included elsewhere in this Report. (4) LifeMap Solutions was transferred to BioTime on June 6, 2017 and subsequently ceased conducting its mobile health co-developed software application business and was dissolved. General and administrative expenses The following table shows the amount and percentages of our consolidated general and administrative expenses of $5.6 million and $3.9 million incurred during the years ended December 31, 2018 and 2017, respectively (amounts in thousands). (1) Amount includes both direct expenses incurred by us or the named subsidiary and indirect overhead costs allocated by BioTime that benefit or support our general and administrative functions. Direct general and administrative expenses attributable to us also include allocations from certain BioTime general and administrative expenses, including allocated stock-based compensation, for carve-out presentation purposes of our consolidated statements of operations. These allocations are principally based on the historical general and administrative functions and expenses relevant to BioTime and our subsidiaries that operated prior to and after our formation during the periods presented. Amount also includes indirect general and administrative expenses allocated by BioTime to us under the Shared Facilities Agreement. See Notes 2 and 4 to our consolidated financial statements included in this Report. (2) LifeMap Sciences is a subsidiary of AgeX. See Notes 2 and 4 to our consolidated financial statements included in this Report. (3) LifeMap Solutions was transferred to BioTime on June 6, 2017 and subsequently ceased conducting its mobile health co-developed software application business and was dissolved. General and administrative expenses for the year ended December 31, 2018 increased by $1.7 million to $5.6 million as compared to $3.9 million in 2017. This increase was primarily attributable to the following: $0.7 million in financial reporting, compliance, legal and other expenses related to our preparation and filing of a registration statement on Form 10 to become a public company; $0.4 million in consulting, travel and related expenses; and $1.0 million increase in noncash stock-based compensation expense. Since our Equity Incentive Plan was established in July 2017 and, based on the timing of our stock option grants occurring during the latter half of 2017, our stock-based compensation expense was significantly higher in 2018. These increases were partially offset by approximately $0.5 million of cost savings after June 6, 2017, resulting from LifeMap Sciences’ disposition of its ownership of LifeMap Solutions as noted in the table above. Gain on sale of equity method investment in Ascendance On March 23, 2018 Ascendance Biotechnology, Inc. (“Ascendance”), a company in which we held shares of common stock accounted for on the equity method, was acquired by a third party in a merger and we received $3.2 million in cash for our Ascendance common stock. We recognized a gain on sale for the same amount included in other income and expenses, net, during the year ended December 31, 2018. Gain on sale of assets Loss from operations for the year ended December 31, 2017 includes a $1.8 million gain we recognized on the sale of certain co-developed assets by LifeMap Solutions to its customer prior to the transfer of LifeMap Solutions to BioTime on June 6, 2017. Income taxes For Federal and California purposes, our activity through August 30, 2018 and for 2017 will be or was included in BioTime’s federal consolidated and California combined tax returns. For these periods, the provision for income taxes has been presented as if we had filed a separate federal consolidated tax return and a California combined tax return using the separate return method. As of December 31, 2018, we had net operating loss carryforwards of approximately $31.5 million for U.S. federal income tax purposes. Of this amount, $8.7 million is attributable to LifeMap Sciences, which includes $2.1 million in NOLs generated while it was included in the consolidated BioTime tax group and would be available to offset income of AgeX in the future. The remaining LifeMap Sciences NOLs of $6.6 million are attributable to NOLs generated for the tax years during which LifeMap Sciences filed a separate federal income tax return and, accordingly, those NOLs are available only to LifeMap Sciences’ taxable income within AgeX in future years. In general, NOLs and other tax credit carryforwards generated by legal entities in a consolidated federal tax group are available to other members of the tax group depending on the nature of the transaction that a member may enter into while still in the consolidated federal tax group. However, under the Tax Matters Agreement between BioTime and AgeX, any use of a member’s NOLs and other tax credit carryforwards by the other member is subject to reimbursement by the benefiting member for the actual tax benefit realized. Since the August 30, 2018 deconsolidation of AgeX, and to date, neither BioTime nor AgeX has used the tax attributes of the other. On June 6, 2017, BioTime and LifeMap Sciences entered into a Debt Conversion Agreement whereby BioTime acquired additional stock in LifeMap Sciences and other assets, including intellectual property and direct ownership of LifeMap Solutions in exchange for settlement of related party indebtedness of approximately $8.8 million owed to BioTime. These transactions occurred between commonly controlled entities, including noncontrolling interests, and the financial reporting impact is discussed in Note 4 to our consolidated financial statements included elsewhere in this Report. For income tax purposes, the purchase by BioTime of LifeMap Sciences’ intellectual property and other assets resulted in a taxable gain to LifeMap Sciences of $3.7 million for the year ended December 31, 2017. Although LifeMap Sciences had sufficient current year operating losses and regular net operating loss carryforwards to offset the entire gain, it incurred a federal alternative minimum tax payable (“AMT”) of $22,000 as of December 31, 2017. As LifeMap Sciences will ultimately receive a full refund of the current AMT payable, fully offsetting the current provision, there is no tax provision or benefit recorded for the year ended December 31, 2017. As of December 31, 2018, we had net operating losses of approximately $32.5 million for California purposes. As we and our subsidiaries have been included in the combined California tax return with BioTime, up to the date of deconsolidation on August 30, 2018, those state net operating losses will remain with AgeX. Federal net operating losses generated on or prior to December 31, 2017, expire in varying amounts between 2030 and 2037, while federal net operating losses generated after December 31, 2017, carryforward indefinitely. The state net operating losses expire in varying amounts between 2028 and 2038. As of December 31, 2018, AgeX had research and development tax credit carryforwards for federal and state tax purposes of $903,000 and $831,000, respectively. Although this LifeMap Sciences credit has been included as part of the AgeX credit carryforwards, LifeMap Sciences filed a separate federal income tax return prior to January 1, 2018 and its prior research credit carryforwards may not be used to offset federal taxable income of AgeX. As AgeX and its subsidiaries were included in the California combined return with BioTime, these credits noted above will remain with AgeX. The federal tax credits expire between 2028 and 2038, while the state tax credits have no expiration date. A valuation allowance is provided when it is more likely than not that some or all of the deferred tax assets will not be realized. We established a full valuation allowance for all periods presented due to the uncertainty of realizing future tax benefits from our net operating loss carryforwards and other deferred tax assets. Accordingly, due to losses incurred for all periods presented, we did not record any provision or benefit for income taxes. Liquidity and Capital Resources Since inception, we have financed our operations through contributions and advances from our former parent company, BioTime, the sale of our common stock, the sale and exercise of warrants, and research grants. BioTime has also provided us with the use of BioTime facilities and services under the Shared Facilities Agreement. Although BioTime may continue to provide administrative support to us on a reimbursable basis, we do not expect BioTime will provide us future financing. We have incurred operating losses and negative cash flows since inception and had an accumulated deficit of $74.1 million as of December 31, 2018. We expect to continue to incur operating losses and negative cash flows. We expect our expenses to increase in the near term in connection with our ongoing activities, including costs related to our planned move to a new office and laboratory facility in Alameda, California under a sublease from a third party that will replace our use of BioTime’s facilities. We will also incur additional costs if we hire our internal administrative personnel and rely less on services provided by BioTime under the terms of the Shared Facilities Agreement. Furthermore, now that we are a public company, we will incur additional costs associated with operating as a public company. In the longer term, we expect our expenses to increase as we continue our pre-clinical research and development activities and, if we initiate clinical trials and seek marketing approval for our product candidates. In addition, if we obtain marketing approval for any of our product candidates, we expect to incur significant commercialization expenses related to product sales, marketing, manufacturing and distribution to the extent that such sales, marketing and distribution are not the responsibility of potential collaborators. Accordingly, we will need to obtain substantial additional funding in connection with our continuing operations. We have evaluated our projected cash flows and believe that our cash and cash equivalents of $6.7 million as of December 31, 2018, plus the $4.5 million we received from the exercise of Warrants during March 2019, provide sufficient cash, cash equivalents, and liquidity to carry out our current operations through at least twelve months from the issuance date of the consolidated financial statements included elsewhere in this Report. However, it is likely that we will need to raise additional capital in the near term to be able to meet our operating expenses beyond that twelve month period. The amount of our future capital requirements will depend on many factors. In the near term these factors will include: ● the scope, progress, results and costs of research and development work on product candidates; ● the scope, prioritization and number of our research and development programs we conduct; ● our ability to establish and maintain collaborations on favorable terms, if at all; ● the costs of preparing, filing and prosecuting patent applications, maintaining and enforcing our intellectual property rights and defending intellectual property-related claims; ● the costs of entering into and maintaining our own leases for laboratory and administrative facilities and equipment; and ● the cost of employing our own administrative personnel rather than relying on services provided by BioTime or Juvenescence. We do not have any committed sources of funds for additional financing and we cannot assure that we will be able to raise additional financing on favorable terms or at all. To the extent that we raise additional capital through the sale of equity or convertible debt securities, the ownership interest of our present stockholders will be diluted, and the terms of any securities we issue may include liquidation or other preferences that adversely affect their rights as common stockholders. Debt financing, if available, may involve agreements that include covenants limiting or restricting our ability to take specific actions, such as incurring additional debt, making capital expenditures or declaring dividends, and may involve the issuance of convertible debt or stock purchase warrants that would dilute the equity interests of our stockholders. If we raise funds through additional strategic partnerships or licensing arrangements with third parties, we may have to relinquish valuable rights to our technologies, future revenue streams, research programs or product candidates or to grant licenses on terms that may not be favorable to us. If we are unable to raise capital when needed or on attractive terms, we would be forced to delay, reduce or eliminate our research and development programs. Cash used in operating activities For the year ended December 31, 2018, our total research and development expenses, including acquired in-process research and development expenses were $6.6 million and our general and administrative expenditures were $5.6 million. Net loss attributable to us for the years ended December 31, 2018 amounted to $7.5 million. Net cash used in operating activities during this period amounted to $8.0 million. The difference between the net loss attributable to us and net cash used in operating activities during the year ended December 31, 2018 was primarily attributable to the following noncash items: $3.2 million gain on the disposition of our ownership of Ascendance common stock offset to some extent by $0.8 million for acquired in-process research and development expense, $1.5 million in stock-based compensation expense, $0.5 million in amortization of intangible assets and depreciation expense, and $0.2 million in net loss attributable to noncontrolling interest. Changes in working capital impacted our cash used in operations by $0.2 million as a net source of cash. Cash provided by investing activities During the year ended December 31, 2018, net cash provided by investing activities was $1.3 million. The primary component of this amount was $3.2 million in proceeds from the disposition of our ownership of Ascendance common stock, offset by a $1.1 million payment to Escape Therapeutics and a $0.8 million payment to Ascendance for the acquisition of in-process research and development assets. Cash provided by financing activities During the year ended December 31, 2018, net cash provided by financing activities amounted to $6.0 million, including $5.0 million of proceeds from the issuance of common stock and $1.0 million of proceeds from the issuance of the AgeX Warrants. Contractual obligations We had no contractual obligations as of December 31, 2018, with the exception of the Shared Facilities Agreement. Under the terms of the Shared Facilities Agreement, BioTime will allow us to use its premises and equipment located at Alameda, California for the purpose of conducting our business. BioTime may also provide accounting, billing, bookkeeping, payroll, treasury, payment of accounts payable, and other similar administrative services. BioTime may also provide the services of attorneys, accountants, and other professionals who may also provide professional services to BioTime and its other subsidiaries. BioTime may also provide us with the services of its laboratory and research personnel, including BioTime employees and contractors, for the performance of our research and development work at the premises. BioTime charges us a “Use Fee” for services received and usage of facilities, equipment, and supplies. For each billing period, BioTime prorates and allocates costs incurred, as applicable, to us, such costs include services of BioTime employees, equipment, insurance, lease, professional, software, supplies and utilities. Allocation depends on key cost drivers including actual documented use, square footage of facilities used, time spent, costs incurred by or for our benefit, or upon proportionate usage by BioTime and us, as reasonably estimated by BioTime (collectively “Use Fees”). BioTime, at its discretion, has the right to charge us a 5% markup on such allocated costs and BioTime has charged this markup since the inception of the Shared Facilities Agreement. The allocated cost of BioTime employees and contractors who provide services is based upon records maintained of the number of hours or percentage of time of such personnel devoted to the performance of services. The Shared Facilities Agreement will remain in effect from year to year, unless (a) either party gives the other party written six months’ notice to terminate, which BioTime may not give to AgeX prior to September 1, 2020, or (b) the agreement is otherwise terminated under another provision of the agreement. BioTime’s lease expires on January 31, 2023. The minimum fixed payments due under the Shared Facilities Agreement are approximately $150,000 per month. We plan to terminate our use of BioTime’s office and laboratory facilities under the Shared Facilities Agreement if the Preconditions to the sublease of our proposed new New Facility are met, or if we locate and lease an alternative office and laboratory facility. Off-Balance Sheet Arrangements As of December 31, 2018, we did not have any off-balance sheet arrangements, as defined in Item 303(a) (4) (ii) of SEC Regulation S-K.

<s>[INST] Emerging Growth Company Status The Jumpstart our Business Startups Act of 2012 (“JOBS Act”) permits an “emerging growth company” such as AgeX to take advantage of an extended transition period to comply with new or revised accounting standards applicable to public companies. However, we elected to comply with newly adopted or revised accounting standards when they become applicable to public companies because our financial statements were consolidated with those of BioTime, which is not an emerging growth company under the JOBS Act and is therefore not permitted to delay the adoption of new or revised accounting standards that become applicable to public companies. This election under the JOBS Act to not delay the adoption of new or revised accounting standards is irrevocable. Overview We were incorporated in January 2017 in the state of Delaware as a subsidiary of BioTime, a publicly traded, clinicalstage biotechnology company targeting degenerative diseases. BioTime common stock trades on the NYSE American and Tel Aviv Stock Exchange under the symbol “BTX”. We are a biotechnology company focused on the development and commercialization of novel therapeutics targeting human aging. Our initial discovery and preclinical programs focus on utilizing brown adipose tissue in targeting diabetes, obesity, and heart disease; and induced tissue regeneration in utilizing the human body’s own abilities to scarlessly regenerate tissues damaged from age or trauma. We may also pursue other earlystage preclinical programs. On August 17, 2017, we completed an asset acquisition and stock sale pursuant to which we received certain assets from BioTime for use in our research and development programs and raised $10.0 million in cash from investors to finance our operations. From February 28, 2018 to July 10, 2018, we sold warrants to purchase 2,000,000 shares of AgeX common stock (the “Warrants”) for $0.50 per warrant for aggregate cash proceeds of $1,000,000. The Warrants were exercisable at $2.50 per share. Pursuant to the Warrant Agreement governing the Warrants, we set March 18, 2019 as the expiration date of the Warrants and by that date Warrant holders purchased 1.8 million shares of common stock through the exercise of the Warrants for $4.5 million in the aggregate. The Warrants were classified as equity since, among other factors, they were not redeemable, could not be settled in cash or other assets and required settlement by issuing a fixed number of shares of AgeX common stock. The Warrants were sold at fair value determined using the Binomial Lattice option pricing model on the issuance date, with certain management assumptions, which included the timing of an initial public offering of AgeX common stock, peergroup volatility, term to maturity, price cap and AgeX current and future stock prices. On June 7, 2018, we sold 2.0 million shares of common stock for $2.50 per share to Juvenescence for aggregate cash proceeds to us of $5.0 million. These financings have allowed us to focus our resources on our preclinical programs. On August 30, 2018, BioTime consummated the secondary sale of 14.4 million of its shares of AgeX common stock to Juvenescence pursuant to a stock purchase agreement. Upon completion of the transaction, BioTime’s ownership in us was reduced from 80.4% to 40.2% of our issued and outstanding shares of common stock, and Juvenescence’s ownership in AgeX was increased from 5.6% to 45.8% of our issued and outstanding shares of common stock. As a result, beginning on August 30, 2018, we are no longer considered a subsidiary of BioTime because, on that date, BioTime experienced a “loss of control” of a subsidiary, as defined by generally accepted accounting principles in the United States. Loss of control is deemed to have occurred when, among other things, a parent company owns less than a majority of the outstanding common stock [/INST] Positive. </s>

AgeX Therapeutics, Inc.

2020-03-30

2019-12-31

Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations The following Management’s Discussion and Analysis of Financial Condition and Results of Operations is intended to provide information necessary to understand our audited consolidated financial statements for the years ended December 31, 2019 and 2018, and highlight certain other information which, in the opinion of management, will enhance a reader’s understanding of our financial condition, changes in financial condition and results of operations. These historical financial statements may not be indicative of our future performance. This Management’s Discussion and Analysis of Financial Condition and Results of Operations contains a number of forward-looking statements, all of which are based on our current expectations and could be affected by the uncertainties and risks described throughout this filing, particularly in “Risk Factors.” Emerging Growth Company Status The Jumpstart our Business Startups Act of 2012 (“JOBS Act”) permits an “emerging growth company” such as AgeX to take advantage of an extended transition period to comply with new or revised accounting standards applicable to public companies. However, we elected to comply with newly adopted or revised accounting standards when they become applicable to public companies because our financial statements were consolidated with those of Lineage, which is not an emerging growth company under the JOBS Act and is therefore not permitted to delay the adoption of new or revised accounting standards that become applicable to public companies. This election under the JOBS Act to not delay the adoption of new or revised accounting standards is irrevocable. Overview We are a biotechnology company focused on the development and commercialization of novel therapeutics targeting human aging and degenerative diseases. Our initial discovery and preclinical programs focus on utilizing brown adipose tissue in targeting diabetes, obesity, and heart disease; and induced tissue regeneration in utilizing the human body’s own abilities to scarlessly regenerate tissues damaged from age or trauma. We may also pursue other early-stage pre-clinical programs. Since inception, our operations have focused on building our technology platform, identifying potential product candidates, establishing and protecting our intellectual property and raising capital. Our revenues have been principally derived from subscription and advertising revenue from LifeMap Sciences’ online databases based upon applicable subscription or advertising periods. We do not have any products approved for sale and have not generated any revenue from product sales. Since inception, we have incurred significant operating losses and we will need to obtain additional financing in order to continue our operations, including our research and development programs. See “Liquidity and Capital Resources” for a discussion of our available capital resources and our need for financing. Our operating losses were $12.6 million and $11.2 million, for the years ended December 31, 2019 and 2018, respectively. As of December 31, 2019, we had an accumulated deficit of $86.2 million. We expect to continue to incur significant expenses and operating losses for the foreseeable future. Critical Accounting Policies The preparation of financial statements in conformity with accounting principles generally accepted in the United States (“GAAP”), requires management to make estimates and assumptions that affect the reported amounts in our consolidated financial statements and related notes. Our significant accounting policies are described in Note 2 to our consolidated financial statements included elsewhere in this Report. We have identified below our critical accounting policies and estimates that we believe require the greatest amount of judgment. On an ongoing basis, we evaluate our estimates that are subject to significant judgment including those related to going concern assessment of consolidated financial statements, allocations and adjustments necessary for carve-out basis of presentation, including the separate return method for income taxes, useful lives associated with long-lived assets, including evaluation of asset impairment, allowances for uncollectible accounts receivables, loss contingencies, deferred income taxes and tax reserves, including valuation allowances related to deferred income taxes, and assumptions used to value stock-based awards, or other equity instruments. Actual results could differ materially from those estimates. On an ongoing basis, we evaluate our estimates compared to historical experience and trends, which form the basis for making judgments about the carrying value of assets and liabilities. To the extent that there are material differences between our estimates and our actual results, our future consolidated financial statement presentation, financial condition, results of operations and cash flows will be affected. We believe the assumptions and estimates associated with the following have the greatest potential impact on our consolidated financial statements. Principles of consolidation - AgeX’s consolidated financial statements include the accounts of its subsidiaries and certain research and development departments, including former Lineage personnel, transferred from Lineage to AgeX in connection with the Asset Contribution Agreement described in Note 4 to our consolidated financial statements. AgeX consolidated its direct and indirect wholly-owned or majority-owned subsidiaries because AgeX has the ability to control their operating and financial decisions and policies through its ownership, and the noncontrolling interest is reflected as a separate element of stockholders’ equity on AgeX’s consolidated balance sheets. As of, and for the year ended, December 31, 2019, AgeX consolidated ReCyte Therapeutics, LifeMap Sciences, Inc. (“LifeMap Sciences”), and LifeMap Sciences, Ltd. (Israel) and included the historical expenses of certain former Lineage research and development departments (see Note 4 to our consolidated financial statements). Going concern assessment - We assess going concern uncertainty for our consolidated financial statements to determine if we have sufficient cash and cash equivalents on hand and working capital to operate for a period of at least one year from the date our consolidated financial statements are issued or are available to be issued, which is referred to as the “look-forward period” as defined by FASB’s ASU No. 2014-15. As part of this assessment, based on conditions that are known and reasonably knowable to us, we consider various scenarios, forecasts, projections, and estimates, and we make certain key assumptions, including the timing and nature of projected cash expenditures or programs, among other factors, and our ability to delay or curtail those expenditures or programs within the look-forward period in accordance with ASU No. 2014-15, if necessary. Related party transactions - Shared Facilities and Services Agreement - As more fully described in Note 4 to our consolidated financial statements included elsewhere in this Report, Lineage provided us with the use of Lineage facilities and services under a Shared Facilities and Services Agreement (the “Shared Facilities Agreement”). Accordingly, Lineage allocated expenses such as salaries and payroll related expenses incurred and paid on our behalf based on the amount of time that particular employees devote to AgeX affairs. Other expenses such as legal, accounting and financial reporting, marketing, and travel expenses were allocated to us to the extent that those expenses were incurred by or on behalf of AgeX. Lineage also allocated certain overhead expenses such as rent and utilities, property taxes, insurance, laboratory expenses and supplies, telecommunications and other indirect expenses. These allocations were made based upon activity-based allocation drivers such as time spent, percentage of square feet of office or laboratory space used, headcount and percentage of personnel devoted to our operations or management. Management evaluated the appropriateness of the allocations on a periodic basis and believes that this basis for allocation was reasonable. The Shared Facilities Agreement terminated on September 30, 2019 and Lineage will not be providing us with further services or use of its facilities. Related party transactions - allocated expenses from Lineage - Consistent with the principles of carve-out financial statements and presentation discussed in Note 2 to our consolidated financial statements, certain expenses were allocated by Lineage and included in our consolidated statements of operations and consolidated statements of stockholders’ equity as a contribution by Lineage. Research and development expenses include allocations from Lineage primarily attributable to certain former Lineage research departments contributed to us. Those expenses are primarily comprised of former Lineage personnel and related expenses, including stock-based compensation, and other outside expenses relevant to the nature of the research projects that were contributed to us pursuant to the Asset Contribution Agreement discussed in Note 4 to our consolidated financial statements included elsewhere in this Report. Management considers the allocation methodologies used to allocate expenses as reasonable and appropriate based on historical Lineage expenses attributable to us and our operations for purposes of the standalone, carve-out consolidated financial statements included elsewhere in this Report. The expenses reflected in the consolidated financial statements may not be indicative of expenses that we will incur in the future. Research and development - Research and development expenses include both direct expenses incurred by us or our subsidiaries and indirect overhead costs allocated by Lineage that benefited or supported our research and development functions. Direct research and development expenses consist primarily of personnel costs and related benefits, including stock-based compensation, amortization of intangible assets, outside consultants and suppliers, and license fees paid to third parties to acquire patents or licenses to use patents and other technology. Direct research and development expenses also include allocations for carve-out presentation purposes from certain former Lineage research departments discussed above under Related party transactions - allocated expenses from Lineage. Indirect research and development expenses include overhead expenses allocated to us by Lineage discussed under Related party transactions - Shared Facilities and Services Agreement above. Research and development costs are expensed as incurred. Research and development expenses incurred and reimbursed by grants from third parties or governmental agencies, including service revenues from co-development projects with customers, if any and as applicable, approximate the respective revenues recognized in the consolidated statements of operations. General and administrative - General and administrative expenses include both direct expenses incurred by us and indirect overhead costs allocated by Lineage that benefited or supported our general and administrative functions. Direct general and administrative expenses consist primarily of compensation and related benefits, including stock-based compensation, for executive and corporate personnel, and professional and consulting fees. Direct general and administrative expenses also include allocations for carve-out presentation purposes discussed above under Related party transactions - allocated expenses from Lineage. Indirect general and administrative expenses include overhead expenses allocated to us by Lineage discussed under Related party transactions - Shared Facilities and Services Agreement above. Income taxes - For Federal and California purposes, AgeX’s activity through August 30, 2018 was included in Lineage’s federal consolidated and California combined tax returns. For those periods, the income tax provision was prepared in accordance with ASC 740, Income Taxes, using the separate return method to determine the tax provision of AgeX for carve-out presentation purposes of its consolidated financial statements. The separate return method, amongst other things, requires that the amount of current and deferred tax expense for a group that files a consolidated income tax return be allocated among the members of that group as if each group member were a separate taxpayer. As a result, the provision for income taxes has been presented as if AgeX had filed a separate federal consolidated tax return and a California combined tax return for the periods presented. In using the separate return method, the sum of the amounts allocated to the members of the income tax return group may not equal the consolidated amount. If tax attributes recorded in the carve-out consolidated financial statements are materially different from the actual tax attributes pertaining to us or our legal entities and our subsidiaries, or to Lineage and its subsidiaries, those differences are identified and disclosed in Note 7 to our consolidated financial statements included elsewhere in the Report. Accordingly, depending on our future legal structure and related tax elections that may be taken by us, our effective tax rate in future years could vary materially from our historical effective tax rates. The historical deferred tax assets, including the operating losses and credit carryforwards generated by certain research and development departments that operated within Lineage and were transferred to us on August 17, 2017, have been presented as our tax attributes consistent with the principles of the separate return method described above. As of December 31, 2019, the deferred tax assets and liabilities presented in Note 7 included elsewhere in this Report, including net operating loss carryforwards and research and development credits, represent the tax attributes of AgeX and its subsidiaries. However, the net operating losses and research and development credits generated before August 17, 2017 with respect to Lineage research departments that were transferred to us on that date will remain as tax attributes of Lineage. In general, net operating losses and other tax credit carryforwards generated by legal entities in a consolidated federal tax group or a combined state tax group, collectively “the tax group”, are available to other members of the tax group depending on the nature of the transaction that a member may enter into while still in the tax group. However, under the Tax Matters Agreement between Lineage and AgeX entered into on August 17, 2017, any use of a member’s net operating loss and other tax credit carryforwards by the other member is subject to reimbursement by the benefiting member for the actual tax benefit realized. Since the August 30, 2018 deconsolidation of AgeX and to date, neither Lineage nor AgeX has used the tax attributes of the other. We account for income taxes in accordance with ASC 740, which prescribes the use of the asset and liability method, whereby deferred tax asset or liability account balances are calculated at the balance sheet date using current tax laws and enacted rates in effect. Valuation allowances are established when necessary to reduce deferred tax assets when it is more likely than not that a portion or all of the deferred tax assets will not be realized. Our judgments, estimates and projections regarding future taxable income may change over time due to changes, among other factors, in market conditions, changes in tax laws, and tax planning strategies. If our assumptions and consequently our estimates change in the future, the valuation allowance may be increased or decreased, which may have a material impact on our consolidated financial statements. The guidance also prescribes a recognition threshold and a measurement attribute for the financial statement recognition and measurement of tax positions taken or expected to be taken in a tax return. For those benefits to be recognized, a tax position must be more-likely-than-not sustainable upon examination by taxing authorities. We recognize accrued interest and penalties related to unrecognized tax benefits as income tax expense. No amounts were accrued for the payment of interest and penalties as of December 31, 2019 and 2018. We do not expect that the total amount of unrecognized tax benefits will materially change over the next twelve months. We are currently unaware of any tax issues under review. On December 22, 2017, the United States enacted major federal tax reform legislation, Public Law No. 115-97, commonly referred to as the 2017 Tax Cuts and Jobs Act (“2017 Tax Act”), which enacted a broad range of changes to the Internal Revenue Code. Changes to taxes on corporations impacted by the 2017 Tax Act include, but not limited to, lowering the U.S. federal tax rates to a 21 percent flat tax rate, eliminating the corporate alternative minimum tax (“AMT”), imposing additional limitations on the deductibility of interest and net operating losses, allowing any net operating loss (“NOLs”) generated in tax years ending after December 31, 2017 to be carried forward indefinitely and generally repealing carrybacks, reducing the maximum deduction for NOL carryforwards arising in tax years beginning after 2017 to a percentage of the taxpayer’s taxable income, and allowing for additional expensing of certain capital expenditures. The 2017 Tax Act also puts into effect a number of changes impacting operations outside of the United States including, but not limited to, the imposition of a one-time tax “deemed repatriation” on accumulated offshore earnings not previously subject to U.S. tax, and shifts the U.S taxation of multinational corporations from a worldwide system of taxation to a territorial system. ASC 740 requires the effects of changes in tax rates and laws on deferred tax balances (including the effects of the one-time transition tax) to be recognized in the period in which the legislation is enacted. On December 22, 2017, the SEC staff issued Staff Accounting Bulletin No. 118 (“SAB 118”) to provide guidance for companies that are not able to complete their accounting for the income tax effects of the 2017 Tax Act in the period of enactment. SAB 118 allows us to record provisional amounts during a measurement period not to extend beyond one year of the enactment date. We applied the guidance in SAB 118 when accounting for the enactment-date effects of the 2017 Tax Act during the year ended December 31, 2018. As of December 31, 2018, we completed the accounting for all the enactment-date income tax effects of the 2017 Tax Act as further discussed in Note 7 to our consolidated financial statements included elsewhere in this Report. Stock-based compensation - We recognize compensation expense related to employee stock option grants and other equity based awards, if any, in accordance with FASB ASC 718, Compensation - Stock Compensation (“ASC 718”). We use the Black-Scholes option pricing model for estimating the fair value of options granted under our 2017 Equity Incentive Plan (the “Plan”). The fair value of each restricted stock or restricted stock unit grant, if any, is determined based on the value of the common stock granted or sold. We have elected to treat stock-based awards with time-based service conditions as a single award and recognize stock-based compensation on a straight-line basis over the requisite service period. Compensation expense for non-employee stock-based awards is recognized in accordance with ASC 718. Stock option awards issued to non-employees, principally consultants or outside contractors, as applicable, are accounted for at fair value using the Black-Scholes option pricing model. Management believes that the fair value of the stock options can more reliably be measured than the fair value of services received. We record compensation expense based on the then-current fair values of the stock options at the grant date in accordance with ASU 2018-07, Compensation - Stock Compensation (Topic 718): Improvements to Nonemployee Share-Based Payment Accounting, which simplifies the accounting for non-employee share-based payment transactions. We adopted ASU 2018-07 on January 1, 2019. As we had one stock option grant issued to a nonemployee as of the adoption date and one additional stock option grant during 2019 to the same nonemployee, the application of the new standard did not have a material impact on our consolidated financial statements. Compensation expense for non-employee grants is recorded on a straight-line basis in the consolidated statements of operations. The Black-Scholes option pricing model requires us to make certain assumptions including the fair value of the underlying common stock, the expected term, the expected volatility, the risk-free interest rate and the dividend yield. The fair value of the shares of common stock underlying the stock options has historically been determined by our Board of Directors. Because there was no public market for our common stock prior to November 29, 2018, our Board of Directors determined the fair value of the common stock at the time of the grant of options prior to that date by considering a number of objective and subjective factors including contemporaneous sales of our common stock to investors, valuation of comparable companies, operating and financial performance and general and industry-specific economic outlook, amongst other factors. The fair value was determined in accordance with applicable elements of the practice aid issued by the American Institute of Certified Public Accountants titled Valuation of Privately Held Company Equity Securities Issued as Compensation. Since our common stock began publicly trading on the NYSE American, the fair value of our common stock underlying stock options has been valued based on prevailing market prices. The expected term of employee stock options represents the weighted-average period that the stock options are expected to remain outstanding. We estimate the expected term of options granted based upon the “simplified method” provided under Staff Accounting Bulletin, Topic 14, or SAB Topic 14. Because our common stock had no publicly traded history prior to November 29, 2018, for the year ended December 31, 2019 and 2018, we estimated the expected volatility using our own stock price volatility to the extent applicable or a combination of our stock price volatility and the stock price volatility of peer companies, for a period equal to the expected term of the options. The peer companies used include selected public companies within the biotechnology industry with comparable characteristics to AgeX, including similarity in size, lines of business, market capitalization, revenue and financial leverage. The risk-free interest rate assumption is based upon observed interest rates on the United States government securities appropriate for the expected term of our stock options. The dividend yield assumption is based on our history and expectation of dividend payouts. We have never declared or paid any cash dividends on our common stock, and we do not anticipate paying any cash dividends in the foreseeable future. All excess tax benefits and tax deficiencies from stock-based compensation awards accounted for under ASC 718 are recognized as an income tax benefit or expense, respectively, in the consolidated statements of operations. An excess income tax benefit arises when the tax deduction of a share-based award for income tax purposes exceeds the compensation cost recognized for financial reporting purposes, and a tax deficiency arises when the compensation cost exceeds the tax deduction. Stock-based compensation expense for the years ended December 31, 2019 and 2018 consists of stock-based compensation under the AgeX 2017 Equity Incentive Plan, and stock-based compensation of AgeX’s subsidiaries that have their own stock option plans. Certain of our consolidated subsidiaries have their own share-based compensation plans. For share-based compensation awards granted by those privately-held consolidated subsidiaries under their respective equity plans, we determine the fair value of the options granted under those plans using similar methodologies and assumptions we used for our stock options discussed above. Although the fair value of stock options is determined in accordance with FASB guidance, changes in the assumptions and allocations can materially affect the estimated value and therefore the amount of compensation expense recognized in the consolidated financial statements. Long-lived intangible assets - Long-lived intangible assets, consisting primarily of acquired patents, acquired in-process research and development (“IPR&D”) with alternative future uses, patent applications, and licenses to use certain patents, are stated at acquired cost, less accumulated amortization. Amortization expense is computed using the straight-line method over the estimated useful lives of the assets, generally over 10 years. Impairment of long-lived assets - Long-lived assets, including long-lived intangible assets, are reviewed for impairment whenever events or changes in circumstances indicate that the carrying amount of an asset may not be fully recoverable. If an impairment indicator is present, we evaluate recoverability by a comparison of the carrying amount of the assets to future undiscounted net cash flows expected to be generated by the assets. If the assets are impaired, the impairment recognized is measured by the amount by which the carrying amount exceeds the estimated fair value of the assets. Through December 31, 2019, there have been no such impairment losses. Revenue recognition - During the first quarter of 2018, we adopted FASB ASU 2014-09, Revenues from Contracts with Customers (Topic 606), which created a single, principle-based revenue recognition model that supersedes and replaces nearly all existing U.S. GAAP revenue recognition guidance. We adopted ASU 2014-09 using the modified retrospective transition method applied to those contracts which were not completed as of the adoption date. Results for reporting periods beginning on January 1, 2018 and thereafter are presented under Topic 606, while prior period amounts are not adjusted and continue to be reported in accordance with our historical revenue recognition accounting under Topic 605. We recognize revenue in a manner that depicts the transfer of control of a product or a service to a customer and reflects the amount of the consideration it expects to receive in exchange for such product or service. In doing so, We follow a five-step approach: (i) identify the contract with a customer, (ii) identify the performance obligations in the contract, (iii) determine the transaction price, (iv) allocate the transaction price to the performance obligations, and (v) recognize revenue when (or as) the customer obtains control of the product or service. We consider the terms of a contract and all relevant facts and circumstances when applying the revenue recognition standard. We apply the revenue recognition standard, including the use of any practical expedients, consistently to contracts with similar characteristics and in similar circumstances. On January 1, 2018, the impact of the adoption and application of Topic 606 was immaterial, and no cumulative effect adjustment was made as of that date. In the applicable paragraphs below, we have summarized our revenue recognition policies for various revenue sources in accordance with Topic 606. Subscription and advertisement revenues. LifeMap Sciences sells subscription-based products, including research databases and software tools, for biomedical, gene, and disease research. LifeMap Sciences sells these subscriptions primarily through the internet to biotech and pharmaceutical companies worldwide. LifeMap Sciences’ principal subscription product is the GeneCards® Suite, which includes the GeneCards® human gene database, and the MalaCards™ human disease database. LifeMap Sciences’ performance obligations for subscriptions include a license of intellectual property related to its genetic information packages and premium genetic information tools. These licenses are deemed functional licenses that provide customers with a “right to access” to LifeMap Sciences’ intellectual property during the subscription period and, accordingly, revenue is recognized over a period of time, which is generally the subscription period. Payments are typically received at the beginning of a subscription period and revenue is recognized according to the type of subscription sold. For subscription contracts in which the subscription term commences before a payment is due, LifeMap Sciences records an accounts receivable as the subscription is earned over time and bills the customer according to the contract terms. LifeMap Sciences continuously monitors collections and payments from customers and maintains a provision for estimated credit losses and uncollectible accounts based upon its historical experience and any specific customer collection issues that have been identified. Amounts determined to be uncollectible are written off against the allowance for doubtful accounts. LifeMap Sciences has not historically provided significant discounts, credits, concessions, or other incentives from the stated price in the contract as the prices are offered on a fixed fee basis for the type of subscription package being purchased. LifeMap Sciences may issue refunds only if the packages cease to be available for reasons beyond its control. In such an event, the customer will get a refund on a pro-rata basis. Both the customer and LifeMap Sciences expect the subscription packages to be available during the entire subscription period, and LifeMap Sciences has not experienced any significant issues with the availability of the product and has not issued any material refunds. Using the most likely amount method for estimating refunds under Topic 606, including historical experience, LifeMap Sciences determined that the single most likely amount of variable consideration for refunds is immaterial as LifeMap Sciences does not expect to pay any refunds. LifeMap Sciences’ performance obligations for advertising are overall advertising services and represent a series of distinct services. Contracts are typically less than a year in duration and the fees charged may include a combination of fixed and variable fees with the variable fees tied to click throughs to the customer’s products on their website. LifeMap Sciences allocates the variable consideration to each month the click through services occur and allocates the annual fee to the performance obligation period of the initial term of the contract because those amounts correspond to the value provided to the customer each month. For click-through advertising services, at the time the variable compensation is known and determinable, the service has been rendered. Revenue is recognized at that time. The annual fee is recognized over the initial subscription period because this is a service and the customers simultaneously receive and consume during the period of the subscription. LifeMap Sciences’ deferred subscription revenues primarily represent subscriptions for which cash payment has been received for the subscription term, but the subscription term has not been completed as of the balance sheet date reported. For the years ended December 31, 2019 and 2018, LifeMap Sciences recognized $1.3 million and $1.2 million, respectively, in subscription and advertisement revenues. As of December 31, 2019, there was $0.3 million included in deferred revenues in the consolidated balance sheets which is expected to be recognized as subscription revenue over the next twelve months. LifeMap Sciences has licensed from third parties the databases and software it commercializes and has a contractual obligation to pay royalties to the licensor on subscriptions sold. These costs are included in cost of sales on the consolidated statements of operations when the cash is received and the royalty obligation is incurred as the royalty payments do not qualify for capitalization of costs to fulfill a contract under ASC 340-40, Other Assets and Deferred Costs - Contracts with Customers. Grant revenues. In applying the provisions of Topic 606, we have determined that government grants are out of the scope of Topic 606 because the government entities do not meet the definition of a “customer”, as defined by Topic 606, as there is not considered to be a transfer of control of good or services to the government entities funding the grant. We account for grants received to perform research and development services in accordance with ASC 730-20, Research and Development Arrangements, which requires an assessment, at the inception of the grant, of whether the grant is a liability or a contract to perform research and development services for others. If we or a subsidiary receiving the grant is obligated to repay the grant funds to the grantor regardless of the outcome of the research and development activities, then we are required to estimate and recognize that liability. Alternatively, if we or a subsidiary receiving the grant is not required to repay, or if it is required to repay the grant funds only if the research and development activities are successful, then the grant agreement is accounted for as a contract to perform research and development services for others, in which case, grant revenue is recognized when the related research and development expenses are incurred. In September 2018, we were awarded a grant of up to approximately $225,000 from the National Institutes of Health (NIH). The NIH grant provides funding for continued development of our technologies for treating osteoporosis. The grant funds will be made available by the NIH as allowable expenses are incurred. For the years ended December 31, 2019 and 2018, we incurred approximately $180,000 and $20,000, respectively, of allowable expenses under the NIH grant and recognized a corresponding amount of grant revenues. Arrangements with multiple performance obligations. Future contracts with customers may include multiple performance obligations. For such arrangements, we will allocate revenue to each performance obligation based on its relative standalone selling price. We generally determines or estimates standalone selling prices based on the prices charged, or that would be charged, to customers for that product or service. As of and for the year ended December 31, 2019, we did not have significant arrangements with multiple performance obligations. Financial Operations Overview To date, our revenues have been principally derived from subscription and advertising revenues from LifeMap Sciences’ online databases based upon applicable subscription or advertising periods. We do not have any products approved for sale and have not generated any revenue from commercialized product sales, and we do not expect to generate any revenue from product sales for the foreseeable future. Our operating expenses consist of research and development expenses primarily from our pre-clinical programs and general and administrative expenses. If we determine to borrow more than $500,000 under the New Loan Agreement with Juvenescence, we will be required to implement a Restructuring Plan during April 2020 to reduce spending on employee salaries and consulting fees to a degree that will result in large staff reductions which may be coupled with salary reductions for certain employees who agree to a pay reduction in order to remain employed. Management believes that implementing such a Restructuring Plan would likely require the elimination a portion of our management and administrative personnel and most of our research personnel, which in turn would mean that we would cease development of some or all of our product candidates or technologies unless research and development work could be contracted out to third party service providers within the newly imposed budgetary constraints. Accordingly, the historical amounts of revenues and expense presented and discussed in this Report are likely not going to be indicative of revenues and expenses during future periods. Results of Operations Comparison of Years Ended December 31, 2019 and 2018 Revenues and Cost of Sales The amounts in the table below show our consolidated revenues by source and cost of sales for the years ended December 31, 2019 and 2018 (in thousands). * Not meaningful. Our revenues were primarily generated by LifeMap Sciences, as subscription and advertising revenues from its GeneCards® online database. Subscription and advertising revenues amounted to $1.3 million and $1.2 million for the years ended December 31, 2019 and 2018. We recognized income of approximately $180,000 during 2019 and approximately $20,000 during 2018 from a grant from the NIH. Other revenues of $216,000 and $149,000 for the years ended December 31, 2019 and 2018, respectively, were generated entirely from non-recurring services associated with LifeMap Sciences’ online database business primarily related to its GeneCards®. Cost of sales for the year ended December 31, 2019 as compared to 2018 decreased primarily due to decrease royalty payments made or incurred by LifeMap Sciences due to a change in the applicable royalty fee terms from a percentage of net collections from customers to a fixed annual fee effective January 1, 2019. Operating Expenses The following table shows our consolidated operating expenses for the years ended December 31, 2019 and 2018 (in thousands). * Not meaningful. Research and development expenses Research and development expenses and acquired IPR&D decreased by $0.7 million to $5.9 million in 2019 as compared to $6.6 million in 2018. The decrease was primarily attributable to the non-recurrence of in-process research and development expense of $0.8 million that was incurred during March 2018 in connection with the purchase of certain assets from Ascendance Biotechnology, Inc. (“Ascendance”) primarily related to stem cell derived cardiomyocytes (heart muscle cells) to be developed by us. Additionally, consulting, outside research and services allocable to research and development expenses decreased by $0.3 million, and shared services from Lineage decreased by $0.5 million with the termination of the Shared Facilities Agreement on September 30, 2019. These decreases were offset to some extent by increases of $0.3 million in rent and facilities related expenses allocable to research and development, $0.3 million in laboratory expense and supplies, $0.2 million in personnel and related expenses allocable to research and development, and $0.1 million in amortization and depreciation expenses. The following table shows the amounts and percentages of our total research and development expenses, including acquired in-process research and development incurred during 2018, allocated to our primary research and development programs, during the years ended December 31, 2019 and 2018, respectively (amounts in thousands). (1) Amount includes research and development expenses incurred both directly by us or the named subsidiary and indirect overhead costs allocated by Lineage that benefit or support our research and development programs. See Notes 2 and 4 to our consolidated financial statements included elsewhere in this Report. (2) See Notes 2 and 4 to our consolidated financial statements included elsewhere in this Report. General and administrative expenses The following table shows the amount and percentages of our consolidated general and administrative expenses incurred during the years ended December 31, 2019 and 2018, respectively (amounts in thousands). (1) Amount includes both direct expenses incurred by us or the named subsidiary and indirect overhead costs allocated by Lineage that benefit or support our general and administrative functions. See Notes 2 and 4 to our consolidated financial statements included in this Report. (2) See Notes 2 and 4 to our consolidated financial statements included in this Report. General and administrative expenses for the year ended December 31, 2019 increased by $2.5 million to $8.1 million as compared to $5.6 million in 2018. This increase was primarily attributable to the following: $1.0 million in professional fees for consulting and accounting services; $0.8 million in insurance premiums; $0.5 million of noncash stock-based compensation expense; $0.2 million in license and patent related expenses; $0.2 million in general office, rent and facilities related expenses; $0.1 million in rent and facilities related expenses allocable to general and administrative; and $0.1 million in director fees. These increases were offset to some extent by decreases of $0.2 million in investor and public relations related expenses and $0.2 million in shared services from Lineage with the termination of the Shared Facilities Agreement on September 30, 2019. Other income, net Other income, net, in 2019 and 2018 consist primarily of net foreign currency transaction gains and losses recognized by LifeMap Sciences for intercompany payables and receivables denominated in currency other than United States dollars, gain on disposition of assets, and interest income and interest expense, net. Gain on sale of equity method investment in Ascendance On March 23, 2018, Ascendance, a company in which we held shares of common stock accounted for on the equity method, was acquired by a third party in a merger and we received $3.2 million in cash for our Ascendance common stock. We recognized a gain on sale for the same amount included in other income, net, during the year ended December 31, 2018. We recognized an additional $354,000 on sale of our Ascendance common stock for the year ended December 31, 2019 when we received a final payment for our Ascendance common stock during 2019. Income taxes For Federal and California purposes, our activity through August 30, 2018 was included in Lineage’s federal consolidated and California combined tax returns. For the year ended December 31, 2019, the provision for income taxes has been presented on a separate federal consolidated tax return and a California combined tax return using the separate return method, as we will file separately from Lineage for periods after August 30, 2018, the date in which Lineage deconsolidated AgeX as discussed in Note 7 to our consolidated financial statements included elsewhere in this Report. Beginning in 2018, the 2017 Tax Act subjects a U.S. stockholder to tax on Global Intangible Low Tax Income “GILTI” earned by certain foreign subsidiaries. In general, GILTI is the excess of a U.S. shareholder’s total net foreign income over a deemed return on tangible assets. The provision further allows a deduction of 50% of GILTI, however this deduction is limited to the company’s pre-GILTI U.S. income. For the year ended December 31, 2018, we included an immaterial amount of GILTI in U.S. gross income related to LifeMap Sciences, Ltd., which was fully offset by current year operating losses. For the year ended December 31, 2019, our foreign income inclusion was less than the deemed return on tangible assets, therefore no GILTI was included in income for 2019. Current interpretations under ASC 740 state that an entity can make an accounting policy election to either recognize deferred taxes for temporary basis differences expected to reverse as GILTI in future years or to provide for the tax expense related to GILTI in the year the tax is incurred as a period expense. We have elected to account for GILTI as a current period expense when incurred. For the year ended December 31, 2019, we experienced a domestic loss from continuing operations but generated foreign income attributable primarily to foreign currency transaction gains for those periods. This income was principally related to the remeasurement of the U.S. dollar denominated intercompany advances payable by LifeMap Sciences, Ltd. to LifeMap Sciences, Inc., for which a foreign income tax provision of $148,000 was recorded for the year ended December 31, 2019. Due to losses incurred for 2019, we did not record a domestic provision or benefit for income taxes for the year ended December 31, 2019. As of December 31, 2019, we had net operating loss carryforwards of approximately $42.0 million for U.S. federal income tax purposes. Of this amount, $10.1 million is attributable to LifeMap Sciences, which includes $3.6 million in NOLs generated while it was included in the consolidated Lineage tax group and would be available to offset income of AgeX in the future. The remaining LifeMap Sciences NOLs of $6.5 million are attributable to NOLs generated for the tax years during which LifeMap Sciences filed a separate federal income tax return and, accordingly, those NOLs are available only to LifeMap Sciences’ taxable income within AgeX in future years. In general, NOLs and other tax credit carryforwards generated by legal entities in a consolidated federal tax group are available to other members of the tax group depending on the nature of the transaction that a member may enter into while still in the consolidated federal tax group. However, under the Tax Matters Agreement between Lineage and AgeX, any use of a member’s NOLs and other tax credit carryforwards by the other member is subject to reimbursement by the benefiting member for the actual tax benefit realized. Since the August 30, 2018 deconsolidation of AgeX, and to date, neither Lineage nor AgeX has used the tax attributes of the other. As of December 31, 2019, we had net operating losses of approximately $36.1 million for California purposes. As we and our subsidiaries have been included in the combined California tax return with Lineage, up to the date of deconsolidation on August 30, 2018, those state net operating losses will remain with AgeX. Federal net operating losses generated on or prior to December 31, 2017, expire in varying amounts between 2028 and 2037, while federal net operating losses generated after December 31, 2017, carryforward indefinitely. The state net operating losses expire in varying amounts between 2028 and 2039. As of December 31, 2019, AgeX had research and development tax credit carryforwards for federal and state tax purposes of $1.1 million and $957,000, respectively. Although this LifeMap Sciences credit has been included as part of the AgeX credit carryforwards, LifeMap Sciences filed a separate federal income tax return prior to January 1, 2018 and its prior research credit carryforwards may not be used to offset federal taxable income of AgeX. As AgeX and its subsidiaries were included in the California combined return with Lineage, these credits noted above will remain with AgeX. The federal tax credits expire between 2028 and 2039, while the state tax credits have no expiration date. A valuation allowance is provided when it is more likely than not that some or all of the deferred tax assets will not be realized. We established a full valuation allowance for all periods presented due to the uncertainty of realizing future tax benefits from our net operating loss carryforwards and other deferred tax assets. Liquidity and Capital Resources Operating Losses and Going Concern Considerations We have incurred operating losses and negative cash flows since inception and had an accumulated deficit of $86.2 million as of December 31, 2019. We expect to continue to incur operating losses and negative cash flows. We have made certain adjustments to our operating plans and budgets to reduce our projected cash expenditures in order to extend the period over which we can continue our operations with our available cash resources. Some of these adjustments entail the deferral of certain work on the development of our product candidates and technologies, which is likely to delay our progress in those research and development efforts. However, notwithstanding those adjustments, based on our most recent projected cash flows, our cash and cash equivalents and potential additional loans that may become available to us from Juvenescence under the Secured Convertible Facility Agreement (the “New Loan Agreement”) discussed in Note 9 to our consolidated financial statements included elsewhere in this Report, would not be sufficient to satisfy our anticipated operating and other funding requirements for the next twelve months from the date of filing of this Report. These factors raise substantial doubt regarding our ability to continue as a going concern. See Notes 4 and 9 to our consolidated financial statements included elsewhere in this Report for additional information about our loan agreements with Juvenescence. We will need to raise additional capital in the near term to be able to meet our operating expenses. If we are unable to raise capital promptly when needed, we would be forced to delay, reduce or eliminate our operations, including our research and development programs. While we expect to borrow an initial $500,000 under the New Loan Agreement, all additional loans to us from Juvenescence under the New Loan Agreement are subject to Juvenescence's discretion, and accordingly there is no assurance that we will be able to borrow additional funds under the New Loan Agreement when we need funding for our operations. The New Loan Agreement prohibits us and our subsidiaries ReCyte Therapeutics and Reverse Bio from borrowing funds or engaging in certain other transactions without the consent of Juvenescence unless we repay all amounts owed to Juvenescence under the New Loan Agreement and the $2 million we owe under the August 2019 Loan Facility Agreement discussed in Note 4 to our consolidated financial statements. The implementation of a Restructuring Plan under the terms of the New Loan Agreement could require AgeX to make significant changes to its operations and research and development plans. The New Loan Agreement also requires AgeX and the Guarantor Subsidiaries to grant Juvenescence a security interest and lien on substantially all of our respective assets if AgeX makes more than two draws of funds (generally meaning if AgeX borrows more than $1,000,000). These factors and the impact of dilution through the issuance of shares of our common stock and warrants under other provisions of the New Loan Agreement could make AgeX less attractive to new equity investors and could impair our ability to finance our operations or the operations of our subsidiaries unless Juvenescence agrees, in its discretion, to lend us funds under the New Loan Agreement. We do not have any other committed sources of funds for additional financing. To the extent that we are able to raise additional capital from sources other than the New Loan Agreement, such as through the sale of AgeX equity or convertible debt securities or the sale of equity or convertible debt securities of any of our subsidiaries, the ownership interest of our present stockholders will be diluted, and the terms of any securities we or our subsidiaries issue may include liquidation or other preferences that adversely affect the rights of our common stockholders. Additional debt financing, if available, may involve agreements that include covenants limiting or restricting our ability to take specific actions, such as incurring additional debt, making capital expenditures or declaring dividends, and may involve the issuance of convertible debt or stock purchase warrants that would dilute the equity interests of our stockholders. The New Loan Agreement requires us to issue shares of our common stock and common stock purchase warrants to Juvenescence in total amounts that will vary depending on the amount of funds we borrow, the market price of our common stock, and in the case of issuances of common stock, whether Juvenescence elects to convert any portion of the outstanding loan balance into common stock. See “Risk Factors” and Note 9 to our consolidated financial statements. If we raise funds through additional strategic partnerships or licensing arrangements with third parties, we may have to relinquish valuable rights to our technologies, future revenue streams, research programs or product candidates or to grant licenses on terms that may not be favorable to us. Cash used in operating activities For the year ended December 31, 2019, our total research and development expenses were $5.9 million and our general and administrative expenditures were $8.1 million. Net loss attributable to us for the year ended December 31, 2019 amounted to $12.2 million. Net cash used in operating activities during this period amounted to $10.2 million. The difference between the net loss attributable to us and net cash used in operating activities during the year ended December 31, 2019 was primarily attributable to the following noncash items: $1.9 million in stock-based compensation expense, $1.0 million in depreciation and amortization, and $0.1 million foreign currency remeasurement. These non-cash amounts were partially offset by $0.6 million in insurance premium liability, $0.4 million we received as a final payment for our Ascendance common stock sold in 2018, and $0.2 million in net loss attributable to noncontrolling interest. Changes in working capital also provided $0.1 million from operating activities. Cash used in investing activities During the year ended December 31, 2019, net cash used in investing activities was $0.4 million, which was attributable to $0.7 million paid for the purchase of equipment, construction at our new office and laboratory facility, and a security deposit under the lease of our new office and research facility, offset by a $0.4 final payment received for the sale of our Ascendance common stock in 2018. Cash provided by financing activities During the year ended December 31, 2019, net cash provided by financing activities amounted to $6.3 million, which was attributable to $4.5 million of proceeds received from the exercise of warrants to purchase 1,800,000 shares of AgeX common stock, and $1.8 million drawn from the $2.0 million loan facility provided by Juvenescence. Off-Balance Sheet Arrangements As of December 31, 2019, we did not have any off-balance sheet arrangements, as defined in Item 303(a) (4) (ii) of SEC Regulation S-K.

<s>[INST] Emerging Growth Company Status The Jumpstart our Business Startups Act of 2012 (“JOBS Act”) permits an “emerging growth company” such as AgeX to take advantage of an extended transition period to comply with new or revised accounting standards applicable to public companies. However, we elected to comply with newly adopted or revised accounting standards when they become applicable to public companies because our financial statements were consolidated with those of Lineage, which is not an emerging growth company under the JOBS Act and is therefore not permitted to delay the adoption of new or revised accounting standards that become applicable to public companies. This election under the JOBS Act to not delay the adoption of new or revised accounting standards is irrevocable. Overview We are a biotechnology company focused on the development and commercialization of novel therapeutics targeting human aging and degenerative diseases. Our initial discovery and preclinical programs focus on utilizing brown adipose tissue in targeting diabetes, obesity, and heart disease; and induced tissue regeneration in utilizing the human body’s own abilities to scarlessly regenerate tissues damaged from age or trauma. We may also pursue other earlystage preclinical programs. Since inception, our operations have focused on building our technology platform, identifying potential product candidates, establishing and protecting our intellectual property and raising capital. Our revenues have been principally derived from subscription and advertising revenue from LifeMap Sciences’ online databases based upon applicable subscription or advertising periods. We do not have any products approved for sale and have not generated any revenue from product sales. Since inception, we have incurred significant operating losses and we will need to obtain additional financing in order to continue our operations, including our research and development programs. See “Liquidity and Capital Resources” for a discussion of our available capital resources and our need for financing. Our operating losses were $12.6 million and $11.2 million, for the years ended December 31, 2019 and 2018, respectively. As of December 31, 2019, we had an accumulated deficit of $86.2 million. We expect to continue to incur significant expenses and operating losses for the foreseeable future. Critical Accounting Policies The preparation of financial statements in conformity with accounting principles generally accepted in the United States (“GAAP”), requires management to make estimates and assumptions that affect the reported amounts in our consolidated financial statements and related notes. Our significant accounting policies are described in Note 2 to our consolidated financial statements included elsewhere in this Report. We have identified below our critical accounting policies and estimates that we believe require the greatest amount of judgment. On an ongoing basis, we evaluate our estimates that are subject to significant judgment including those related to going concern assessment of consolidated financial statements, allocations and adjustments necessary for carveout basis of presentation, including the separate return method for income taxes, useful lives associated with longlived assets, including evaluation of asset impairment, allowances for uncollectible accounts receivables, loss contingencies, deferred income taxes and tax reserves, including valuation allowances related to deferred income taxes, and assumptions used to value stockbased awards, or other equity instruments. Actual results could differ materially from those estimates. On an ongoing basis, we evaluate our estimates compared to historical experience and trends, which form the basis for making judgments about the carrying value of assets and liabilities. To the extent that there are material differences between our estimates and our actual results, our future consolidated financial statement presentation, financial condition, results of operations and cash flows will be affected. We believe the assumptions and estimates associated with the following have the greatest potential impact on our consolidated financial statements. Principles of consolidation AgeX’s consolidated financial statements include the accounts of its subsidiaries and certain research and development departments, including former Lineage personnel, transferred from Lineage to AgeX in connection with the Asset Contribution Agreement described in Note 4 to our consolidated financial statements. AgeX consolidated its direct and indirect whollyowned or majorityowned subsidiaries because AgeX has the ability to control their operating and financial decisions and policies through its ownership, and the noncontrolling interest is reflected as a separate element of stockholders’ equity on AgeX’s consolidated balance sheets. As [/INST] Positive. </s>

ARVINAS, INC.

2019-03-26

2018-12-31

Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations. You should read the following discussion and analysis of financial condition and operating results together with the section titled “Selected Financial Data” and our consolidated financial statements and the related notes appearing elsewhere in this Annual Report on Form 10-K. This discussion contains forward-looking statements that involve risks and uncertainties. As a result of many factors, such as those set forth in the section titled “Risk Factors” and elsewhere in this Annual Report on Form 10-K, our actual results may differ materially from those anticipated in or implied by these forward-looking statements. For convenience of presentation some of the numbers have been rounded in the text below. Overview We are a biopharmaceutical company dedicated to improving the lives of patients suffering from debilitating and life-threatening diseases through the discovery, development and commercialization of therapies to degrade disease-causing proteins. We use our proprietary technology platform to engineer proteolysis targeting chimeras, or PROTAC targeted protein degraders, that are designed to harness the body’s own natural protein disposal system to selectively and efficiently degrade and remove disease-causing proteins. We believe that our targeted protein degradation approach is a new therapeutic modality that may provide distinct advantages over existing modalities, including traditional small molecule therapies and gene-based medicines. Our small molecule PROTAC technology has the potential to address a broad range of intracellular disease targets, including those representing the up to 80% of proteins that cannot be addressed by existing small molecule therapies, commonly referred to as undruggable targets. We are using our PROTAC platform to build an extensive pipeline of protein degradation product candidates to target diseases in a wide range of organ systems and tissues. We are advancing our lead product candidates, ARV-110 and ARV-471, into Phase 1 clinical trials. In March 2019, we initiated a Phase 1 clinical trial for ARV-110 in men with metastatic castration-resistant prostate cancer, or mCRPC, and we expect to initiate a Phase 1 clinical trial for ARV-471 in women with locally advanced or metastatic ER positive / HER2 negative breast cancer in the third quarter of 2019. Our two lead product candidates are ARV-110 and ARV-471. We are developing ARV-110, a PROTAC targeted protein degrader targeting the androgen receptor protein, or AR, for the treatment of men with mCRPC. In March 2019, we initiated a Phase 1 trial and we expect to receive preliminary clinical data in the second half of 2019. We are developing ARV-471, a PROTAC targeted protein degrader targeting the estrogen receptor protein, or ER, for the treatment of women with locally advanced or metastatic ER positive / HER2 negative breast cancer. We expect to submit an investigational new drug, or IND, application to the U.S. Food and Drug Administration, or FDA, for ARV-471 in the second quarter of 2019, initiate a Phase 1 trial in the third quarter of 2019 and receive preliminary clinical data in 2020. We commenced operations in 2013, and our operations to date have been limited to organizing and staffing our company, business planning, raising capital, conducting discovery and research activities, filing patent applications, identifying potential product candidates, undertaking preclinical studies and establishing arrangements with third parties for the manufacture of initial quantities of our product candidates. To date, we have not generated any revenue from product sales and have financed our operations primarily through sales of our equity interests, proceeds from our collaborations, grant funding and debt financing. Through December 31, 2018, we raised approximately $235.1 million in gross proceeds from the sale of common stock, and series A, series B and series C convertible preferred units, and had received an aggregate of $89.2 million in payments from collaboration partners, grant funding and loans from the State of Connecticut. We are a development stage company and our lead product candidates and our research initiatives are at a preclinical stage of development. Our ability to generate revenue from product sales sufficient to achieve profitability will depend heavily on the successful development and eventual commercialization of one or more of our product candidates. Since inception, we have incurred significant operating losses. We expect to continue to incur significant expenses and increasing operating losses for at least the next several years. Our net loss was $41.5 million for the year ended December 31, 2018 and $24.0 million for the year ended December 31, 2017. As of December 31, 2018, we had an accumulated deficit of $302.3 million. Our total operating expenses were $58.1 million for the year ended December 31, 2018 and $32.3 million for the year ended December 31, 2017. We anticipate that our expenses will increase substantially due to costs associated with our preclinical activities for our lead product candidates and the advancement of these candidates into Phase 1 clinical trials in the United States, which we initiated in the first quarter of 2019 for ARV-110 and expect to initiate in the third quarter of 2019 for ARV-471, development activities associated with our other product candidates, research activities in oncology, neurological and other disease areas to expand our pipeline, hiring additional personnel in research, clinical trials, quality and other functional areas, increased expenses incurred with contract manufacturing organizations, or CMOs, to supply us with product for our preclinical and clinical studies, as well as other associated costs including the management of our intellectual property portfolio. We do not expect to generate revenue from sales of any product for many years, if ever. Accordingly, we will need to obtain substantial additional funding in connection with our continuing operations. If we are unable to raise capital when needed or on attractive terms, we could be forced to delay, reduce or eliminate our research or product development programs or any future commercialization efforts, or to relinquish valuable rights to our technologies, future revenue streams, research programs or product candidates or grant licenses on terms that may not be favorable to us. Financial Operations Overview Revenue To date, we have not generated any revenue from product sales and do not expect to generate any revenue from the sale of products in the foreseeable future. Our revenues to date have been generated through research collaboration and license agreements. Revenue is recognized ratably over our expected performance period under each agreement. We expect that our revenue for the next several years will be derived primarily from our current collaboration agreements and any additional collaborations that we may enter into in the future. To date, we have not received any royalties under any of the collaboration agreements. Genentech License Agreement In September 2015, we entered into an Option and License Agreement with Genentech, Inc. and F. Hoffmann-La Roche Ltd, collectively referred to as Genentech, focused on PROTAC targeted protein degrader discovery and research for target proteins, or Targets, based on our proprietary platform technology, other than excluded Targets as described below. This collaboration was expanded in November 2017 through an Amended and Restated Option, License and Collaboration Agreement, which we refer to as the Restated Genentech Agreement. Under the Restated Genentech Agreement, Genentech has the right to designate up to ten Targets for further discovery and research utilizing our PROTAC platform technology. Genentech may designate as a Target any protein to which a PROTAC targeted protein degrader, by design, binds to achieve its mechanism of action, subject to certain exclusions. Genentech also has the right to remove a Target from the collaboration and substitute a different Target that is not an excluded Target at any time prior to us commencing research on such Target or in certain circumstances following commencement of research by us. At the time we entered into the original agreement with Genentech we received an upfront payment of $11.0 million, and at the time we entered into the Restated Genentech Agreement, we also received an additional $34.5 million in upfront payments and expansion target payments. We are eligible to receive up to an aggregate of $27.5 million in additional expansion target payments if Genentech exercises its options for all remaining Targets. We are also eligible to receive payments aggregating up to $44.0 million per Target upon the achievement of specified development milestones; payments aggregating up to $52.5 million per Target (assuming approval of two indications) subject to the achievement of specified regulatory milestones; and payments aggregating up to $60.0 million per PROTAC targeted protein degrader directed against the applicable Target, subject to the achievement of specified sales milestones. These milestone payments are subject to reduction if we do not have a valid patent claim covering the licensed PROTAC targeted protein degrader at the time the milestone is achieved. We are also eligible to receive, on net sales of licensed PROTAC targeted protein degraders, mid-single digit royalties, which may be subject to reductions. Pfizer License Agreement In December 2017, we entered into a Research Collaboration and License Agreement with Pfizer, Inc., or Pfizer, setting forth our collaboration to identify or optimize PROTAC targeted protein degraders that mediate for degradation of Targets using our proprietary platform technology that are identified in the agreement or subsequently selected by Pfizer, subject to certain exclusions. We refer to this agreement as the Pfizer Collaboration Agreement. Under the Pfizer Collaboration Agreement, Pfizer has designated a number of initial Targets. For each identified Target, we and Pfizer will conduct a separate research program pursuant to a research plan. Pfizer may make substitutions for any of the initial Target candidates, subject to the stage of research for such Target. In the year ended December 31, 2018, we received an aggregate of $28.0 million in upfront payments and certain additional payments under the terms of the Pfizer Collaboration Agreement. We are also eligible to receive up to an additional $37.5 million in non-refundable option payments if Pfizer exercises its options for all Targets under the agreement. Pfizer exercised an option for $2.5 million in December 2018 and the amount is included in accounts receivable at December 31, 2018. We are also entitled to receive up to $225.0 million in development milestone payments and up to $550.0 million in sales-based milestone payments for all designated Targets under the agreement, as well as mid- to high-single digit tiered royalties based on sales of PROTAC targeted protein degrader-related products, which may be subject to reductions. Prior License Agreement In April 2015, we entered into a collaboration agreement with Merck Sharp & Dohme Corp. We received an upfront non-refundable payment of $7.0 million, which was recognized as revenue over the total estimated period of performance. The agreement expired in April 2018. Operating Expenses Our operating expenses since inception have consisted solely of research and development costs and general and administrative costs. Research and Development Expenses Research and development expenses consist primarily of costs incurred for our research activities, including our discovery efforts, and the development of our product candidates, and include: • salaries, benefits and other related costs, including stock-based compensation expense, for personnel engaged in research and development functions; • expenses incurred under agreements with third parties, including contract research organizations and other third parties that conduct research and preclinical activities on our behalf as well as third parties that manufacture our product candidates for use in our preclinical and potential future clinical trials; • costs of outside consultants, including their fees, equity-based compensation and related travel expenses; • the costs of laboratory supplies and acquiring, developing preclinical studies and clinical trial materials; • facility-related expenses, which include direct depreciation costs of equipment and allocated expenses for rent and maintenance of facilities and other operating costs; and • third-party licensing fees. We expense research and development costs as incurred. We typically use our employee and infrastructure resources across our development programs, and as such, do not track our internal research and development expenses on a program-by-program basis. We track outsourced development costs and certain personnel costs by product candidate. Other internal costs are not allocated. The following table summarizes our external research and development expenses by product candidate or development program: Research and development activities are central to our business model. We expect that our research and development expenses will continue to increase substantially for the foreseeable future as we continue to advance ARV-110 and ARV-471 into clinical trials, including our Phase 1 clinical trials, and continue to discover and develop additional product candidates. We cannot reasonably estimate or determine with certainty the duration and costs of future clinical trials of ARV-110 and ARV-471 or any other product candidate we may develop or if, when, or to what extent we will generate revenue from the commercialization and sale of any product candidate for which we obtain marketing approval. We may never succeed in obtaining marketing approval for any product candidate. The successful development and commercialization of our product candidates is highly uncertain. This is due to the numerous risks and uncertainties associated with developing drugs, including the uncertainty of: • successful completion of preclinical studies; • successful initiation of clinical trials; • successful patient enrollment in and completion of clinical trials; • receipt and related terms of marketing approvals from applicable regulatory authorities; • obtaining and maintaining patent and trade secret protection and regulatory exclusivity for our product candidates; • making arrangements with third-party manufacturers, or establishing manufacturing capabilities, for both clinical and commercial supplies of our product candidates; • establishing sales, marketing and distribution capabilities and launching commercial sales of our products, if and when approved, whether alone or in collaboration with others; • acceptance of our products, if and when approved, by patients, the medical community and third-party payors; • obtaining and maintaining third-party coverage and adequate reimbursement; • maintaining a continued acceptable safety profile of the products following approval; and • effectively competing with other therapies. A change in the outcome of any of these variables with respect to the development of a product candidate could mean a significant change in the costs and timing associated with the development of that product candidate. For example, if the FDA or another regulatory authority were to require us to conduct clinical trials beyond those that we anticipate will be required for the completion of clinical development of a product candidate, or if we experience significant delays in our clinical trials due to patient enrollment or other reasons, we would be required to expend significant additional financial resources and time on the completion of clinical development. General and Administrative Expenses General and administrative expenses consist primarily of salaries and other related costs, including stock-based compensation, for personnel in our executive, finance, business development and administrative functions. General and administrative expenses also include legal fees relating to intellectual property and corporate matters; professional fees for accounting, auditing, tax and consulting services; insurance costs; travel expenses; and facility-related expenses, which include direct depreciation costs and allocated expenses for rent and maintenance of facilities and other operating costs. We expect that our general and administrative expenses will increase in the future as we increase our personnel headcount to support increased research and development activities relating to our product candidates. We also expect to incur increased expenses associated with being a public company, including costs of accounting, audit, legal, regulatory and tax-related services associated with maintaining compliance with Nasdaq and Securities and Exchange Commission requirements; director and officer insurance costs; and investor and public relations costs. Interest Income (Expense) Interest income consists of interest earned on our cash, cash equivalents and short-term investments. Interest income increased in 2018 as we invested our excess cash from the proceeds of our initial public offering and series C financing, and the payments received under the collaboration agreements. Our interest income had decreased due to lower investment balances as we proceeded through 2017. Interest expense consists of interest paid or accrued on our outstanding debt. Interest expense was approximately $57,000 in 2018 and we expect that it will increase in 2019 with the additional interest payment on the State of Connecticut partially forgivable loan borrowed in September 2018. Income Taxes Since our inception in 2013, we have not recorded any U.S. federal or state income tax benefits for the net losses we have incurred in any year or for our federal earned research and development tax credits, due to our uncertainty of realizing a benefit from those items. As of December 31, 2018, we had federal net operating loss carryforwards of $58.3 million, which begin to expire in 2033. As of December 31, 2018, we also had federal and state research and development tax credit carryforwards of $2.7 million and $2.2 million, respectively, which begin to expire in 2033 and 2028, respectively. As of December 31, 2018, Arvinas, Inc. had five wholly owned subsidiaries organized as C-corporations: Arvinas Operations, Inc., Arvinas Androgen Receptor, Inc., Arvinas Estrogen Receptor, Inc., Arvinas BRD4, Inc. and Arvinas Winchester, Inc. Prior to December 31, 2018, these subsidiaries were separate filers for federal tax purposes. Net operating loss carryforwards are generated from the C-corporation subsidiaries’ filings. We have provided a valuation allowance against the full amount of the deferred tax assets since, in the opinion of management, based upon our earnings history, it is more likely than not that the benefits will not be realized. In December 2017, the United States enacted the Tax Cuts and Jobs Act, or the Act. The Act significantly changes U.S. corporate income tax laws by, among other provisions, reducing the maximum U.S. corporate income tax rate from 35% to 21% starting in 2018. During the year ended December 31, 2017, we reduced our deferred income tax asset by approximately $7.2 million as a result of the re-measurement of deferred tax assets and liabilities to the new lower statutory rate of 21%. The rate change did not result in an income tax expense as the change was offset by the change in the valuation allowance. Critical Accounting Policies and Use of Estimates Our management’s discussion and analysis of financial condition and results of operations is based on our consolidated financial statements, which have been prepared in accordance with generally accepted accounting principles in the United States. The preparation of our consolidated financial statements and related disclosures requires us to make estimates and assumptions that affect the reported amounts of assets and liabilities, costs and expenses and the disclosure of contingent assets and liabilities in our consolidated financial statements. We base our estimates on historical experience, known trends and events and various other factors that we believe are reasonable under the circumstances, the results of which form the basis for making judgments about the carrying values of assets and liabilities that are not readily apparent from other sources. We evaluate our estimates and assumptions on an ongoing basis. Our actual results may differ from these estimates under different assumptions or conditions. While our significant accounting policies are described in more detail in the notes to our consolidated financial statements appearing elsewhere in this Annual Report on Form 10-K, we believe that the following accounting policies are those most critical to the judgments and estimates used in the preparation of our consolidated financial statements. Revenue Recognition As discussed in Note 2 to our consolidated audited financial statements, we adopted Accounting Standards Codification (ASC) 606, Revenue from Contracts with Customers as of January 1, 2017 using the full retrospective method. Our revenue is generated through research collaboration and license agreements with pharmaceutical partners. The terms of these agreements contain multiple goods and services which may include (i) licenses, (ii) research and development activities and (iii) participation in joint research and development steering committees. The terms of these agreements may include non-refundable upfront license or option fees, payments for research and development activities, payments upon the achievement of certain milestones, and royalty payments based on product sales derived from the collaboration. Under ASC 606, we evaluate whether the license agreement, research and development services, and participation in research and development steering committees, represent separate or combined performance obligations. We have determined that these services within our existing contracts represent a combined single performance obligation. The research collaboration and license agreements typically include contingent milestone payments related to specified preclinical and clinical development milestones and regulatory milestones. These milestone payments represent variable consideration that are not initially recognized within the transaction price as they are fully constrained under the guidance in ASC 606. We will continue to assess the probability of significant reversals for any amounts that become likely to be realized prior to recognizing the variable consideration associated with these payments within the transaction price. Revenue is recognized ratably over our expected performance period under each respective arrangement. We make our best estimate of the period over which we expect to fulfill our performance obligations, which includes access to technology through the license agreement and research activities. Given the uncertainties of these collaboration arrangements, significant judgement is required to determine the duration of the performance period. For the years ended December 31, 2018 and 2017, transaction price allocated to the combined performance obligation identified under the agreements was recognized as revenue on a straight-line basis over the estimated performance period under each respective arrangement. Straight-line basis was considered the best measure of progress in which control of the combined obligation transfers to the customers, due to the contract containing license rights to technology, research and development services, and joint committee participation, which in totality are expected to occur ratably over the performance period. Our contracts may also call for certain sales-based milestone and royalty payments upon successful commercialization of a target. In accordance with ASC 606-10-55-65, we recognize revenues from sales-based milestone and royalty payments at the later of (i) the occurrence of the subsequent sale; or (ii) the performance obligation to which some or all of the sales-based milestone or royalty payments has been allocated has been satisfied (or partially satisfied). We anticipate recognizing these milestone and royalty payments if and when subsequent sales are generated by the customer from the use of the technology. To date, no revenue from these sales-based milestone and royalty payments has been recognized for any periods. Amounts received prior to satisfying the above revenue recognition criteria are recorded as a contract liability in our accompanying consolidated balance sheets. Incentive Units Prior to our initial public offering, we issued equity-based compensation awards to employees and non-employees through the granting of incentive units. We had periodically granted incentive units to employees and non-employees, which generally vested over a four-year period. The incentive units represented a separate substantive class of equity with defined rights within the limited liability company agreement of Arvinas Holding Company, LLC, or the LLC Operating Agreement. The incentive units represented profit interest in the increase in the value of the entity over a participation threshold, as determined at the time of grant. The holder, therefore, had the right to participate in distributions of profits only in excess of such participation threshold. The participation threshold was based on the valuation of the incentive unit on or around the grant date. We accounted for unit-based compensation in accordance with ASC 718, Compensation-Stock Compensation (ASC 718). In accordance with ASC 718, compensation cost is measured at estimated fair value and is included as compensation expense over the vesting period during which an employee provides service in exchange for the award. We used a Black-Scholes option pricing model to determine the fair value of our incentive units, due to the existence of a participation threshold. The Black-Scholes option pricing model includes various assumptions, including the expected life of incentive units, the expected volatility and the expected risk-free interest rate. The fair value of the underlying common units represented the exercise price utilized in the Black-Scholes option pricing model. These assumptions reflected our best estimates, but they involved inherent uncertainties based on market conditions generally outside our control. As a result, if other assumptions had been used, unit-based compensation cost could have been materially impacted. Furthermore, if we used different assumptions for future grants, unit-based compensation cost could have been materially impacted in future periods. As there had been no public market for our common units prior to our initial public offering, the estimated fair value of our common units had been determined by our board of directors as of the date of each incentive unit grant, with input from management, considering our most recently available third-party valuations of common stock units. Valuations were updated when facts and circumstances indicated that the most recent valuation was no longer valid, such as changes in the stage of our development efforts, various exit strategies and their timing, and other scientific developments that could be related to the valuation of our company, or, at a minimum, annually. Third-party valuations were performed in accordance with the guidance outlined in the American Institute of Certified Public Accountants’ Accounting and Valuation Guide, Valuation of Privately-Held-Company Equity Securities Issued as Compensation. Our common unit valuations in 2017 and January 2018 were prepared using a market approach, specifically the subject company transaction method. The subject company transaction method solves for the total equity value which allocates a probability-weighted present value to the series B preferred unit holders consistent with the investment amount of that financing round adjusted to account for the impact of progress or changes in the business since the closing of the series B financing. Our common unit valuation as of June 30, 2018 was prepared using the income and market approaches simultaneously. Under the income approach, the hybrid method was used, which is a combination of the probability weighted expected return method, or PWERM, and the option pricing method, or OPM. Under the market approach, the subject company transaction method was used. Within both the PWERM and OPM, the subject company transaction method was used to solve for the total equity value which allocates a probability weighted present value to the series C preferred unit holders consistent with the investment amount of that financing round. These third-party valuations resulted in participation thresholds of $127.1 million as of December 31, 2017, $270.8 million as of March 31, 2018 and $292.0 million as of June 30, 2018. Fair value estimates of underlying shares are no longer necessary to determine the fair value of new equity awards because the underlying shares are traded in the public market. Immediately prior to the effectiveness of our registration statement on Form S-1 (File No. 333-227112), Arvinas Holding Company, LLC, or Arvinas LLC, our predecessor company, converted from a Delaware limited liability company into Arvinas, Inc., a Delaware corporation, which we refer to as the Conversion. In connection with the Conversion, incentive units in Arvinas LLC were exchanged for common stock and restricted common stock of Arvinas, Inc. New Accounting Pronouncements For information on new accounting standards, see Note 2 to our consolidated audited financial statements appearing elsewhere in this Annual Report on Form 10-K. Results of Operations Comparison of Years Ended December 31, 2018 and 2017 Revenues Revenues for the year ended December 31, 2018 were $14.3 million, compared with $7.6 million for the year ended December 31, 2017. The increase in revenues of $6.7 million was due to an increase in license and rights to technology fees and research and development activities primarily related to the Pfizer Collaboration Agreement initiated in January 2018 and the Restated Genentech Agreement that was initiated in November 2017. Research and Development Expenses Research and development expenses for the year ended December 31, 2018 were $45.2 million, compared with $28.8 million for the year ended December 31, 2017. The increase of $16.4 million was primarily due to an increase in personnel and personnel costs utilized across all our programs of $9.8 million, including an increase in stock compensation expense of $6.0 million. Direct expenses related to our platform and exploratory targets increased $5.0 million as we expand the number of protein targets in the exploratory phase. Direct research expenses related to our androgen receptor, or AR, program increased by $2.8 million as we incurred a full-year of IND enabling activities in 2018. Direct research expenses related to our estrogen receptor, or ER, program decreased by $1.2 million due to the timing of IND enabling studies extending into 2019. General and Administrative Expenses General and administrative expenses were $12.9 million for the year ended December 31, 2018, compared with $3.5 million for the year ended December 31, 2017. The increase of $9.4 million was primarily due to an increase of $7.1 million in personnel related costs, including $5.4 million related to stock compensation expense. Increases in other costs, including legal and other professional fees of $1.3 million, corporate insurance of $0.3 million, and franchise taxes of $0.3 million are primarily related to public company costs incurred for the first time in 2018. Other Income (Expenses) Other income (expenses) was $2.3 million for the year ended December 31, 2018, compared with $0.7 million for the year ended December 31, 2017. The increase of $1.6 million was primarily related an increase in interest income of $2.2 million, partially offset by a reduction in refundable research and development credits of $0.4 million and an increase in the value of the preferred unit warrant of $0.2 million. The increase in interest income was the result of our higher average cash, cash equivalent and short-term investment balances for the year ended December 31, 2018 compared to the year ended December 31, 2017 and an increase in bond yields. Liquidity and Capital Resources Sources of Liquidity We do not currently have any approved products and have never generated any revenue from product sales. To date, we have financed our operations primarily through the sale of equity interests and through payments from collaboration partners, grant funding and loans from the State of Connecticut. Through December 31, 2018, we raised approximately $235.1 million in gross proceeds from the sale of common stock, and series A, series B and series C convertible preferred units, and had received an aggregate of $89.2 million in payments from collaboration partners, grant funding and forgivable and partially forgivable loans from the State of Connecticut. In October 2018, we completed our IPO in which we issued and sold an aggregate of 7,700,482 shares of common stock, including 200,482 additional shares of common stock at a subsequent closing upon the exercise in part by the underwriters of their option to purchase additional shares at a public offering price of $16.00 per share, for aggregate gross proceeds of $123.2 million before fees and expenses. Cash Flows Our cash, cash equivalents and marketable securities totaled $187.8 million as of December 31, 2018 and $39.2 million as of December 31, 2017. We had an outstanding loan balance of $2.2 million as of December 31, 2018 and $0.3 million as of December 31, 2017. The following table summarizes our sources and uses of cash for the period presented: Operating Activities Net cash used in operating activities for the year ended December 31, 2018 was $16.1 million, resulting from our net loss of $41.5 million and a reduction in our deferred revenue of $8.5 million, partially offset by non-cash expenses of $12.8 million and a decrease in accounts receivable of $22.2 million. The reduction in deferred revenue is primarily due to $14.3 million of revenue recognized, partially offset by $5.8 million in target payments received from a collaboration partner. Net cash provided by operating activities for the year ended December 31, 2017 was $5.1 million, consisting of an increase of $51.9 million in deferred revenue, a net increase of $0.9 million in accrued expenses and accounts payable, and non-cash charges of $0.9 million, partially offset by our net loss of $24.0 million and an increase in account and other receivables of $24.6 million. The increase in deferred revenue was due to $34.5 million in up-front payments received from a collaboration partner and a $25.0 million up-front payment from a collaboration partner included in account receivable, reduced by $7.6 million of recognized deferred revenue. Our non-cash charges totaling $0.9 million included depreciation, unit-based compensation expense, and accretion on short-term investments. Investing Activities Net cash used in investing activities for the year ended December 31, 2018 was $179.7 million, attributable to the net investment of excess cash of $176.8 million and the purchases of property and equipment of $2.8 million. Net cash provided by investing activities for the year ended December 31, 2017 was $20.9 million, attributable to the maturities and sales of marketable securities of $25.1 million, partially offset by the purchase of new marketable securities of $3.2 million and the purchases of property and equipment of $1.0 million. Financing Activities Net cash provided by financing activities for the year ended December 31, 2018 was $168.1 million, primarily attributable to the net proceeds from the sale of series C preferred units of $55.0 million and the sale of common stock, net of underwriter discounts and offering costs, of $111.2 million. We also received loan proceeds of $2.0 million and made $0.2 million in debt payments. Net cash used in financing activities for the year ended December 31, 2017 was $0.2 million for payments on our long-term debt. Funding Requirements Since our inception, we have incurred significant operating losses. We expect to continue to incur significant expenses and increasing operating losses for the foreseeable future as we advance the preclinical and clinical development of our product candidates. In addition, we expect to continue to incur additional costs associated with operating as a public company. Specifically, we anticipate that our expenses will increase substantially if and as we: • conduct a Phase 1 clinical trial of our product candidate, ARV-110, in men with mCRPC; • initiate a planned Phase 1 clinical trial of our product candidate, ARV-471, in women with locally advanced or metastatic ER positive / HER2 negative breast cancer; • apply our PROTAC platform to advance additional product candidates into preclinical and clinical development; • expand the capabilities of our PROTAC platform; • seek marketing approvals for any product candidates that successfully complete clinical trials; • ultimately establish a sales, marketing and distribution infrastructure and scale up external manufacturing capabilities to commercialize any products for which we may obtain marketing approval; • expand, maintain and protect our intellectual property portfolio; • hire additional clinical, regulatory and scientific personnel; and • add operational, financial and management information systems and personnel to support our research, product development and future commercialization efforts and support our operations as a public company. As of December 31, 2018, we believe that our existing cash, cash equivalents and marketable securities, will enable us to fund our operating expenses and capital expenditure requirements for at least the next 24 months. We have based this estimate on assumptions that may prove to be wrong, and we could use our capital resources sooner than we currently expect. Our future capital requirements will depend on many factors, including: • the progress, costs and results of our Phase 1 clinical trial for ARV-110 and our planned Phase 1 clinical trial for ARV-471 and any future clinical development of ARV-110 and ARV-471; • the scope, progress, costs and results of preclinical and clinical development for our other product candidates and development programs; • the number and development requirements of other product candidates that we pursue, including our neurodegenerative research programs; • the success of our collaborations with Pfizer and Genentech; • the costs, timing and outcome of regulatory review of our product candidates; • the costs and timing of future commercialization activities, including product manufacturing, marketing, sales and distribution, for any of our product candidates for which we receive marketing approval; • the revenue, if any, received from commercial sales of our product candidates for which we receive marketing approval; • the costs and timing of preparing, filing and prosecuting patent applications, maintaining and enforcing our intellectual property rights and defending any intellectual property-related claims; and • our ability to establish collaboration arrangements with other biotechnology or pharmaceutical companies on favorable terms, if at all, for the development or commercialization of our product candidates. As a result of these anticipated expenditures, we will need to obtain substantial additional financing in connection with our continuing operations. Until such time, if ever, as we can generate substantial revenue from product sales, we expect to finance our cash needs through a combination of equity offerings, debt financings, collaborations, strategic alliances and marketing, distribution or licensing arrangements. Although we may receive potential future payments under our collaborations with Pfizer and Genentech, we do not currently have any committed external source of funds. Adequate additional funds may not be available to us on acceptable terms, or at all. If we are unable to raise capital when needed or on attractive terms, we may be required to delay, limit, reduce or terminate our research, product development programs or any future commercialization efforts or grant rights to develop and market product candidates that we would otherwise prefer to develop and market ourselves. To the extent that we raise additional capital through the sale of equity or convertible debt securities, the terms of these securities may include liquidation or other preferences that adversely affect the rights of our common stockholders. Debt financing and preferred equity financing, if available, may involve agreements that include covenants limiting or restricting our ability to take specific actions, such as incurring additional debt, making acquisitions or capital expenditures or declaring dividends. If we raise additional funds through collaborations, strategic alliances or marketing, distribution or licensing arrangements with third parties, we may have to relinquish valuable rights to our technologies, future revenue streams, research programs or product candidates or grant licenses on terms that may not be favorable to us. Borrowings In August 2013, we entered into a Loan Agreement, or Loan, with Connecticut Innovations, Incorporated, or CII, the strategic venture capital arm and a component unit of the State of Connecticut. Under the Loan, we borrowed $750,000 for the purchase of laboratory equipment, information technology equipment and leasehold improvements. Interest on the Loan is compounded on a monthly basis at a rate of 7.50% per annum. The Loan provided for monthly, interest-only payments for ten months. Beginning on June 1, 2015 we were required to make monthly principal and interest payments through July 31, 2019. We can prepay the amount due at any time without premium or penalty. The Loan is secured by substantially all of our assets. The amount outstanding under the Loan was $0.2 million as of December 31, 2018 and $0.3 million as of December 31, 2017. In connection with the issuance of the Loan, we granted CII a warrant to purchase 110,116 of our series A preferred units at a purchase price of $0.6811 per unit, with a seven-year term from the date of issuance. The warrant was exercised in July 2018. In January 2014, we entered into an Assistance Agreement with the State of Connecticut, or the 2014 Assistance Agreement. Under the terms of the 2014 Assistance Agreement, we borrowed $2.5 million. Borrowings under the 2014 Assistance Agreement were forgivable if we maintained a minimum number of full-time jobs in the State of Connecticut for a minimum period at a minimum annual salary. Effective in March 2016, the full principal amount under the 2014 Assistance Agreement had been forgiven. While borrowings under the 2014 Assistance Agreement have been forgiven, we remain subject to an ongoing covenant to be located in the State of Connecticut through January 2024. Upon violation of this covenant we would be required to repay the full original funding amount of $2.5 million plus liquidated damages of 7.50%. In June 2018, we entered into an additional Assistance Agreement with the State of Connecticut, or the 2018 Assistance Agreement, to provide funding for the expansion and renovation of laboratory and office space. Under the terms of the 2018 Assistance Agreement, we could borrow from the State of Connecticut a maximum of $2.0 million, provided that the funding does not exceed more than 50% of the total costs of the expansion and renovation. Borrowings under the 2018 Assistance Agreement bear an interest rate of 3.25% per annum and interest payments are required for the first 60 months from the funding date. Interest expense related to the Assistance Agreement is expected to be $65,000 annually for the first five years. Thereafter, the loan begins to fully amortize through month 120, maturing in June 2028. Up to $1.0 million of the funding can be forgiven if we meet certain employment conditions. We may be required to prepay a portion of the loan if the employment conditions are not met. The 2018 Assistance Agreement requires that we be located in the State of Connecticut through June 2028 with a default penalty of repayment of the full original funding amount of $2.0 million plus liquidated damages of 7.5% of the total amount of funding received. We borrowed the full $2.0 million under the 2018 Assistance Agreement in September 2018 and the full amount remains outstanding at December 31, 2018. Off-Balance Sheet Arrangements We have not entered into any off-balance sheet arrangements and do not have any holdings in variable interest entities. Emerging Growth Company Status As an “emerging growth company,” the Jumpstart Our Business Startups Act of 2012 allows us to delay adoption of new or revised accounting standards applicable to public companies until such standards are made applicable to private companies. However, we have irrevocably elected not to avail ourselves of this extended transition period for complying with new or revised accounting standards and, therefore, we will be subject to the same new or revised accounting standards as other public companies that are not emerging growth companies.

<s>[INST] Overview We are a biopharmaceutical company dedicated to improving the lives of patients suffering from debilitating and lifethreatening diseases through the discovery, development and commercialization of therapies to degrade diseasecausing proteins. We use our proprietary technology platform to engineer proteolysis targeting chimeras, or PROTAC targeted protein degraders, that are designed to harness the body’s own natural protein disposal system to selectively and efficiently degrade and remove diseasecausing proteins. We believe that our targeted protein degradation approach is a new therapeutic modality that may provide distinct advantages over existing modalities, including traditional small molecule therapies and genebased medicines. Our small molecule PROTAC technology has the potential to address a broad range of intracellular disease targets, including those representing the up to 80% of proteins that cannot be addressed by existing small molecule therapies, commonly referred to as undruggable targets. We are using our PROTAC platform to build an extensive pipeline of protein degradation product candidates to target diseases in a wide range of organ systems and tissues. We are advancing our lead product candidates, ARV110 and ARV471, into Phase 1 clinical trials. In March 2019, we initiated a Phase 1 clinical trial for ARV110 in men with metastatic castrationresistant prostate cancer, or mCRPC, and we expect to initiate a Phase 1 clinical trial for ARV471 in women with locally advanced or metastatic ER positive / HER2 negative breast cancer in the third quarter of 2019. Our two lead product candidates are ARV110 and ARV471. We are developing ARV110, a PROTAC targeted protein degrader targeting the androgen receptor protein, or AR, for the treatment of men with mCRPC. In March 2019, we initiated a Phase 1 trial and we expect to receive preliminary clinical data in the second half of 2019. We are developing ARV471, a PROTAC targeted protein degrader targeting the estrogen receptor protein, or ER, for the treatment of women with locally advanced or metastatic ER positive / HER2 negative breast cancer. We expect to submit an investigational new drug, or IND, application to the U.S. Food and Drug Administration, or FDA, for ARV471 in the second quarter of 2019, initiate a Phase 1 trial in the third quarter of 2019 and receive preliminary clinical data in 2020. We commenced operations in 2013, and our operations to date have been limited to organizing and staffing our company, business planning, raising capital, conducting discovery and research activities, filing patent applications, identifying potential product candidates, undertaking preclinical studies and establishing arrangements with third parties for the manufacture of initial quantities of our product candidates. To date, we have not generated any revenue from product sales and have financed our operations primarily through sales of our equity interests, proceeds from our collaborations, grant funding and debt financing. Through December 31, 2018, we raised approximately $235.1 million in gross proceeds from the sale of common stock, and series A, series B and series C convertible preferred units, and had received an aggregate of $89.2 million in payments from collaboration partners, grant funding and loans from the State of Connecticut. We are a development stage company and our lead product candidates and our research initiatives are at a preclinical stage of development. Our ability to generate revenue from product sales sufficient to achieve profitability will depend heavily on the successful development and eventual commercialization of one or more of our product candidates. Since inception, we have incurred significant operating losses. We expect to continue to incur significant expenses and increasing operating losses for at least the next several years. Our net loss was $41.5 million for the year ended December 31, 2018 and $24.0 million for the year ended December 31, 2017. As of December 31, 2018, we had an accumulated deficit of $302.3 million. Our total operating expenses were $58.1 million for the [/INST] Negative. </s>

ARVINAS, INC.

2020-03-16

2019-12-31

Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations. You should read the following discussion and analysis of financial condition and operating results together with the section titled “Selected Financial Data” and our consolidated financial statements and the related notes appearing elsewhere in this Annual Report on Form 10-K. This discussion contains forward-looking statements that involve risks and uncertainties. As a result of many factors, such as those set forth in the section titled “Risk Factors” and elsewhere in this Annual Report on Form 10-K, our actual results may differ materially from those anticipated in or implied by these forward-looking statements. For convenience of presentation some of the numbers have been rounded in the text below. Overview We are a clinical-stage biopharmaceutical company dedicated to improving the lives of patients suffering from debilitating and life-threatening diseases through the discovery, development and commercialization of therapies to degrade disease-causing proteins. We use our proprietary technology platform to engineer proteolysis targeting chimeras, or PROTAC targeted protein degraders, that are designed to harness the body’s own natural protein disposal system to selectively remove disease-causing proteins. We believe that our targeted protein degradation approach is a therapeutic modality that may provide distinct advantages over existing modalities, including traditional small molecule therapies and gene-based medicines. Our small-molecule PROTAC technology has the potential to address a broad range of intracellular disease targets, including those representing the up to 80% of proteins that cannot be addressed by existing small molecule therapies, commonly referred to as “undruggable” targets. We are using our PROTAC platform to build an extensive pipeline of protein degradation product candidates to target diseases in oncology, neuroscience, and other therapeutic areas. Our two lead product candidates are ARV-110 and ARV-471. We are developing ARV-110, a PROTAC protein degrader targeting the androgen receptor protein, or AR, for the treatment of men with metastatic castration-resistant prostate cancer, or mCRPC. We initiated a Phase 1 clinical trial of ARV-110 in March 2019. We are also developing ARV-471, a PROTAC protein degrader targeting the estrogen receptor protein, or ER, for the treatment of patients with locally advanced or metastatic ER positive / HER2 negative breast cancer. We initiated a Phase 1 clinical trial of ARV-471 in August 2019. In October 2019, we announced initial safety, tolerability and pharmacokinetic data from the ongoing Phase 1 clinical trial for each of ARV-110 and ARV-471. The initial data from these Phase 1 clinical trials showed dose proportionality for ARV-110 and that exposures of both ARV-110 and ARV-471 had reached levels associated with tumor growth inhibition in preclinical studies. In addition, both ARV-110 and ARV-471 at each dose tested to date was well tolerated, with no dose-limiting toxicities and no grade 2, 3, or 4 treatment-related adverse events observed. Since October 2019, dose escalation for each of the Phase 1 clinical trials has continued and both trials are currently ongoing. We commenced operations in 2013, and our operations to date have been limited to organizing and staffing our company, business planning, raising capital, conducting discovery and research activities, filing patent applications, identifying potential product candidates, undertaking preclinical studies and establishing arrangements with third parties for the manufacture of initial quantities of our product candidates. To date, we have not generated any revenue from product sales and have financed our operations primarily through sales of our equity interests, proceeds from our collaborations, grant funding and debt financing. Through December 31, 2019, we raised approximately $385.4 million in gross proceeds from the sale of common stock, the exercise of stock options, and the sale of series A, series B and series C convertible preferred units, and had received an aggregate of $112.4 million in payments from collaboration partners, grant funding and partially forgivable loans from the State of Connecticut. In June 2019, we entered into a Collaboration and License Agreement, or the Collaboration Agreement, with Bayer AG, or, together with its controlled affiliates, Bayer, which agreement became effective in July 2019. We also entered into a Stock Purchase Agreement with Bayer, or the Stock Purchase Agreement, pursuant to which we issued and sold to Bayer 1,346,313 shares of our common stock, or the Shares, for an aggregate purchase price of approximately $32.5 million. The price per share was $24.14, based on a 15% premium above our 60-day trading average from April 2, 2019 through May 31, 2019. The closing price of our stock on July 16, 2019, the closing date for the issuance of shares under the Stock Purchase Agreement, was $25.10. In connection with the closing under the Stock Purchase Agreement, we also entered into an Investor Agreement providing for registration rights, standstill and lock-up restrictions and a voting agreement with respect to the Shares. On October 1, 2019, we filed a registration statement on Form S-3 covering the resale of the Shares. Also in June 2019, we entered into a Commitment Agreement with Bayer, relating to the formation of a joint venture entity, Oerth Bio LLC, or Oerth, for the purpose of researching, developing and commercializing PROTAC targeted protein degraders for applications in the field of agriculture. We consummated the formation of the joint venture with Bayer as contemplated by the Commitment Agreement in July 2019, upon the expiration of the applicable waiting period under the Hart-Scott-Rodino Antitrust Improvements Act of 1976, as amended, with respect to the reportable transactions and the satisfaction of other application closing conditions, or the JV Closing. Pursuant to the terms of the Commitment Agreement and certain other agreements entered into at the JV Closing, we and Bayer each made an in-kind intellectual property contribution to Oerth at the JV Closing. In addition, Bayer has made a $56.0 million total cash commitment to Oerth, $16.0 million of which Bayer contributed to Oerth in connection with the JV Closing. We and Bayer each hold an ownership interest in Oerth initially representing 50% of the ownership interests. A 15% ownership interest of Oerth is reserved for the future grant of incentive units to employees and service providers of Oerth. Oerth will generally be governed by a board of managers, or the JV Board, which will initially be comprised of four voting members, two of which will be designated by us and two of which will be designated by Bayer. JV Board decisions will generally be made by majority vote of the managers, with each manager having one vote. Certain matters will require both our consent and Bayer’s or both of our and Bayer’s designated managers on the JV Board. During the term of the jjoint venture and, in certain limited cases as described below, for one year following the end of the term of the joint venture, neither we, Bayer nor any of their respective affiliates may research, develop, manufacture, use or commercialize in the field of agriculture any PROTAC targeted protein degraders whose primary mechanism of action by design is the binding to and degradation of any Target, as defined below, subject to certain exclusions for early stage research activities and minority investments. Oerth and Bayer also entered into an option agreement, or the Option Agreement, pursuant to which the parties will agree to certain procedures for, and preferential rights relating to, the possible transfer to Bayer of PROTAC targeted protein degrader product candidates researched, developed and commercialized by Oerth under the joint venture. In addition, in the event either Bayer or a third party licenses a PROTAC targeted protein degrader candidate from Oerth pursuant to the Option Agreement, the non-licensing party or parties to the Commitment Agreement will be prohibited from developing, commercializing or otherwise exploiting any product utilizing PROTAC technology to target the same Target as that of the licensed product candidate in the field of agriculture. We are a clinical-stage company. ARV-110 and ARV-471 are each in a Phase 1 clinical trial and our other drug discovery activities are at the research and preclinical development stages. Our ability to generate revenue from product sales sufficient to achieve profitability will depend heavily on the successful development and eventual commercialization of one or more of our product candidates. Since inception, we have incurred significant operating losses. We expect to continue to incur significant expenses and increasing operating losses for at least the next several years. Our net loss was $70.3 million for the year ended December 31, 2019 and $41.5 million for the year ended December 31, 2018. As of December 31, 2019, we had an accumulated deficit of $372.6 million. Our total operating expenses were $94.5 million for the year ended December 31, 2019 and $58.1 million for the year ended December 31, 2018. We anticipate that our expenses will increase substantially due to costs associated with our anticipated clinical activities for ARV-110 and ARV-471, development activities associated with our other product candidates, research activities in oncology, neurological and other disease areas to expand our pipeline, hiring additional personnel in research, clinical trials, quality and other functional areas, increased expenses incurred with contract manufacturing organizations, or CMOs, to supply us with product for our preclinical and clinical studies and contract research organizations for the synthesis of compounds in our pre-clinical development activities, as well as other associated costs including the management of our intellectual property portfolio. We do not expect to generate revenue from sales of any product for many years, if ever. Accordingly, we will need to obtain substantial additional funding in connection with our continuing operations. If we are unable to raise capital when needed or on attractive terms, we could be forced to delay, reduce or eliminate our research or product development programs or any future commercialization efforts, or to relinquish valuable rights to our technologies, future revenue streams, research programs or product candidates or grant licenses on terms that may not be favorable to us. Financial Operations Overview Revenue To date, we have not generated any revenue from product sales and do not expect to generate any revenue from the sale of products in the foreseeable future. Our revenues to date have been generated through research collaboration and license agreements. Revenue is recognized ratably over our expected performance period under each agreement. We expect that any revenue for the next several years will be derived primarily from our current collaboration agreements and any additional collaborations that we may enter into in the future. To date, we have not received any royalties under any of the collaboration agreements. Genentech License Agreement In September 2015, we entered into an Option and License Agreement with Genentech, Inc. and F. Hoffmann-La Roche Ltd, collectively referred to as Genentech, focused on PROTAC targeted protein degrader discovery and research for target proteins, or Targets, based on our proprietary platform technology, other than excluded Targets as described below. This collaboration was expanded in November 2017 through an Amended and Restated Option, License and Collaboration Agreement, which we refer to as the Restated Genentech Agreement. Under the Restated Genentech Agreement, Genentech has the right to designate up to ten Targets for further discovery and research utilizing our PROTAC platform technology. Genentech may designate as a Target any protein to which a PROTAC targeted protein degrader, by design, binds to achieve its mechanism of action, subject to certain exclusions. Genentech also has the right to remove a Target from the collaboration and substitute a different Target that is not an excluded Target at any time prior to us commencing research on such Target or in certain circumstances following commencement of research by us. At the time we entered into the original agreement with Genentech we received an upfront payment of $11.0 million, and at the time we entered into the Restated Genentech Agreement, we also received an additional $34.5 million in upfront payments and expansion target payments. We are eligible to receive up to an aggregate of $27.5 million in additional expansion target payments if Genentech exercises its options for all remaining Targets. We are also eligible to receive payments aggregating up to $44.0 million per Target upon the achievement of specified development milestones; payments aggregating up to $52.5 million per Target (assuming approval of two indications) subject to the achievement of specified regulatory milestones; and payments aggregating up to $60.0 million per PROTAC targeted protein degrader directed against the applicable Target, subject to the achievement of specified sales milestones. These milestone payments are subject to reduction if we do not have a valid patent claim covering the licensed PROTAC targeted protein degrader at the time the milestone is achieved. We are also eligible to receive, on net sales of licensed PROTAC targeted protein degraders, mid-single digit royalties, which may be subject to reductions. Pfizer License Agreement In December 2017, we entered into a Research Collaboration and License Agreement with Pfizer, Inc., or Pfizer, setting forth our collaboration to identify or optimize PROTAC targeted protein degraders that mediate for degradation of Targets using our proprietary platform technology that are identified in the agreement or subsequently selected by Pfizer, subject to certain exclusions. We refer to this agreement as the Pfizer Collaboration Agreement. Under the Pfizer Collaboration Agreement, Pfizer has designated a number of initial Targets. For each identified Target, we and Pfizer will conduct a separate research program pursuant to a research plan. Pfizer may make substitutions for any of the initial Target candidates, subject to the stage of research for such Target. In the year ended December 31, 2018, we received an aggregate of $28.0 million in upfront payments and certain additional payments under the terms of the Pfizer Collaboration Agreement. We are also eligible to receive up to an additional $37.5 million in non-refundable option payments if Pfizer exercises its options for all Targets under the agreement. In the year ended December 31, 2019, we received an aggregate of $4.0 million for options and substitution targets payments under the agreement. We are also entitled to receive up to $225.0 million in development milestone payments and up to $550.0 million in sales-based milestone payments for all designated Targets under the agreement, as well as mid- to high-single digit tiered royalties based on sales of PROTAC targeted protein degrader-related products, which may be subject to reductions. Bayer Collaboration Agreement In June 2019, we entered into the Bayer Collaboration Agreement with Bayer, setting forth our collaboration to identify or optimize PROTAC targeted protein degraders that mediate for degradation of Targets, using our proprietary platform technology, that are selected by Bayer, subject to certain exclusions and limitations. The Bayer Collaboration Agreement became effective in July 2019. Under the Bayer Collaboration Agreement, we and Bayer will conduct a research program pursuant to separate research plans mutually agreed to by us and Bayer and tailored to each Target selected by Bayer. Bayer may make substitutions for any such initial Target candidates, subject to certain conditions and based on the stage of research for such Target. During the term of the Bayer Collaboration Agreement, we are not permitted, either directly or indirectly, to design, identify, discover or develop any small molecule pharmacologically-active agent whose primary mechanism of action is, by design, directed to the inhibition or degradation of any Target selected or reserved by Bayer, or grant any license, covenant not to sue or other right to any third party in the field of human disease under the licensed intellectual property for the conduct of such activities. Under the terms of the Bayer Collaboration Agreement, we received an aggregate upfront non-refundable payment of $17.5 million, plus an additional $1.5 million in research funding payments. Bayer is committed to fund an additional $10.5 million in research funding payments through 2022, subject to potential increases if our costs for research activities exceed the research funding payments allocated to a Target and certain conditions are met. We are also eligible to receive up to $197.5 million in development milestone payments and up to $490.0 million in sales-based milestone payments for all designated Targets. In addition, we are eligible to receive, on net sales of PROTAC targeted protein degrader-related products, mid-single digit to low-double digit tiered royalties, which may be subject to reductions. Prior License Agreement In April 2015, we entered into a collaboration agreement with Merck Sharp & Dohme Corp. We received an upfront non-refundable payment of $7.0 million, which was recognized as revenue over the total estimated period of performance. The agreement expired in April 2018. Operating Expenses Our operating expenses since inception have consisted solely of research and development costs and general and administrative costs. Research and Development Expenses Research and development expenses consist primarily of costs incurred for our research activities, including our discovery efforts, and the development of our product candidates, and include: • salaries, benefits and other related costs, including stock-based compensation expense, for personnel engaged in research and development functions; • expenses incurred under agreements with third parties, including contract research organizations and other third parties that conduct research and preclinical activities on our behalf as well as third parties that manufacture our product candidates for use in our preclinical and clinical trials; • costs of outside consultants, including their fees, stock-based compensation and related travel expenses; • the costs of laboratory supplies and developing preclinical studies and clinical trial materials; • facility-related expenses, which include direct depreciation costs of equipment and allocated expenses for rent and maintenance of facilities and other operating costs; and • third-party licensing fees. We expense research and development costs as incurred. We typically use our employee and infrastructure resources across our development programs, and as such, do not track all of our internal research and development expenses on a program-by-program basis. The following table summarizes our research and development expenses for our AR program, ER program and all other platform and exploratory research and development costs: Research and development activities are central to our business model. We expect that our research and development expenses will continue to increase substantially for the foreseeable future as we conduct clinical trials for ARV-110 and ARV-471, including our ongoing Phase 1 clinical trials, and continue to discover and develop additional product candidates. We cannot reasonably estimate or determine with certainty the duration and costs of future clinical trials of ARV-110 and ARV-471 or any other product candidate we may develop or if, when, or to what extent we will generate revenue from the commercialization and sale of any product candidate for which we obtain marketing approval. We may never succeed in obtaining marketing approval for any product candidate. The successful development and commercialization of our product candidates is highly uncertain. This is due to the numerous risks and uncertainties associated with developing drugs, including the uncertainty of: • successful completion of preclinical studies; • successful initiation of clinical trials; • successful patient enrollment in and completion of clinical trials; • receipt and related terms of marketing approvals from applicable regulatory authorities; • obtaining and maintaining patent and trade secret protection and regulatory exclusivity for our product candidates; • making arrangements with third-party manufacturers, or establishing manufacturing capabilities, for both clinical and commercial supplies of our product candidates; • establishing sales, marketing and distribution capabilities and launching commercial sales of our products, if and when approved, whether alone or in collaboration with others; • acceptance of our products, if and when approved, by patients, the medical community and third-party payors; • obtaining and maintaining third-party coverage and adequate reimbursement; • maintaining a continued acceptable safety profile of the products following approval; and • effectively competing with other therapies. A change in the outcome of any of these variables with respect to the development of a product candidate could mean a significant change in the costs and timing associated with the development of that product candidate. For example, if the FDA or another regulatory authority were to require us to conduct clinical trials beyond those that we anticipate will be required for the completion of clinical development of a product candidate, or if we experience significant delays in our clinical trials due to patient enrollment or other reasons, we would be required to expend significant additional financial resources and time on the completion of clinical development. General and Administrative Expenses General and administrative expenses consist primarily of salaries and other related costs, including stock-based compensation for personnel in our executive, finance, business development and administrative functions. General and administrative expenses also include legal fees relating to intellectual property and corporate matters; professional fees for accounting, auditing, tax and consulting services; insurance costs; travel expenses; and facility-related expenses, which include direct depreciation costs and allocated expenses for rent and maintenance of facilities and other operating costs. We expect that our general and administrative expenses will increase in the future as we increase our personnel headcount to support increased research and development activities relating to our product candidates. We also expect to incur increased expenses associated with being a public company, including costs of accounting, audit, legal, regulatory and tax-related services associated with maintaining compliance with Nasdaq and Securities and Exchange Commission requirements; director and officer insurance costs; and investor and public relations costs. Interest Income (Expense) Interest income consists of interest earned on our cash, cash equivalents and short-term investments. Interest income increased in 2019 as we invested our excess cash from the proceeds of our initial public offering, the Bayer stock purchase, our follow-on offering in November 2019, and payments received under the collaboration agreements. Interest expense consists of interest paid or accrued on our outstanding partially forgivable debt of $2.0 million. Interest expense was approximately $0.1 million in 2019 and we expect that it will remain relatively stable at that level in 2020. Income Taxes Since our inception in 2013, we have not recorded any U.S. federal or state income tax benefits for the net losses we have incurred in any year or for our federal earned research and development tax credits, due to our uncertainty of realizing a benefit from those items. As of December 31, 2019, we had federal net operating loss carryforwards of $103.5 million, which begin to expire in 2033. As of December 31, 2019, we also had federal and state research and development tax credit carryforwards of $5.1 million and $2.6 million, respectively, which begin to expire in 2033 and 2028, respectively. As of December 31, 2019, Arvinas, Inc. had four wholly owned subsidiaries organized as C-corporations: Arvinas Operations, Inc., Arvinas Androgen Receptor, Inc., Arvinas Estrogen Receptor, Inc., and Arvinas Winchester, Inc. Prior to December 31, 2018, these subsidiaries were separate filers for federal tax purposes. Net operating loss carryforwards are generated from the C-corporation subsidiaries’ filings. We have provided a valuation allowance against the full amount of the deferred tax assets since, in the opinion of management, based upon our earnings history, it is more likely than not that the benefits will not be realized. Critical Accounting Policies and Use of Estimates Our management’s discussion and analysis of financial condition and results of operations is based on our consolidated financial statements, which have been prepared in accordance with generally accepted accounting principles in the United States. The preparation of our consolidated financial statements and related disclosures requires us to make estimates and assumptions that affect the reported amounts of assets and liabilities, costs and expenses and the disclosure of contingent assets and liabilities in our consolidated financial statements. We base our estimates on historical experience, known trends and events and various other factors that we believe are reasonable under the circumstances, the results of which form the basis for making judgments about the carrying values of assets and liabilities that are not readily apparent from other sources. We evaluate our estimates and assumptions on an ongoing basis. Our actual results may differ from these estimates under different assumptions or conditions. While our significant accounting policies are described in more detail in the notes to our consolidated financial statements appearing elsewhere in this Annual Report on Form 10-K, we believe that the following accounting policies are those most critical to the judgments and estimates used in the preparation of our consolidated financial statements. Revenue Recognition We recognize revenue under Accounting Standards Codification, or ASC, 606, Revenue from Contracts with Customers. Our revenue is generated through research collaboration and license agreements with pharmaceutical partners. The terms of these agreements contain multiple goods and services which may include (i) licenses, (ii) research and development activities and (iii) participation in joint research and development steering committees. The terms of these agreements may include non-refundable upfront license or option fees, payments for research and development activities, payments upon the achievement of certain milestones, and royalty payments based on product sales derived from the collaboration. Under ASC 606, we evaluate whether the license agreement, research and development services, and participation in research and development steering committees, represent separate or combined performance obligations. We have determined that these services within our existing contracts represent a combined single performance obligation. The research collaboration and license agreements typically include contingent milestone payments related to specified preclinical and clinical development milestones and regulatory milestones. These milestone payments represent variable consideration that are not initially recognized within the transaction price as they are fully constrained under the guidance in ASC 606. We will continue to assess the probability of significant reversals for any amounts that become likely to be realized prior to recognizing the variable consideration associated with these payments within the transaction price. Revenue is recognized ratably over our expected performance period under each respective arrangement. We make our best estimate of the period over which we expect to fulfill our performance obligations, which includes access to technology through the license agreement and research activities. Given the uncertainties of these collaboration arrangements, significant judgement is required to determine the duration of the performance period. For the years ended December 31, 2019 and 2018, transaction price allocated to the combined performance obligation identified under the agreements was recognized as revenue on a straight-line basis over the estimated performance period under each respective arrangement. Straight-line basis was considered the best measure of progress in which control of the combined obligation transfers to the customers, due to the contract containing license rights to technology, research and development services, and joint committee participation, which in totality are expected to occur ratably over the performance period. Our contracts may also call for certain sales-based milestone and royalty payments upon successful commercialization of a target. In accordance with ASC 606-10-55-65, we recognize revenues from sales-based milestone and royalty payments at the later of (i) the occurrence of the subsequent sale; or (ii) the performance obligation to which some or all of the sales-based milestone or royalty payments has been allocated has been satisfied (or partially satisfied). We anticipate recognizing these milestone and royalty payments if and when subsequent sales are generated by the customer from the use of the technology. To date, no revenue from these sales-based milestone and royalty payments has been recognized for any periods. Amounts received prior to satisfying the above revenue recognition criteria are recorded as a contract liability in our accompanying consolidated balance sheets. Incentive Units Prior to our initial public offering, we issued equity-based compensation awards to employees and non-employees through the granting of incentive units. We had periodically granted incentive units to employees and non-employees, which generally vested over a four-year period. The incentive units represented a separate substantive class of equity with defined rights within the limited liability company agreement of Arvinas Holding Company, LLC, or the LLC Operating Agreement. The incentive units represented profit interest in the increase in the value of the entity over a participation threshold, as determined at the time of grant. The holder, therefore, had the right to participate in distributions of profits only in excess of such participation threshold. The participation threshold was based on the valuation of the incentive unit on or around the grant date. We accounted for unit-based compensation in accordance with ASC 718, Compensation-Stock Compensation. In accordance with ASC 718, compensation cost is measured at estimated fair value and is included as compensation expense over the vesting period during which an employee provides service in exchange for the award. We used a Black-Scholes option pricing model to determine the fair value of our incentive units, due to the existence of a participation threshold. The Black-Scholes option pricing model includes various assumptions, including the expected life of incentive units, the expected volatility and the expected risk-free interest rate. The fair value of the underlying common units represented the exercise price utilized in the Black-Scholes option pricing model. These assumptions reflected our best estimates, but they involved inherent uncertainties based on market conditions generally outside our control. As a result, if other assumptions had been used, unit-based compensation cost could have been materially impacted. Furthermore, if we used different assumptions for future grants, unit-based compensation cost could have been materially impacted in future periods. As there had been no public market for our common units prior to our initial public offering, the estimated fair value of our common units had been determined by our board of directors as of the date of each incentive unit grant, with input from management, considering our most recently available third-party valuations of common stock units. Valuations were updated when facts and circumstances indicated that the most recent valuation was no longer valid, such as changes in the stage of our development efforts, various exit strategies and their timing, and other scientific developments that could be related to the valuation of our company, or, at a minimum, annually. Third-party valuations were performed in accordance with the guidance outlined in the American Institute of Certified Public Accountants’ Accounting and Valuation Guide, Valuation of Privately-Held-Company Equity Securities Issued as Compensation. Our common unit valuation in January 2018 was prepared using a market approach, specifically the subject company transaction method. The subject company transaction method solves for the total equity value which allocates a probability-weighted present value to the series B preferred unit holders consistent with the investment amount of that financing round adjusted to account for the impact of progress or changes in the business since the closing of the series B financing. Our common unit valuation as of June 30, 2018 was prepared using the income and market approaches simultaneously. Under the income approach, the hybrid method was used, which is a combination of the probability weighted expected return method, or PWERM, and the option pricing method, or OPM. Under the market approach, the subject company transaction method was used. Within both the PWERM and OPM, the subject company transaction method was used to solve for the total equity value which allocates a probability weighted present value to the series C preferred unit holders consistent with the investment amount of that financing round. These third-party valuations resulted in participation thresholds of $270.8 million as of March 31, 2018 and $292.0 million as of June 30, 2018. Fair value estimates of underlying shares are no longer necessary to determine the fair value of new equity awards because the underlying shares are traded in the public market. Immediately prior to the effectiveness of our registration statement on Form S-1 (File No. 333-227112) in September 2018, Arvinas Holding Company, LLC, or Arvinas LLC, our predecessor company, converted from a Delaware limited liability company into Arvinas, Inc., a Delaware corporation, which we refer to as the Conversion. In connection with the Conversion, incentive units in Arvinas LLC were exchanged for common stock and restricted common stock of Arvinas, Inc. New Accounting Pronouncements For information on new accounting standards, see Note 2 to our consolidated audited financial statements appearing elsewhere in this Annual Report on Form 10-K. Results of Operations Comparison of Years Ended December 31, 2019 and 2018 Revenues Revenues for the year ended December 31, 2019 were $43.0 million, compared with $14.3 million for the year ended December 31, 2018. Revenues for the year ended December 31, 2019 included $24.7 million recognized from the contribution of the license to Oerth. The remaining revenues of $18.3 million increased by $4.0 million over the prior year primarily related to the revenue associated with the Bayer Collaboration Agreement which was initiated in the third quarter of 2019 and an increase in license and rights to technology fees and research and development activities related to the Pfizer Collaboration Agreement. Research and Development Expenses Research and development expenses for the year ended December 31, 2019 were $67.2 million, compared with $45.2 million for the year ended December 31, 2018. The increase of $22.0 million was primarily due to an increase in our continued investment in our wholly-owned platform and exploratory programs of $19.2 million, expenses related to our ER program of $2.0 million and AR program of $0.8 million. The increase in spending over all of our programs was primarily due to increased personnel and personnel costs utilized across all our programs of $10.9 million, including an increase in stock compensation expense of $3.6 million. Direct expenses related to our platform and exploratory targets increased $11.1 million in 2019 as we expanded the number of protein targets in the exploratory phase. Clinical trial costs increased by $3.0 million but were more than offset by a decrease in lead optimization costs and IND-enabling costs for our AR and ER programs in 2019. General and Administrative Expenses General and administrative expenses were $27.3 million for the year ended December 31, 2019, compared with $12.9 million for the year ended December 31, 2018. The increase of $14.4 million was primarily due to an increase of $10.0 million in personnel and facility related costs, including $5.0 million related to stock compensation expense. Increases in other costs, including legal and other professional fees of $3.0 million and corporate insurance of $0.9 million, are primarily related to costs incurred in our first full year as a public company in 2019. Other Income (Expenses) Other income (expenses) was $5.9 million for the year ended December 31, 2019, compared with $2.3 million for the year ended December 31, 2018. The increase of $3.6 million was primarily related to an increase in interest income of $2.1 million and an increase in refundable research and development credits from the State of Connecticut of $1.2 million. The increase in interest income was the result of our higher average cash, cash equivalent and short-term investment balances for the year ended December 31, 2019 due to the proceeds from our initial public offering in 2018, the Stock Purchase Agreement, the Bayer Collaboration Agreement and our follow-on public offering in 2019. Loss on Equity Method Investment Loss on equity method investment for the year ended December 31, 2019 was $24.7 million, generated from Oerth’s expensing intellectual property contributed to it. Liquidity and Capital Resources Sources of Liquidity We do not currently have any approved products and have never generated any revenue from product sales. To date, we have financed our operations primarily through the sale of equity interests and through payments from collaboration partners, grant funding and loans from the State of Connecticut. Through December 31, 2019, we raised approximately $385.4 million in gross proceeds from the sale of common stock, the exercise of stock options, and the sale of series A, series B and series C convertible preferred units, and had received an aggregate of $112.4 million in payments from collaboration partners, grant funding and forgivable and partially forgivable loans from the State of Connecticut. In October 2018, we completed our IPO in which we issued and sold an aggregate of 7,700,482 shares of common stock, including 200,482 additional shares of common stock at a subsequent closing upon the exercise in part by the underwriters of their option to purchase additional shares at a public offering price of $16.00 per share, for aggregate gross proceeds of $123.2 million before fees and expenses. In July 2019, we sold 1,346,313 shares of common stock to Bayer AG for aggregate gross proceeds of $32.5 million. In November 2019, we completed a follow-on offering in which we issued 5,227,273 shares of common stock at a public offering price of $22.00 per share, for aggregate gross proceeds of $115.0 million before fees and expenses. Cash Flows Our cash, cash equivalents and marketable securities totaled $280.9 million as of December 31, 2019 and $187.8 million as of December 31, 2018. We had an outstanding loan balance of $2.0 million as of December 31, 2019 and $2.2 million as of December 31, 2018. The following table summarizes our sources and uses of cash for the period presented: Operating Activities Net cash used in operating activities for the year ended December 31, 2019 was $40.6 million, resulting from our net loss of $70.3 million and an increase in other receivables of $4.0 million, partially offset by non-cash expenses of $22.5 million and an increase in accounts payable and accrued expenses of $5.2 million and deferred revenue of $4.9 million. The increase in deferred revenue is primarily due to $23.1 million in payments received from collaboration partners, partially offset by $18.3 million of revenue recognized. Net cash used in operating activities for the year ended December 31, 2018 was $16.1 million, resulting from our net loss of $41.5 million and a reduction in our deferred revenue of $8.5 million, partially offset by non-cash expenses of $12.8 million and a decrease in accounts receivable of $22.2 million. The reduction in deferred revenue is primarily due to $14.3 million of revenue recognized, partially offset by $5.8 million in target payments received from a collaboration partner. Investing Activities Net cash used in investing activities for the year ended December 31, 2019 was $93.1 million, attributable to the net investment of excess cash of $86.9 million and the purchases of property and equipment of $6.2 million. Net cash used in investing activities for the year ended December 31, 2018 was $179.7 million, attributable to the net investment of excess cash of $176.8 million and the purchases of property and equipment of $2.8 million. Financing Activities Net cash provided by financing activities for the year ended December 31, 2019 was $139.7 million, primarily attributable to the proceeds from the sales of common stock, net of underwriter discounts and offering costs, of $137.1 million and the proceeds from the exercise of stock options of $2.8 million. We also made $0.2 million in debt payments. Net cash provided by financing activities for the year ended December 31, 2018 was $168.1 million, primarily attributable to the net proceeds from the sale of series C preferred units of $55.0 million and the sale of common stock, net of underwriter discounts and offering costs, of $111.2 million. We also received loan proceeds of $2.0 million and made $0.2 million in debt payments. Funding Requirements Since our inception, we have incurred significant operating losses. We expect to continue to incur significant expenses and increasing operating losses for the foreseeable future as we advance the preclinical and clinical development of our product candidates. In addition, we expect to continue to incur additional costs associated with operating as a public company. Specifically, we anticipate that our expenses will increase substantially if and as we: • continue a Phase 1 clinical trial of our product candidate, ARV-110, in men with mCRPC; • continue a Phase 1 clinical trial of our product candidate, ARV-471, in patients with locally advanced or metastatic ER positive / HER2 negative breast cancer; • apply our PROTAC platform to advance additional product candidates into preclinical and clinical development; • expand the capabilities of our PROTAC platform; • seek marketing approvals for any product candidates that successfully complete clinical trials; • ultimately establish a sales, marketing and distribution infrastructure and scale up external manufacturing capabilities to commercialize any products for which we may obtain marketing approval; • expand, maintain and protect our intellectual property portfolio; • hire additional clinical, regulatory and scientific personnel; and • add operational, financial and management information systems and personnel to support our research, product development and future commercialization efforts and support our operations as a public company. As of December 31, 2019, we believe that our existing cash, cash equivalents and marketable securities, will enable us to fund our operating expenses and capital expenditure requirements into 2022. We have based this estimate on assumptions that may prove to be wrong, and we could use our capital resources sooner than we currently expect. Our future capital requirements will depend on many factors, including: • the progress, costs and results of our Phase 1 clinical trial for ARV-110 and our Phase 1 clinical trial for ARV-471 and any future clinical development of ARV-110 and ARV-471; • the scope, progress, costs and results of preclinical and clinical development for our other product candidates and development programs; • the number and development requirements of other product candidates that we pursue, including our neurodegenerative research programs; • the success of our collaborations with Pfizer, Genentech and Bayer; • the costs, timing and outcome of regulatory review of our product candidates; • the costs and timing of future commercialization activities, including product manufacturing, marketing, sales and distribution, for any of our product candidates for which we receive marketing approval; • the revenue, if any, received from commercial sales of our product candidates for which we receive marketing approval; • the costs and timing of preparing, filing and prosecuting patent applications, maintaining and enforcing our intellectual property rights and defending any intellectual property-related claims; and • our ability to establish collaboration arrangements with other biotechnology or pharmaceutical companies on favorable terms, if at all, for the development or commercialization of our product candidates. As a result of these anticipated expenditures, we will need to obtain substantial additional financing in connection with our continuing operations. Until such time, if ever, as we can generate substantial revenue from product sales, we expect to finance our cash needs through a combination of equity offerings, debt financings, collaborations, strategic alliances and marketing, distribution or licensing arrangements. Although we may receive potential future payments under our collaborations with Pfizer, Genentech and Bayer, we do not currently have any committed external source of funds. Adequate additional funds may not be available to us on acceptable terms, or at all. If we are unable to raise capital when needed or on attractive terms, we may be required to delay, limit, reduce or terminate our research, product development programs or any future commercialization efforts or grant rights to develop and market product candidates that we would otherwise prefer to develop and market ourselves. To the extent that we raise additional capital through the sale of equity or convertible debt securities, the terms of these securities may include liquidation or other preferences that adversely affect the rights of our common stockholders. Debt financing and preferred equity financing, if available, may involve agreements that include covenants limiting or restricting our ability to take specific actions, such as incurring additional debt, making acquisitions or capital expenditures or declaring dividends. If we raise additional funds through collaborations, strategic alliances or marketing, distribution or licensing arrangements with third parties, we may have to relinquish valuable rights to our technologies, future revenue streams, research programs or product candidates or grant licenses on terms that may not be favorable to us. Borrowings In August 2013, we entered into a Loan Agreement, or Loan, with Connecticut Innovations, Incorporated, or CII, the strategic venture capital arm and a component unit of the State of Connecticut. Under the Loan, we borrowed $750,000 for the purchase of laboratory equipment, information technology equipment and leasehold improvements. Interest on the Loan was compounded on a monthly basis at a rate of 7.50% per annum. The Loan provided for monthly, interest-only payments for ten months. Beginning on June 1, 2015 we were required to make monthly principal and interest payments through July 31, 2019. We could have prepaid the amount due at any time without premium or penalty. The Loan was secured by substantially all of our assets. The amount outstanding under the Loan was $0.2 million as of December 31, 2018. We paid the Loan in full in July 2019. In connection with the issuance of the Loan, we granted CII a warrant to purchase 110,116 of our series A preferred units at a purchase price of $0.6811 per unit, with a seven-year term from the date of issuance. The warrant was exercised in July 2018. In January 2014, we entered into an Assistance Agreement with the State of Connecticut, or the 2014 Assistance Agreement. Under the terms of the 2014 Assistance Agreement, we borrowed $2.5 million. Borrowings under the 2014 Assistance Agreement were forgivable if we maintained a minimum number of full-time jobs in the State of Connecticut for a minimum period at a minimum annual salary. Effective in March 2016, the full principal amount under the 2014 Assistance Agreement had been forgiven. While borrowings under the 2014 Assistance Agreement have been forgiven, we remain subject to an ongoing covenant to be located in the State of Connecticut through January 2024. Upon violation of this covenant we would be required to repay the full original funding amount of $2.5 million plus liquidated damages of 7.50%. In June 2018, we entered into an additional Assistance Agreement with the State of Connecticut, or the 2018 Assistance Agreement, to provide funding for the expansion and renovation of laboratory and office space. Under the terms of the 2018 Assistance Agreement, we could borrow from the State of Connecticut a maximum of $2.0 million, provided that the funding does not exceed more than 50% of the total costs of the expansion and renovation. Borrowings under the 2018 Assistance Agreement bear an interest rate of 3.25% per annum and interest payments are required for the first 60 months from the funding date. Interest expense related to the Assistance Agreement is expected to be $65,000 annually for the first five years. Thereafter, the loan begins to fully amortize through month 120, maturing in June 2028. Up to $1.0 million of the funding can be forgiven if we meet certain employment conditions. We may be required to prepay a portion of the loan if the employment conditions are not met. The 2018 Assistance Agreement requires that we be located in the State of Connecticut through June 2028 with a default penalty of repayment of the full original funding amount of $2.0 million plus liquidated damages of 7.5% of the total amount of funding received. We borrowed the full $2.0 million under the 2018 Assistance Agreement in September 2018 and the full amount remains outstanding at December 31, 2019. Off-Balance Sheet Arrangements We have not entered into any off-balance sheet arrangements and do not have any holdings in variable interest entities. Emerging Growth Company Status As an “emerging growth company,” the Jumpstart Our Business Startups Act of 2012 allows us to delay adoption of new or revised accounting standards applicable to public companies until such standards are made applicable to private companies. However, we have irrevocably elected not to avail ourselves of this extended transition period for complying with new or revised accounting standards and, therefore, we will be subject to the same new or revised accounting standards as other public companies that are not emerging growth companies.

<s>[INST] Overview We are a clinicalstage biopharmaceutical company dedicated to improving the lives of patients suffering from debilitating and lifethreatening diseases through the discovery, development and commercialization of therapies to degrade diseasecausing proteins. We use our proprietary technology platform to engineer proteolysis targeting chimeras, or PROTAC targeted protein degraders, that are designed to harness the body’s own natural protein disposal system to selectively remove diseasecausing proteins. We believe that our targeted protein degradation approach is a therapeutic modality that may provide distinct advantages over existing modalities, including traditional small molecule therapies and genebased medicines. Our smallmolecule PROTAC technology has the potential to address a broad range of intracellular disease targets, including those representing the up to 80% of proteins that cannot be addressed by existing small molecule therapies, commonly referred to as “undruggable” targets. We are using our PROTAC platform to build an extensive pipeline of protein degradation product candidates to target diseases in oncology, neuroscience, and other therapeutic areas. Our two lead product candidates are ARV110 and ARV471. We are developing ARV110, a PROTAC protein degrader targeting the androgen receptor protein, or AR, for the treatment of men with metastatic castrationresistant prostate cancer, or mCRPC. We initiated a Phase 1 clinical trial of ARV110 in March 2019. We are also developing ARV471, a PROTAC protein degrader targeting the estrogen receptor protein, or ER, for the treatment of patients with locally advanced or metastatic ER positive / HER2 negative breast cancer. We initiated a Phase 1 clinical trial of ARV471 in August 2019. In October 2019, we announced initial safety, tolerability and pharmacokinetic data from the ongoing Phase 1 clinical trial for each of ARV110 and ARV471. The initial data from these Phase 1 clinical trials showed dose proportionality for ARV110 and that exposures of both ARV110 and ARV471 had reached levels associated with tumor growth inhibition in preclinical studies. In addition, both ARV110 and ARV471 at each dose tested to date was well tolerated, with no doselimiting toxicities and no grade 2, 3, or 4 treatmentrelated adverse events observed. Since October 2019, dose escalation for each of the Phase 1 clinical trials has continued and both trials are currently ongoing. We commenced operations in 2013, and our operations to date have been limited to organizing and staffing our company, business planning, raising capital, conducting discovery and research activities, filing patent applications, identifying potential product candidates, undertaking preclinical studies and establishing arrangements with third parties for the manufacture of initial quantities of our product candidates. To date, we have not generated any revenue from product sales and have financed our operations primarily through sales of our equity interests, proceeds from our collaborations, grant funding and debt financing. Through December 31, 2019, we raised approximately $385.4 million in gross proceeds from the sale of common stock, the exercise of stock options, and the sale of series A, series B and series C convertible preferred units, and had received an aggregate of $112.4 million in payments from collaboration partners, grant funding and partially forgivable loans from the State of Connecticut. In June 2019, we entered into a Collaboration and License Agreement, or the Collaboration Agreement, with Bayer AG, or, together with its controlled affiliates, Bayer, which agreement became effective in July 2019. We also entered into a Stock Purchase Agreement with Bayer, or the Stock Purchase Agreement, pursuant to which we issued and sold to Bayer 1,346,313 shares of our common stock, or the Shares, for an aggregate purchase price of approximately $32.5 million. The price per share was $24.14, based on a 15% premium above our 60day [/INST] Positive. </s>

Stitch Fix, Inc.

2018-10-03

2018-07-28

Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations. You should read the following discussion and analysis of our financial condition and results of operations together with our audited consolidated financial statements and related notes thereto included in Part II, Item 8 of this Annual Report on Form 10-K, or Annual Report. We use a 52- or 53-week fiscal year, with our fiscal year ending on the Saturday that is closest to July 31 of that year. Each fiscal year generally consists of four 13-week fiscal quarters, with each fiscal quarter ending on the Saturday that is closest to the last day of the last month of the quarter. Each of the fiscal years ended July 28, 2018, July 29, 2017, and July 30, 2016, included 52 weeks of operations. Throughout this Annual Report, all references to quarters and years are to our fiscal quarters and fiscal years unless otherwise noted. In addition, this discussion contains forward-looking statements that reflect our plans, estimates and beliefs, and involve risks and uncertainties. Our actual results and the timing of certain events could differ materially from those anticipated in or implied by these forward-looking statements as a result of several factors, including those discussed in the section titled “Risk Factors” included under Part I, Item 1A and elsewhere in this Annual Report. See “Special Note Regarding Forward-Looking Statements” in this Annual Report. Overview Stitch Fix is transforming the way people find what they love, one client at a time and one Fix at a time. We are reinventing the shopping experience by delivering one-to-one personalization to our clients through the combination of data science and human judgment. This combination drives a better client experience and a more powerful business model than either element could deliver independently. Our stylists hand select items from a broad range of merchandise. Stylists pair their own judgment with our analysis of client and merchandise data to provide a personalized shipment of apparel, shoes and accessories suited to each client’s needs. We call each of these unique shipments a Fix. Our clients may choose to schedule automatic shipments that arrive every two to three weeks or on a monthly, bi-monthly or quarterly cadence, or schedule a Fix on demand. Clients can increase or decrease their desired Fix frequency at any time, and can select the exact date by which they want to receive a Fix. After receiving a Fix, our clients purchase the items they want to keep and return the other items. Historically, we have charged clients a $20 styling fee that is credited towards the merchandise purchased. If the client chooses to keep all items in a Fix, she receives a 25% discount on her entire purchase. We also provide select clients with an alternative to paying a $20 styling fee per Fix, known as Style Pass. Style Pass clients pay a $49 annual fee for unlimited styling that is credited towards merchandise purchases. In February 2018, we launched Extras, a new feature that allows clients to select items such as socks, bras, underwear and other intimates that are then added to the five items their stylist selects for their Fix. In July 2018, we launched Stitch Fix Kids in time for back-to-school season. In addition, in October 2018, we announced our plan to launch in the United Kingdom, or UK. The very human experience that we deliver is powered by data science. Our data science capabilities consist of our rich data set and our proprietary algorithms, which fuel our business by enhancing the client experience and driving business model efficiencies. The vast majority of our client data is provided directly and explicitly by our clients, rather than inferred, scraped or obtained from other sources. We also gather extensive merchandise data, such as inseam, pocket shape, silhouette and fit. This large and growing data set provides the foundation for proprietary algorithms that we use throughout our business, including those that predict purchase behavior, forecast demand, optimize inventory and enable us to design new apparel. We believe our data science capabilities give us a significant competitive advantage, and as our data set grows, our algorithms become more powerful. Our stylists leverage our data science through a custom-built, web-based styling application that provides recommendations from our broad selection of merchandise. Our stylists then apply their judgment to select what they believe to be the best items for each Fix. Our stylists provide a personal touch, offer styling advice and context to each item selected, and help us develop long-term relationships with our clients. Our stylists are U.S.-based employees, most of whom work part-time and remotely. We maintain a broad range of product offerings to serve our clients. We offer both merchandise sourced from brand partners and our own Exclusive Brands. We use our data to inform the merchandise we buy and develop to best suit our clients. We reach clients through a combination of word of mouth, referrals, advertising and other marketing efforts. We invest in marketing with the goal of attracting new clients, improving engagement with current clients and expanding our client closet share over time. As we continue to expand our marketing efforts, we plan to remain disciplined in measuring the return on advertising spend. We believe our success in serving clients has resulted in our rapid and profitable growth. We have achieved positive cash flows from operations on an annual basis since 2014, while continuing to make meaningful investments to drive growth. For the fiscal year ended July 28, 2018, we reported $1.2 billion of revenue representing year-over-year growth of 25.5% from the fiscal year ended July 29, 2017, compared to year-over-year growth of 33.8% from the fiscal year ended July 30, 2016, to the fiscal year ended July 29, 2017. As of July 28, 2018, July 29, 2017, and July 30, 2016, we had active clients of 2,742,000, 2,194,000 and 1,674,000, respectively, representing year-over-year growth of 25.0% and 31.1%, respectively. Net income for the fiscal year ended July 28, 2018, was $44.9 million, an increase of $45.5 million from the fiscal year ended July 29, 2017. Net loss for the fiscal year ended July 29, 2017, was $0.6 million, a decrease of $33.8 million from the fiscal year ended July 30, 2016. Included in net income for the fiscal year ended July 28, 2018, was a $10.7 million gain on remeasurement of our preferred stock warrant liability prior to our initial public offering, or IPO, and a $6.7 million remeasurement expense on our net deferred tax assets related to the Tax Cuts and Jobs Act, or the Tax Act, which was enacted on December 22, 2017. Included in net income for the fiscal year ended July 29, 2017, was a $21.3 million compensation expense related to certain stock sales by current and former employees and a $18.9 million loss on remeasurement of our preferred stock warrant liability. Included in net income for the fiscal year ended July 29, 2016, was a $4.8 million compensation expense related to certain stock sales by current and former employees and a $3.0 million loss on remeasurement of our preferred stock warrant liability. Key Metrics We report our financial results in accordance with generally accepted accounting principles in the United States, or GAAP. However, management believes that certain non-GAAP financial measures provide users of our financial information with additional useful information in evaluating our performance. Management believes that excluding certain items that may vary substantially in frequency and magnitude period-to-period from net income (loss) and earnings (loss) per share, or EPS, provides useful supplemental measures that assist in evaluating our ability to generate earnings and to more readily compare these metrics between past and future periods. Management also believes that adjusted EBITDA is frequently used by investors and securities analysts in their evaluations of companies, and that this supplemental measure facilitates comparisons between companies. We believe free cash flow is an important metric because it represents a measure of how much cash from operations we have available for discretionary and non-discretionary items after the deduction of capital expenditures. These non-GAAP financial measures may be different than similarly titled measures used by other companies. For instance, we do not exclude stock-based compensation expense from adjusted EBITDA or non-GAAP net income. Stock-based compensation is an important part of how we attract and retain our employees, and we consider it to be a real cost of running the business. Our non-GAAP financial measures should not be considered in isolation from, or as substitutes for, financial information prepared in accordance with GAAP. There are several limitations related to the use of our non-GAAP financial measures as compared to the closest comparable GAAP measures. Some of these limitations include: • our non-GAAP net income, adjusted EBITDA and non-GAAP EPS - diluted measures exclude compensation expense that we recognized related to certain stock sales by current and former employees; • our non-GAAP net income and non-GAAP EPS - diluted measures exclude the impact of the remeasurement of our net deferred tax assets following the adoption of the Tax Act; • our non-GAAP net income, adjusted EBITDA and non-GAAP EPS - diluted measures exclude the remeasurement of the preferred stock warrant liability, which is a non-cash expense incurred in the periods prior to the completion of our IPO; • adjusted EBITDA also excludes the recurring, non-cash expenses of depreciation and amortization of property and equipment and, although these are non-cash expenses, the assets being depreciated and amortized may have to be replaced in the future; • adjusted EBITDA does not reflect our tax provision, which reduces cash available to us; and • free cash flow does not represent the total residual cash flow available for discretionary purposes and does not reflect our future contractual commitments. Adjusted EBITDA We define adjusted EBITDA as net income (loss) excluding other (income), net, provision for income taxes, depreciation and amortization, and, when present, the remeasurement of preferred stock warrant liability and compensation expense related to certain stock sales by current and former employees. The following table presents a reconciliation of net income (loss), the most comparable GAAP financial measure, to adjusted EBITDA for each of the periods presented: Non-GAAP Net Income We define non-GAAP net income as net income (loss) excluding, when present, the remeasurement of preferred stock warrant liability, compensation expense related to certain stock sales by current and former employees, and the related tax impact of those items, as well as the remeasurement of our net deferred tax assets in relation to the adoption of the Tax Act. The following table presents a reconciliation of net income (loss), the most comparable GAAP financial measure, to non-GAAP net income for each of the periods presented: (1) The U.S. government enacted comprehensive tax legislation in December 2017. This resulted in a net charge of $4.2 million for the fiscal year ended July 28, 2018, due to the remeasurement of our net deferred tax assets for the reduction in tax rate from 35% to 21%. The adjustment to non-GAAP net income only includes this transitional impact. It does not include the ongoing impacts of the lower U.S. statutory rate on current year earnings. Non-GAAP Earnings Per Share - Diluted We define non-GAAP EPS as diluted EPS excluding, when present, the per share impact of the remeasurement of preferred stock warrant liability, compensation expense related to certain stock sales by current and former employees, and the related tax impact of those items, as well as the per share impact of the remeasurement of our net deferred tax assets in relation to the adoption of the Tax Act. The following table presents a reconciliation of EPS attributable to common stockholders - diluted, the most comparable GAAP financial measure, to non-GAAP EPS attributable to common stockholders - diluted for each of the periods presented: (1) For the fiscal year ended July 28, 2018, the preferred stock warrant liability was dilutive and included in earnings per share attributable to common stockholders - diluted. Therefore, it is not an adjustment to arrive at non-GAAP EPS - diluted. (2) The U.S. government enacted comprehensive tax legislation in December 2017. This resulted in a net charge of $4.2 million for the fiscal year ended July 28, 2018, due to the remeasurement of our net deferred tax assets for the reduction in tax rate from 35% to 21%. The adjustment to non-GAAP net income only includes this transitional impact. It does not include the ongoing impacts of the lower U.S. statutory rate on current year earnings. Free Cash Flow We define free cash flow as cash flow from operations reduced by purchases of property and equipment that are included in cash flow from investing activities. The following table presents a reconciliation of cash flows from operating activities, the most comparable GAAP financial measure, to free cash flow for each of the periods presented: Active Clients We believe that the number of active clients is a key indicator of our growth and the overall health of our business. We define an active client as a client who checked out a Fix in the preceding 12-month period, measured as of the last date of that period. A client checks out a Fix when she indicates what items she is keeping through our mobile application or on our website. We had 2,742,000, 2,194,000 and 1,674,000 active clients as of July 28, 2018, July 29, 2017, and July 30, 2016, respectively, representing year-over-year growth of 25.0% and 31.1%, respectively. Factors Affecting Our Performance Client Acquisition and Engagement To grow our business, we must continue to acquire clients and successfully engage them. We believe that implementing broad-based marketing strategies that increase our brand awareness has the potential to strengthen Stitch Fix as a national consumer brand, help us acquire new clients and drive revenue growth. As our business has achieved a greater scale and we are able to support a large and growing client base, we have increased our investments in marketing to take advantage of more marketing channels to efficiently acquire clients. For example, we recently significantly increased our advertising spend, from $70.5 million and $25.0 million for the fiscal years ended July 29, 2017, and July 30, 2016, respectively, to $102.1 million for the fiscal year ended July 28, 2018, to support the growth of our business. We expect to continue to make significant marketing investments to grow our business. We currently utilize both digital and offline channels to attract new visitors to our website or mobile app and subsequently convert them into clients. Our current marketing efforts include client referrals, affiliate programs, partnerships, display advertising, television, print, radio, video, content, direct mail, social media, email, mobile “push” communications, search engine optimization and keyword search campaigns. To successfully acquire clients and increase engagement, we must also continue to improve the diversity of our offering. These efforts may include broadening our brand partnerships and expanding into new categories, product types, price points and geographies. For example, in July 2018 we launched Stitch Fix Kids, expanding our client and vendor base, and in October 2018, we announced our intention to launch in the UK, expanding our geographic scope. Investment in our Operations and Infrastructure To grow our client base and enhance our offering, we will incur additional expenses. We intend to leverage our data science and deep understanding of our clients’ needs to inform investments in operations and infrastructure. We anticipate that our expenses will increase as we continue to hire additional personnel and further advance our technological and data science capabilities. Moreover, we intend to make capital investments in our inventory, fulfillment centers and office space and logistics infrastructure as we launch new categories, expand internationally and drive operating efficiencies. We expect to increase our spending on these investments in the future and cannot be certain that these efforts will grow our client base or be cost-effective. However, we believe these strategies will yield positive returns in the long term. Inventory Management We leverage our data science to buy and manage our inventory, including merchandise assortment and fulfillment center optimization. To ensure sufficient availability of merchandise, we generally enter into purchase orders well in advance and frequently before apparel trends are confirmed by client purchases. As a result, we are vulnerable to demand and pricing shifts and availability of merchandise at time of purchase. We incur inventory write-offs and changes in inventory reserves that impact our gross margins. Because our merchandise assortment directly correlates to client success, we may at times optimize our inventory to prioritize long-term client success over short-term gross margin impact. Moreover, our inventory investments will fluctuate with the needs of our business. For example, entering new categories such as our recent launch of Stitch Fix Kids or adding new fulfillment centers will require additional investments in inventory. Merchandise Mix We offer apparel, shoes and accessories across categories, brands, product types and price points. We currently serve our clients in the following categories: Women’s, Petite, Maternity, Men’s, Plus and Kids. We carry a mix of third-party branded merchandise, including premium brands, and our own Exclusive Brands. We also offer a wide variety of product types, including denim, dresses, blouses, skirts, shoes, jewelry and handbags. We sell merchandise across a broad range of price points and may further broaden our price point offerings in the future. While changes in our merchandise mix have not caused significant fluctuations in our gross margin to date, categories, brands, product types and price points do have a range of margin profiles. For example, our Exclusive Brands have generally contributed higher margin, shoes have generally contributed lower margin, and new categories, such as Kids, tend to initially have lower margins. Shifts in merchandise mix driven by client demand may result in fluctuations in our gross margin from period to period. Components of Results of Operations Revenue We generate revenue from the sale of merchandise. We charge a $20 nonrefundable upfront fee, referred to as a “styling fee,” that is credited towards any merchandise purchased in the Fix. We deduct discounts, sales tax and estimated refunds to arrive at net revenue, which we refer to as revenue throughout the report. In December 2017, we launched Style Pass to provide select clients with an alternative to paying a $20 styling fee per Fix. Style Pass clients pay a $49 nonrefundable annual fee for unlimited styling that is credited towards merchandise purchases. We expect our revenue to increase in absolute dollars as we grow our business, although our revenue growth rate may continue to slow in future periods. Cost of Goods Sold Cost of goods sold consists of the costs of merchandise, expenses for shipping to and from clients and inbound freight, inventory write-offs and changes in our inventory reserve, payment processing fees and packaging materials costs. We expect our cost of goods sold to fluctuate as a percentage of revenue primarily due to how we manage our inventory and merchandise mix. Our classification of cost of goods sold may vary from other companies in our industry and may not be comparable. Selling, General and Administrative Expenses Selling, general and administrative expenses consist primarily of compensation and benefits costs, including stock-based compensation expense, for our employees including our stylist, fulfillment center operations, data analytics, merchandising, engineering, client experience, marketing and corporate personnel. Selling, general and administrative expenses also include marketing and advertising costs, third-party logistics costs, facility costs for our fulfillment centers and offices, professional service fees, information technology costs and depreciation and amortization expense. We expect our selling, general and administrative expenses to increase in absolute dollars and to fluctuate as a percentage of revenue due to the anticipated growth of our business, increased marketing investments and additional costs associated with being a public company. Our classification of selling, general and administrative expenses may vary from other companies in our industry and may not be comparable. Remeasurement of Preferred Stock Warrant Liability We estimate the fair value of the preferred stock warrant liability at the end of each reporting period and recognize changes in the fair value through our statement of operations. In connection with our IPO, all warrants were automatically exercised for no consideration, therefore we do not expect to have preferred stock warrant liability in future periods. Provision for Income Taxes Our provision for income taxes consists of an estimate of federal and state income taxes based on enacted federal and state tax rates, as adjusted for allowable credits, deductions and uncertain tax positions. Results of Operations Comparison of the Fiscal Years Ended July 28, 2018, July 29, 2017 and July 30, 2016 The following table sets forth our results of operations for the periods indicated: * Not meaningful The following table sets forth the components of our results of operations as a percentage of revenue: Revenue and Gross Margin Revenue in the fiscal year ended July 28, 2018, increased by $249.4 million, or 25.5%, from revenue in the fiscal year ended July 29, 2017. The increase in revenue was primarily attributable to a 25.0% increase in active clients from July 29, 2017, to July 28, 2018, which drove increased sales of merchandise. Gross margin for the fiscal year ended July 28, 2018, decreased by 0.8% compared with the fiscal year ended July 29, 2017. The decrease was primarily attributable to an increase in inventory shrink, shipping expense and expansion into new categories, partially offset by a decrease in inventory obsolescence reserves due to improved inventory management. Revenue in the fiscal year ended July 29, 2017, increased by $246.8 million, or 33.8%, from revenue in the fiscal year ended July 30, 2016. The increase in revenue was primarily attributable to a 31.1% increase in active clients, which drove increased sales of merchandise. Gross margin increased by 0.2% in the fiscal year ended July 29, 2017, from 44.3% in fiscal year ended July 30, 2016. The increase was primarily attributable to improved inventory management. Selling, General and Administrative Expenses Selling, general and administrative expenses increased by $90.2 million, or 22.4%, during the fiscal year ended July 28, 2018, compared with the fiscal year ended July 29, 2017. The increase was primarily related to higher compensation and benefits expense and stock-based compensation expense due to increased headcount as we continue to invest in technology talent and higher advertising spend as we expanded our advertising initiatives, partially offset by improvements in variable labor. Selling, general and administrative expenses in the fiscal year ended July 29, 2017, increased by $143.8 million, or 55.5%, from the fiscal year ended July 30, 2016. The increase in selling, general and administrative expenses was primarily attributable to an increase in compensation and benefits expenses as we increased our headcount, including a $16.5 million increase related to compensation expense recognized for certain stock sales by current and former employees. In addition, the increase was driven by higher marketing spend as we expanded our television, online and radio advertising initiatives. Remeasurement of Preferred Stock Warrant Liability The change in the preferred stock warrant liability was due to a change in the underlying fair value of our preferred stock until the conversion of our preferred stock warrants into Class B common stock as part of our IPO. Provision for Income Taxes The following table summarizes our effective tax rate from income for the periods presented: We are subject to income taxes in the United States. Our effective tax rate and provision for income taxes decreased from the fiscal year ended July 29, 2017, to the fiscal year ended July 28, 2018, primarily due to stock-based compensation deductions, analysis of our 2016 through 2018 qualified activities for U.S. and California research and development tax credits, and a decrease in the nondeductible remeasurement of the preferred stock warrant liability. These tax benefits were partially offset by tax charges for the remeasurement of our net deferred tax assets associated with the enactment of the Tax Act, which reduced the corporate tax rate from 35% to 21%. Our effective tax rate and provision for income taxes increased from the fiscal year ended July 30, 2016, to fiscal year ended July 29, 2017, primarily due to an increase in the nondeductible remeasurement of the preferred stock warrant liability. Quarterly Results of Operations The following tables set forth our unaudited quarterly consolidated statements of operations for each of the quarters indicated. The information for each quarter has been prepared on a basis consistent with our audited consolidated financial statements included in this Annual Report and reflect, in the opinion of management, all adjustments of a normal, recurring nature that are necessary for a fair presentation of the financial information contained in those statements. Our historical results are not necessarily indicative of the results that may be expected for the full year or any other period in the future. The following quarterly financial information should be read in conjunction with our audited consolidated financial statements and related notes included in this Annual Report. The following table provides a reconciliation of net income (loss) to adjusted EBITDA: The following table provides a reconciliation of net income (loss) to non-GAAP net income (loss): (1) The U.S. government enacted comprehensive tax legislation in December 2017. This resulted in a net charge of $4.7 million for the three months ended January 27, 2018 and a net benefit of $0.5 million for the three months ended July 28, 2018, due to the remeasurement of our net deferred tax assets for the reduction in tax rate from 35% to 21%. The adjustment to non-GAAP net income only includes this transitional impact. It does not include the ongoing impacts of the lower U.S. statutory rate on current year earnings. The following table provides a reconciliation of earnings per share - diluted to non-GAAP earnings per share - diluted: (1) For fiscal 2018, the preferred stock warrant liability was dilutive and included in earnings per share attributable to common stockholders - diluted. Therefore, it is not an adjustment to arrive at non-GAAP EPS - diluted. (2) The U.S. government enacted comprehensive tax legislation in December 2017. This resulted in a net charge of $4.7 million for the three months ended January 27, 2018 and a net benefit of $0.5 million for the three months ended July 28, 2018, due to the remeasurement of our net deferred tax assets for the reduction in tax rate from 35% to 21%. The adjustment to non-GAAP net income only includes this transitional impact. It does not include the ongoing impacts of the lower U.S. statutory rate on current year earnings. The following table sets forth components of results of operations as a percentage of revenue: Our quarterly revenue increased for all periods presented primarily due to increases in active clients. Our growth rate fluctuated from quarter to quarter and we expect that it will continue to do so because of a variety of factors, including the success of our marketing initiatives, our ability to match merchandise to client demand, the launch of new categories and product types, seasonality and economic cycles that influence retail apparel purchase trends. Seasonality in our business does not follow that of traditional retailers, such as typical concentration of revenue in the holiday quarter. For example, in the three months ended January 27, 2018, we experienced a lower quarter over quarter growth rate due to slower active client growth during the holiday season. Additionally, while we expect our revenue base to continue to expand, our revenue may increase at a lower rate as compared to our prior periods. Our quarterly gross profit increased for all periods presented, except for the three months ended January 27, 2018, April 29, 2017, and January 28, 2017. Our gross profit decreased in the three months ended January 27, 2018, as compared to the three months ended October 28, 2017, due to higher than expected clearance on fall goods following an extended summer season. Our gross profit decreased in the three months ended April 29, 2017, as compared to the three months ended January 28, 2017, primarily due to an increase in the inventory provision as a result of a higher balance of inventory. Our gross profit decreased in the three months ended January 28, 2017, as compared to the three months ended October 29, 2016, due to slower revenue growth over the holidays and increased inventory write-offs. Our selling, general and administrative expenses increased for all periods presented, except for the three months ended January 27, 2018, and April 29, 2017, primarily due to increased compensation and benefits as a result of growth in headcount and higher marketing expenses as we continued to grow our business. In addition, our selling, general and administrative expenses in the three months ended January 28, 2017, was impacted by a compensation expense of $21.3 million, related to certain stock sales by current and former employees, which were discrete transactions and consequently led to a decrease in selling, general and administrative expenses from the three months ended January 28, 2017, to the three months ended April 29, 2017. Excluding this discrete transaction, our selling, general and administrative expenses increased significantly in the three months ended April 29, 2017, due to increased marketing expenses as we expanded our television, online and radio advertising initiatives. The decrease in selling, general and administrative expenses from the three months ended October 28, 2017, to the three months ended January 27, 2018, was primarily related to an increase in advertising spend due to certain marketing initiatives during the three months ended October 28, 2017, that did not reoccur the following quarter. We had net income for all periods presented except for the three months ended July 29, 2017 and April 29, 2017. Our net loss in the three months ended July 29, 2017 and April 29, 2017, was driven by the $3.4 million and $12.9 million expense, respectively, related to the remeasurement of the preferred stock warrant liability due to increases in the underlying fair value of our preferred stock. In addition, our net income for the three months ended January 28, 2017, was impacted by the discrete transaction mentioned above. We had positive adjusted EBITDA for all periods presented. We had positive non-GAAP net income for all periods presented except for the three months ended July 29, 2017. The decline in the three months ended April 29, 2017, and July 29, 2017, for both adjusted EBITDA and non-GAAP net income (loss) was primarily due to increased headcount and increased marketing expenses as we expanded our television, online and radio advertising initiatives. Liquidity and Capital Resources Sources of Liquidity Our principal sources of liquidity since inception have been our cash flows from operations, as well as the net proceeds we received through private sales of equity securities and our IPO. We have had positive and growing cash flows from operations since 2014. As of July 28, 2018, we had raised an aggregate of $169.6 million of equity capital including proceeds from our IPO. We had $297.5 million of cash and $12.9 million of restricted cash as of July 28, 2018. Our primary use of cash includes operating costs such as merchandise purchases, compensation and benefits, marketing and other expenditures necessary to support our business growth. We have been able to fund these costs through our cash flows from operations since 2014 and expect to continue to do so. We believe our existing cash balances and cash flows from operations will be sufficient to meet our working capital and capital expenditure needs for at least the next 12 months. Cash Flows The following table summarizes our cash flows for the periods indicated and our cash and working capital balances as of the end of the period (in thousands): Cash provided by operating activities During the fiscal year ended July 28, 2018, cash provided by operating activities was $72.2 million, which consisted of net income of $44.9 million, adjusted by non-cash charges of $23.9 million and a change of $3.4 million in our net operating assets and liabilities. The non-cash charges were largely driven by $15.4 million of stock-based compensation expense, $10.5 million of depreciation and amortization and a $6.6 million increase in deferred tax expense primarily related to a remeasurement of our net deferred tax assets under the Tax Act, partially offset by $10.7 million related to the remeasurement of the preferred stock warrant liability. The change in our net operating assets and liabilities was primarily due to an increase of $35.5 million in accounts payable related to the increased business activity, substantially offset by an increase of $19.4 million in our inventory balance due to increased inventory purchases to support our growth. During the fiscal year ended July 29, 2017, cash provided by operating activities was $38.6 million, which was primarily due to net loss of $0.6 million and non-cash expenses of $36.6 million. The non-cash expenses were largely driven by $18.9 million in expenses related to the remeasurement of the preferred stock warrant liability, a $13.2 million non-cash compensation expense related to stock-based compensation and certain stock sales by the then-current and former employees, $7.7 million of depreciation and amortization and a $3.6 million increase in our inventory reserve, partially offset by a $6.7 million increase in our deferred tax asset. During the fiscal year ended July 30, 2016, cash provided by operating activities was $45.1 million, which was primarily due to net income of $33.2 million and non-cash expenses of $13.2 million. The non-cash expenses were largely driven by a $4.8 million non-cash compensation expense related to a stock sale by an employee, a $5.9 million increase in our inventory reserve and $3.5 million of depreciation and amortization, partially offset by a $5.9 million increase in our deferred tax asset. Cash used in investing activities During the fiscal year ended July 28, 2018, cash used in investing activities was $16.6 million, due to the purchase of property and equipment primarily related to the expansion of our fulfillment centers and offices as well as continued investment in our proprietary systems. During the fiscal year ended July 29, 2017 and July 30, 2016, cash used in investing activities was $17.1 million and $15.2 million, respectively, due to the purchase of property and equipment primarily related to the expansion of our fulfillment centers and offices. Cash (used in) provided by financing activities During the fiscal year ended July 28, 2018, cash provided by financing activities was $134.8 million, which was primarily due to the net proceeds from our IPO. During the fiscal year ended July 29, 2017, cash used in financing activities was $3.0 million, which was primarily due to $3.6 million for the repurchase of our common stock in a tender offer and $1.9 million in deferred payments for offering costs, partially offset by $2.3 million in proceeds from the issuance of common stock upon exercise of stock options. During fiscal year ended July 30, 2016, cash provided by financing activities was $0.5 million, which was primarily due to proceeds from the exercise of stock options. Contractual Obligations and Other Commitments The following table summarizes our contractual obligations as of July 28, 2018: (1) Represents estimated open purchase orders to purchase inventory in the normal course of business. (2) Due to the uncertainty with respect to the timing of future cash flows associated with our $5.5 million of unrecognized tax benefits at July 28, 2018, we are unable to make reasonably reliable estimates of the period of cash settlement with the respective taxing authorities. Therefore, the related balances have not been included in the table above. Off-Balance Sheet Arrangements We have not entered any off-balance sheet arrangements and do not have any holdings in variable interest entities. Critical Accounting Policies and Estimates Our consolidated financial statements are prepared in accordance with GAAP. The preparation of our financial statements requires us to make assumptions and estimates about future events and apply judgments that affect the reported amounts of assets, liabilities, revenues and expenses and the related disclosures. We base our estimates on historical experience and other assumptions that we believe to be reasonable under the circumstances. Actual results may differ from these estimates. The critical accounting policies, estimates and judgments that we believe to have the most significant impacts to our consolidated financial statements are described below. Inventory Inventory consists of finished goods, which are recorded at the lower of cost or net realizable value using the specific identification method. We establish a reserve for excess and slow-moving inventory we expect to write off based on historical trends. In addition, we estimate and accrue shrinkage and damage as a percentage of revenue based on historical trends. Inventory shrinkage and damage estimates are made to reduce the inventory value for lost, stolen or damaged items. If actual experience differs significantly from our estimates, our operating results could be adversely affected. Stock-Based Compensation We grant stock options to our employees, consultants and members of our board of directors and recognize stock-based compensation expense based on the fair value of stock options at grant date. We estimate the fair value of stock options using the Black-Scholes option-pricing model. This model requires us to use certain estimates and assumptions such as: • Fair value of our common stock-estimated using the methodology as discussed below in Common Stock Valuation; • Expected volatility of our common stock-based on the volatility of comparable publicly traded companies; • Expected term of our stock options-as we do not have sufficient historical experience for determining the expected term of the stock option awards granted, we base our expected term on the simplified method, generally calculated as the mid-point between the vesting date and the end of the contractual term; • Expected dividend yield-as we have not paid and do not anticipate paying dividends on our common stock, our expected dividend yield is 0%; and • Risk-free interest rates-based on the U.S. Treasury zero coupon notes in effect at the grant date with maturities equal to the expected terms of the options granted. If any of the assumptions used in the Black-Scholes option-pricing model changes significantly, stock-based compensation for future awards may differ materially compared with the awards granted previously. We record stock-based compensation expense net of estimated forfeitures so that expense is recorded for only those stock options that we expect to vest. We estimate forfeitures based on our historical forfeiture of stock options adjusted to reflect future changes in facts and circumstances, if any. We will revise our estimated forfeiture rate if actual forfeitures differ from our initial estimates. We have granted certain option awards that contain both service and performance conditions. The service condition for such awards is satisfied ratably over the 24-month period following the fourth anniversary of the grant date. The performance condition for such awards was satisfied if we consummated an IPO, within 12 months of the grant date. Expense related to awards which contain both service and performance conditions is recognized using the accelerated attribution method. Since an IPO is not deemed probable until such event occurs, no compensation cost related to the performance condition was recognized prior to the consummation of our IPO in November 2017. Subsequently, we recorded stock-based compensation expense of $0.5 million related to periods prior to the IPO. Common Stock Valuations Prior to our IPO in November 2017, the valuation of our common stock was determined based on the guidelines outlined in the American Institute of Certified Public Accountants Accounting & Valuation Guide, Valuation of Privately-Held-Company Equity Securities Issued as Compensation. We considered objective and subjective factors to determine our best estimate of the fair value of our common stock including the following factors: • contemporaneous valuations of our common stock by an independent valuation specialist; • the prices, rights, preferences and privileges of our convertible preferred stock relative to the common stock; • the prices of our common stock in sale transactions; • our operating and financial performance and projections; • the likelihood of achieving a liquidity event, such as an IPO given internal company and external market condition; • the lack of marketability of our common stock; • the market multiples of comparable publicly traded companies; and • macroeconomic conditions and outlook. In 2016 and through the three months ended October 29, 2016, the equity value of our business was determined using the market approach. The market approach estimates the fair value of a company by applying market multiples of comparable publicly traded companies in the same industry or similar lines of business. The selection of our comparable industry peer companies requires us to make significant judgments as to the comparability of these companies to us. We considered several factors including business description, business size, market share, revenue model, development stage and historical operating results. The equity value was then allocated to the common stock using the Option Pricing Method, or OPM. The OPM treats common shares and preferred shares as call options on the total equity value of a company, with exercise prices based on the value thresholds at which the allocation among the various holders of a company’s securities changes. Under this method, the common shares have value only if the funds available for distribution to stockholders exceed the value of the preferred shares liquidation preferences at the time of the liquidity event, such as a strategic sale or a merger. Starting in the three months ended January 28, 2017, we began using a hybrid method, which is an application of the Probability Weighted Expected Return Method, or PWERM, in which at least one of the scenarios includes an OPM analysis. In our application of the hybrid method a discrete IPO scenario was weighted with an OPM analysis (intended to represent exit scenarios other than the defined IPO scenario). For the IPO scenario, our enterprise value was estimated using a market approach. The market approach estimated the fair value of our company by applying market multiples derived from companies that recently completed IPO transactions. We then applied an appropriate weighting to the results of each scenario to determine the per share fair value of our common stock. The determination of the weighting requires significant judgment including our overall expectations for a possible IPO. Subsequent to the completion of our IPO in November 2017, the fair value of our common stock is based on observable market prices. Remeasurement of Preferred Stock Warrant Liability Our preferred stock warrants are classified as liabilities and recorded at fair value at the end of each reporting period with the change in fair value recorded in the statements of operations. We estimate the fair value of our preferred stock using a methodology and assumptions that are consistent with those used in estimating the fair value of our common stock discussed above. We continued to remeasure these warrants until they were exercised for no consideration in connection with our IPO. Income Taxes We are subject to income taxes in the United States. We compute our provision for income taxes using the asset and liability method, under which deferred tax assets and liabilities are recognized for the expected future tax consequences of temporary differences between the financial reporting and tax bases of assets and liabilities and for tax credit carryforwards. Deferred tax assets and liabilities are measured using the currently enacted tax rates that are expected to apply to taxable income for the years in which those tax assets and liabilities are expected to be realized or settled. Significant judgment is required in determining our uncertain tax positions. We continuously review issues raised in connection with all ongoing examinations and open tax years to evaluate the adequacy of our tax liabilities. We evaluate uncertain tax positions under a two-step approach. The first step is to evaluate the uncertain tax position for recognition by determining if the weight of available evidence indicates that it is more likely than not that the position will be sustained upon examination based on its technical merits. The second step is, for those positions that meet the recognition criteria, to measure the tax benefit as the largest amount that is more than 50% likely of being realized. We believe our recorded tax liabilities are adequate to cover all open tax years based on our assessment. This assessment relies on estimates and assumptions and involves significant judgments about future events. To the extent that our view as to the outcome of these matters changes, we will adjust income tax expense in the period in which such determination is made. We classify interest and penalties related to income taxes as income tax expense. Revenue Recognition While our revenue recognition does not involve significant judgment, it represents an important accounting policy. Revenue is recognized net of sales taxes, discounts and estimated refunds. We generate revenue when clients purchase merchandise, at which point we apply the nonrefundable upfront styling fee against the price of merchandise purchased. If none of the items within the Fix are purchased, we recognize the nonrefundable upfront styling fee as revenue at that time. For Style Pass clients, we recognize revenue at the earlier of the time the annual Style Pass fee is applied against the price of merchandise purchased or the expiry of the annual period. If a client exchanges an item, we recognize revenue at the time the client receives the new item. Sales tax collected from clients is not considered revenue and is included in accrued liabilities until remitted to the taxing authorities. Discounts are recorded as a reduction to revenue when merchandise is purchased. We record a refund reserve based on our historical refund patterns. We sell gift cards to clients and establish a liability based on the face value of such gift cards. The liability is relieved and we recognize revenue upon redemption by our clients. For unredeemed gift cards, we will recognize revenue when the likelihood of gift card redemption becomes remote. To date, we have not recognized any revenue related to unredeemed gift cards as we are unable to determine whether the possibility of redemption has become remote. Recent Accounting Pronouncements For recent accounting pronouncements, please see "Significant Accounting Policies" in Note 2 of the Notes to Consolidated Financial Statements included in this Annual Report.

<s>[INST] In addition, this discussion contains forwardlooking statements that reflect our plans, estimates and beliefs, and involve risks and uncertainties. Our actual results and the timing of certain events could differ materially from those anticipated in or implied by these forwardlooking statements as a result of several factors, including those discussed in the section titled “Risk Factors” included under Part I, Item 1A and elsewhere in this Annual Report. See “Special Note Regarding ForwardLooking Statements” in this Annual Report. Overview Stitch Fix is transforming the way people find what they love, one client at a time and one Fix at a time. We are reinventing the shopping experience by delivering onetoone personalization to our clients through the combination of data science and human judgment. This combination drives a better client experience and a more powerful business model than either element could deliver independently. Our stylists hand select items from a broad range of merchandise. Stylists pair their own judgment with our analysis of client and merchandise data to provide a personalized shipment of apparel, shoes and accessories suited to each client’s needs. We call each of these unique shipments a Fix. Our clients may choose to schedule automatic shipments that arrive every two to three weeks or on a monthly, bimonthly or quarterly cadence, or schedule a Fix on demand. Clients can increase or decrease their desired Fix frequency at any time, and can select the exact date by which they want to receive a Fix. After receiving a Fix, our clients purchase the items they want to keep and return the other items. Historically, we have charged clients a $20 styling fee that is credited towards the merchandise purchased. If the client chooses to keep all items in a Fix, she receives a 25% discount on her entire purchase. We also provide select clients with an alternative to paying a $20 styling fee per Fix, known as Style Pass. Style Pass clients pay a $49 annual fee for unlimited styling that is credited towards merchandise purchases. In February 2018, we launched Extras, a new feature that allows clients to select items such as socks, bras, underwear and other intimates that are then added to the five items their stylist selects for their Fix. In July 2018, we launched Stitch Fix Kids in time for backtoschool season. In addition, in October 2018, we announced our plan to launch in the United Kingdom, or UK. The very human experience that we deliver is powered by data science. Our data science capabilities consist of our rich data set and our proprietary algorithms, which fuel our business by enhancing the client experience and driving business model efficiencies. The vast majority of our client data is provided directly and explicitly by our clients, rather than inferred, scraped or obtained from other sources. We also gather extensive merchandise data, such as inseam, pocket shape, silhouette and fit. This large and growing data set provides the foundation for proprietary algorithms that we use throughout our business, including those that predict purchase behavior, forecast demand, optimize inventory and enable us to design new apparel. We believe our data science capabilities give us a significant competitive advantage, and as our data set grows, our algorithms become more powerful. Our stylists leverage our data science through a custombuilt, webbased styling application that provides recommendations from our broad selection of merchandise. Our stylists then apply their judgment to select what they believe to be the best items for each Fix. Our stylists provide a personal touch, offer styling advice and context to each item selected, and help us develop longterm relationships with our clients. Our stylists are U.S.based employees, most of whom work parttime and remotely. We maintain a broad range of product offerings to serve our clients. We offer both merchandise sourced from brand partners and our own Exclusive Brands. We use our data to inform the merchandise we buy and develop to best suit our clients. We reach clients through a combination of word of mouth, referrals, advertising and other marketing efforts. We invest in marketing with the goal of attracting new clients, improving engagement with current clients and expanding our client closet share over time. As we continue to expand our marketing efforts, we plan to remain disciplined in measuring the return on advertising spend. We believe our success in serving clients has resulted in our rapid and profitable growth. We have achieved positive cash flows from [/INST] Negative. </s>

Stitch Fix, Inc.

2019-10-02

2019-08-03

Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations. You should read the following discussion and analysis of our financial condition and results of operations together with our audited consolidated financial statements and related notes thereto included in Part II, Item 8 of this Annual Report on Form 10-K, or Annual Report. We use a 52- or 53-week fiscal year, with our fiscal year ending on the Saturday that is closest to July 31 of that year. Each fiscal year generally consists of four 13-week fiscal quarters, with each fiscal quarter ending on the Saturday that is closest to the last day of the last month of the quarter. The fiscal year ended August 3, 2019, included 53 weeks of operations. The fiscal years ended July 28, 2018, and July 29, 2017, included 52 weeks of operations. Throughout this Annual Report, all references to quarters and years are to our fiscal quarters and fiscal years unless otherwise noted. In addition, this discussion contains forward-looking statements that reflect our plans, estimates, and beliefs, and involve risks and uncertainties. Our actual results and the timing of certain events could differ materially from those anticipated in or implied by these forward-looking statements as a result of several factors, including those discussed in the section titled “Risk Factors” included under Part I, Item 1A and elsewhere in this Annual Report. See “Special Note Regarding Forward-Looking Statements” in this Annual Report. A discussion regarding our financial condition and results of operation for the fiscal year ended August 3, 2019, compared to the fiscal year ended July 28, 2018, is presented below. A discussion regarding our financial condition and results of operations for fiscal year ended July 28, 2018, compared to the fiscal year ended July 29, 2017, can be found under Item 7 in our Annual Report on Form 10-K for the fiscal year ended July 28, 2018, filed with the SEC on October 3, 2018, which is available on the SEC’s website at www.sec.gov and on the SEC Filings section of the Investor Relations section of our website at: https://investors.stitchfix.com. Overview Since our founding in 2011, we have helped millions of men, women, and kids discover and buy what they love through personalized shipments of apparel, shoes, and accessories, hand-selected by Stitch Fix stylists and delivered to our clients’ homes. We call each of these shipments a Fix. Clients can choose to schedule automatic shipments or order a Fix on demand after they fill out a style profile on our website or mobile app. For each Fix, we charge clients a styling fee that is credited toward items they purchase. Alternatively, select U.S. clients may purchase an annual Style Pass, which offers unlimited styling for the year for a $49 fee that is also credited towards items they purchase. After receiving a Fix, our clients purchase the items they want to keep and return the other items, if any, at no additional charge. In addition, our Extras feature allows clients to select items such as socks, bras, underwear, and other intimates that are then added to the items their stylist selects for their Fix. In May 2019, we launched our service in the UK. In June 2019, we launched direct-buy functionality to allow clients the flexibility of purchasing items outside of a Fix. The first offering of this direct-buy functionality is Shop New Colors, which is available for Men’s and Women’s clients in the United States and allows clients to order previously purchased items in different colors, sizes, or prints. No styling fee is charged for direct purchases. We believe our success in serving clients has resulted in our rapid and profitable growth. We have achieved positive cash flows from operations on an annual basis since 2014, while continuing to make meaningful investments to drive growth. For the fiscal year ended August 3, 2019, we reported $1.6 billion of revenue representing year-over-year growth of 28.6% from the fiscal year ended July 28, 2018. As of August 3, 2019, and July 28, 2018, we had active clients of 3,236,000 and 2,742,000, respectively, representing year-over-year growth of 18.0%. Net income for the fiscal year ended August 3, 2019, was $36.9 million, a decrease of $8.0 million from the fiscal year ended July 28, 2018. Included in net income for the fiscal year ended July 28, 2018, was a $10.7 million gain on remeasurement of our preferred stock warrant liability prior to our initial public offering, or IPO, and a $6.7 million remeasurement expense on our net deferred tax assets related to the Tax Cuts and Jobs Act (the “Tax Act”) which was enacted on December 22, 2017. Key Metrics We report our financial results in accordance with generally accepted accounting principles in the United States (“GAAP”). However, management believes that certain non-GAAP financial measures provide users of our financial information with additional useful information in evaluating our performance. Management believes that excluding certain items that may vary substantially in frequency and magnitude period-to-period from net income (loss) and earnings (loss) per share (“EPS”), provides useful supplemental measures that assist in evaluating our ability to generate earnings and to more readily compare these metrics between past and future periods. Management also believes that adjusted EBITDA is frequently used by investors and securities analysts in their evaluations of companies, and that this supplemental measure facilitates comparisons between companies. We believe free cash flow is an important metric because it represents a measure of how much cash from operations we have available for discretionary and non-discretionary items after the deduction of capital expenditures. These non-GAAP financial measures may be different than similarly titled measures used by other companies. Our non-GAAP financial measures should not be considered in isolation from, or as substitutes for, financial information prepared in accordance with GAAP. There are several limitations related to the use of our non-GAAP financial measures as compared to the closest comparable GAAP measures. Some of these limitations include: • our non-GAAP net income, adjusted EBITDA, and non-GAAP EPS attributable to common stockholders - diluted measures exclude compensation expense that we recognized related to certain stock sales by current and former employees; • our non-GAAP net income and non-GAAP EPS attributable to common stockholders - diluted measures exclude the impact of the remeasurement of our net deferred tax assets following the adoption of the Tax Act; • our non-GAAP net income, adjusted EBITDA, and non-GAAP EPS attributable to common stockholders - diluted measures exclude the remeasurement of the preferred stock warrant liability, which is a non-cash expense incurred in the periods prior to the completion of our IPO; • adjusted EBITDA also excludes the recurring, non-cash expenses of depreciation and amortization of property and equipment and, although these are non-cash expenses, the assets being depreciated and amortized may have to be replaced in the future; • adjusted EBITDA does not reflect our tax provision, which reduces cash available to us; • adjusted EBITDA excludes interest income and other income, net, as these items are not components of our core business; and • free cash flow does not represent the total residual cash flow available for discretionary purposes and does not reflect our future contractual commitments. Adjusted EBITDA We define adjusted EBITDA as net income (loss) excluding interest income, other (income), net, provision for income taxes, depreciation and amortization, and, when present, the remeasurement of preferred stock warrant liability and compensation expense related to certain stock sales by current and former employees. The following table presents a reconciliation of net income (loss), the most comparable GAAP financial measure, to adjusted EBITDA for each of the periods presented: Non-GAAP Net Income We define non-GAAP net income as net income (loss) excluding, when present, the remeasurement of preferred stock warrant liability, compensation expense related to certain stock sales by current and former employees, and the related tax impact of those items, as well as the remeasurement of our net deferred tax assets in relation to the adoption of the Tax Act. The following table presents a reconciliation of net income (loss), the most comparable GAAP financial measure, to non-GAAP net income for each of the periods presented: (1) The U.S. government enacted comprehensive tax legislation in December 2017. This resulted in a net charge of $4.2 million for the fiscal year ended July 28, 2018, due to the remeasurement of our net deferred tax assets for the reduction in tax rate from 35% to 21%. The adjustment to non-GAAP net income only includes this transitional impact. It does not include the ongoing impacts of the lower U.S. statutory rate on current year earnings. Non-GAAP Earnings Per Share Attributable to Common Stockholders - Diluted We define non-GAAP EPS attributable to common stockholders - diluted as diluted EPS attributable to common stockholders excluding, when present, the per share impact of the remeasurement of preferred stock warrant liability, compensation expense related to certain stock sales by current and former employees, and the related tax impact of those items, as well as the per share impact of the remeasurement of our net deferred tax assets in relation to the adoption of the Tax Act. The following table presents a reconciliation of EPS attributable to common stockholders - diluted, the most comparable GAAP financial measure, to non-GAAP EPS attributable to common stockholders - diluted for each of the periods presented: (1) For the fiscal year ended July 28, 2018, the preferred stock warrant liability was dilutive and included in EPS attributable to common stockholders - diluted. Therefore, it is not an adjustment to arrive at non-GAAP EPS attributable to common stockholders - diluted. (2) The U.S. government enacted comprehensive tax legislation in December 2017. This resulted in a net charge of $4.2 million for the fiscal year ended July 28, 2018, due to the remeasurement of our net deferred tax assets for the reduction in tax rate from 35% to 21%. The adjustment to non-GAAP EPS attributable to common stockholders - diluted only includes this transitional impact. It does not include the ongoing impacts of the lower U.S. statutory rate on current year earnings. Free Cash Flow We define free cash flow as cash flows provided by operating activities reduced by purchases of property and equipment that are included in cash flows used in investing activities. The following table presents a reconciliation of cash flows provided by operating activities, the most comparable GAAP financial measure, to free cash flow for each of the periods presented: Active Clients We believe that the number of active clients is a key indicator of our growth and the overall health of our business. We define an active client as a client who checked out a Fix or was shipped an item using our new direct-buy functionality in the preceding 12-month period (52 weeks), measured as of the last day of that period. A client checks out a Fix when she indicates what items she is keeping through our mobile application or on our website. We consider each Men’s, Women’s, or Kids account as a client, even if they share the same household. We had 3,236,000 and 2,742,000 active clients as of August 3, 2019, and July 28, 2018, respectively, representing year-over-year growth of 18.0%. Factors Affecting Our Performance Client Acquisition and Engagement To grow our business, we must continue to acquire clients and successfully engage them. We believe that implementing broad-based marketing strategies that increase our brand awareness has the potential to strengthen Stitch Fix as a prominent consumer brand, help us acquire new clients and drive revenue growth. As our business has achieved a greater scale and we are able to support a large and growing client base, we have increased our investments in marketing to take advantage of more marketing channels to efficiently acquire clients. For example, we continue to increase our advertising spend, from $102.1 million for the fiscal year ended July 28, 2018, to $152.1 million for the fiscal year ended August 3, 2019, to support the growth of our business. We expect to continue to make significant marketing investments to grow our business, such as our integrated brand campaign launched in February 2019. We currently utilize both digital and offline channels to attract new visitors to our website or mobile app and subsequently convert them into clients. Our current marketing efforts include client referrals, affiliate programs, partnerships, display advertising, television, print, radio, video, content, direct mail, social media, email, mobile “push” communications, search engine optimization, and keyword search campaigns. To successfully acquire clients and increase engagement, we must also continue to improve the diversity of our offering. These efforts may include broadening our brand partnerships and expanding into new categories, product types, price points, and geographies. For example, in July 2018 we launched Stitch Fix Kids, expanding our client and vendor base, and in May 2019 we launched our service in the UK, expanding our geographic scope. Investment in our Operations and Infrastructure To grow our client base and enhance our offering, we will incur additional expenses. We intend to leverage our data science and deep understanding of our clients’ needs to inform investments in operations and infrastructure. We anticipate that our expenses will increase as we continue to hire additional personnel and further advance our technological and data science capabilities. Moreover, we intend to make capital investments in our inventory, fulfillment centers and office space, and logistics infrastructure as we launch new categories, expand internationally, and drive operating efficiencies. We expect to increase our spending on these investments in the future and cannot be certain that these efforts will grow our client base or be cost-effective. However, we believe these strategies will yield positive returns in the long term. Inventory Management We leverage our data science to buy and manage our inventory, including merchandise assortment and fulfillment center optimization. To ensure sufficient availability of merchandise, we generally enter into purchase orders well in advance and frequently before apparel trends are confirmed by client purchases. As a result, we are vulnerable to demand and pricing shifts and availability of merchandise at time of purchase. We incur inventory write-offs and changes in inventory reserves that impact our gross margins. Because our merchandise assortment directly correlates to client success, we may at times optimize our inventory to prioritize long-term client success over short-term gross margin impact. Moreover, our inventory investments will fluctuate with the needs of our business. For example, entering new locations such as the UK, launching new categories such as Stitch Fix Kids, introducing direct-buy offerings such as Shop New Colors, or adding new fulfillment centers will all require additional investments in inventory. Merchandise Mix We offer apparel, shoes, and accessories across categories, brands, product types, and price points. We currently serve our clients in the following categories: Women’s, Petite, Maternity, Men’s, Plus, and Kids. We carry a mix of third-party branded merchandise, including premium brands, and our own Exclusive Brands. We also offer a wide variety of product types, including denim, dresses, blouses, skirts, shoes, jewelry, and handbags. We sell merchandise across a broad range of price points and may further broaden our price point offerings in the future. While changes in our merchandise mix have not caused significant fluctuations in our gross margin to date, categories, brands, product types, and price points do have a range of margin profiles. For example, our Exclusive Brands have generally contributed higher margins, shoes have generally contributed lower margins, and newer categories, such as Kids, tend to initially have lower margins. Shifts in merchandise mix driven by client demand may result in fluctuations in our gross margin from period to period. Components of Results of Operations Revenue We generate revenue from the sale of merchandise. We charge a nonrefundable upfront fee, referred to as a “styling fee,” that is credited towards any merchandise purchased in the Fix. We deduct discounts, sales tax, and estimated refunds to arrive at net revenue, which we refer to as revenue throughout the report. We offer Style Pass to provide select U.S. clients with an alternative to paying a styling fee per Fix. Style Pass clients pay a nonrefundable annual fee for unlimited styling that is credited towards merchandise purchases. To a lesser extent, we also recognize revenue resulting from direct purchases and estimated breakage income on gift cards. We expect our revenue to increase in absolute dollars as we grow our business, although our revenue growth rate may slow in future periods. Cost of Goods Sold Cost of goods sold consists of the costs of merchandise, expenses for shipping to and from clients and inbound freight, inventory write-offs and changes in our inventory reserve, payment processing fees, and packaging materials costs. We expect our cost of goods sold to fluctuate as a percentage of revenue primarily due to how we manage our inventory and merchandise mix. Our classification of cost of goods sold may vary from other companies in our industry and may not be comparable. Selling, General, and Administrative Expenses Selling, general, and administrative expenses consist primarily of compensation and benefits costs, including stock-based compensation expense, for our employees including our stylists, fulfillment center operations, data analytics, merchandising, engineering, marketing, client experience, and corporate personnel. Selling, general, and administrative expenses also include marketing and advertising costs, third-party logistics costs, facility costs for our fulfillment centers and offices, professional service fees, information technology costs, and depreciation and amortization expense. We expect our selling, general, and administrative expenses to increase in absolute dollars and to fluctuate as a percentage of revenue due to the anticipated growth of our business, increased marketing investments, and additional costs associated with being a public company. Our classification of selling, general, and administrative expenses may vary from other companies in our industry and may not be comparable. Remeasurement of Preferred Stock Warrant Liability We estimate the fair value of the preferred stock warrant liability at the end of each reporting period and recognize changes in the fair value through our statement of operations. In connection with our IPO, all warrants were automatically exercised for no consideration, therefore we do not expect to have preferred stock warrant liability in future periods. Interest Income Interest income is generated from our cash, cash equivalents, and investments in available-for-sale securities. Provision for Income Taxes Our provision for income taxes consists of an estimate of federal, state, and international income taxes based on enacted federal, state, and international tax rates, as adjusted for allowable credits, deductions, and uncertain tax positions. Results of Operations Comparison of the Fiscal Years Ended August 3, 2019, July 28, 2018, and July 29, 2017 The following table sets forth our results of operations for the periods indicated: (1) Fiscal 2019 was a 53-week year. Fiscal 2018 and 2017 included 52 weeks. * Not meaningful The following table sets forth the components of our results of operations as a percentage of revenue: Revenue and Gross Margin Revenue in the fiscal year ended August 3, 2019, which included a 53rd week, increased by $351.1 million, or 28.6%, from revenue in the fiscal year ended July 28, 2018. The increase in revenue was primarily attributable to a 18.0% increase in active clients from July 28, 2018, to August 3, 2019, which drove increased sales of merchandise, and an increase in revenue per active client. Gross margin for the fiscal year ended August 3, 2019, increased by 0.9% compared with the fiscal year ended July 28, 2018. The increase was primarily attributable to a decrease in clearance expense due to improved inventory management and a reduction in shrink expense. Selling, General, and Administrative Expenses Selling, general, and administrative expenses in the fiscal year ended August 3, 2019, which included a 53rd week, increased by $186.6 million during the fiscal year ended August 3, 2019, compared with the fiscal year ended July 28, 2018. As a percentage of revenue, selling, general, and administrative expenses increased to 43.1% for the fiscal year ended August 3, 2019, compared with 40.2% for the fiscal year ended July 28, 2018. The increase was primarily related to higher compensation and benefits expense and stock-based compensation expense due to increased headcount as we continue to invest in technology talent, higher advertising spend year over year, primarily due to the launch of our integrated brand campaign in February 2019, and investments related to our UK launch. Remeasurement of Preferred Stock Warrant Liability Prior to our IPO, the change in the preferred stock warrant liability was due to a change in the underlying fair value of our preferred stock. In November 2017, in connection with our IPO, the preferred stock warrants were automatically exercised into shares of Class B common stock and the preferred stock warrant liability was reclassified to additional paid-in capital. Provision for Income Taxes The following table summarizes our effective tax rate from income for the periods presented: We are subject to income taxes in the United States and the UK. Our effective tax rate and provision for income taxes decreased from the fiscal year ended July 28, 2018, to the fiscal year ended August 3, 2019, primarily due to increased excess tax benefits from stock-based compensation, additional qualified activities for U.S. and California research and development tax credits, and the prior year Tax Act remeasurement of deferred tax assets that was not in effect for the current year.. Quarterly Results of Operations The following tables set forth our unaudited quarterly consolidated statements of operations for each of the quarters indicated. The information for each quarter has been prepared on a basis consistent with our audited consolidated financial statements included in this Annual Report and reflect, in the opinion of management, all adjustments of a normal, recurring nature that are necessary for a fair presentation of the financial information contained in those statements. Our historical results are not necessarily indicative of the results that may be expected for the full year or any other period in the future. The fiscal year ended August 3, 2019, includes the impact of an additional week compared to the prior fiscal year, which occurred in the fourth quarter of 2019. The following quarterly financial information should be read in conjunction with our audited consolidated financial statements and related notes included in this Annual Report. Liquidity and Capital Resources Sources of Liquidity Our principal sources of liquidity since inception have been our cash flows from operations, as well as the net proceeds we received through private sales of equity securities and our IPO. We have had positive and growing cash flows from operations since 2014. As of August 3, 2019, we had raised an aggregate of $169.6 million of equity capital including proceeds from our IPO. We had $170.9 million of cash and cash equivalents and investments of $196.6 million as of August 3, 2019. Our investment balance includes $143.3 million of short-term investments with contractual maturities of 12 months or less as of August 3, 2019. Our primary use of cash includes operating costs such as merchandise purchases, compensation and benefits, marketing, and other expenditures necessary to support our business growth. We have been able to fund these costs through our cash flows from operations since 2014 and expect to continue to do so. We believe our existing cash balances and cash flows from operations will be sufficient to meet our working capital and capital expenditure needs for at least the next 12 months. Cash Flows The following table summarizes our cash flows for the periods indicated and our cash and working capital balances as of the end of the period (in thousands): Cash provided by operating activities During the fiscal year ended August 3, 2019, cash provided by operating activities was $78.6 million, which consisted of net income of $36.9 million, adjusted by non-cash charges of $49.5 million and a change of $7.8 million in our net operating assets and liabilities. The non-cash charges were largely driven by $35.3 million of stock-based compensation expense and $14.3 million of depreciation, amortization, and accretion, partially offset by a $8.2 million decrease in deferred tax expense. The change in our net operating assets and liabilities was primarily due to an increase of $41.2 million in our inventory balance due to increased inventory purchases to support our growth, substantially offset by an increase of $33.6 million in accrued expenses and account payable related to increased business activity. During the fiscal year ended July 28, 2018, cash provided by operating activities was $72.2 million, which consisted of net income of $44.9 million, adjusted by non-cash charges of $23.9 million and a change of $3.4 million in our net operating assets and liabilities. The non-cash charges were largely driven by $15.4 million of stock-based compensation expense, $10.5 million of depreciation and amortization, and a $6.6 million increase in deferred tax expense primarily related to a remeasurement of our net deferred tax assets under the Tax Act, partially offset by $10.7 million related to the remeasurement of the preferred stock warrant liability. The change in our net operating assets and liabilities was primarily due to an increase of $35.5 million in accounts payable related to the increased business activity, substantially offset by an increase of $19.4 million in our inventory balance due to increased inventory purchases to support our growth. Cash used in investing activities During the fiscal year ended August 3, 2019, cash used in investing activities was $225.2 million, primarily related to our investment of $285.2 million in highly rated available-for-sale securities and $30.8 million in purchases of property and equipment, partially offset by maturities of available-for-sale securities of $80.3 million. During the fiscal year ended July 28, 2018, cash used in investing activities was $16.6 million due to the purchase of property and equipment primarily related to the expansion of our fulfillment centers and offices as well as continued investment in our proprietary systems. Cash provided by financing activities During the fiscal year ended August 3, 2019, cash provided by financing activities was $6.9 million, which was primarily due to proceeds from the exercise of stock options, partially offset by tax withholding related to vesting of restricted stock units. During the fiscal year ended July 28, 2018, cash provided by financing activities was $134.8 million, which was primarily due to the net proceeds from our IPO. Contractual Obligations and Other Commitments The following table summarizes our contractual obligations as of August 3, 2019: (1) Represents estimated open purchase orders to purchase inventory in the normal course of business. (2) Due to the uncertainty with respect to the timing of future cash flows associated with our $11.0 million of unrecognized tax benefits at August 3, 2019, we are unable to make reasonably reliable estimates of the period of cash settlement with the respective taxing authorities. Therefore, the related balances have not been included in the table above. Off-Balance Sheet Arrangements We have not entered into any off-balance sheet arrangements and do not have any holdings in variable interest entities. Critical Accounting Policies and Estimates Our consolidated financial statements are prepared in accordance with GAAP. The preparation of our financial statements requires us to make assumptions and estimates about future events and apply judgments that affect the reported amounts of assets, liabilities, revenues and expenses and the related disclosures. We base our estimates on historical experience and other assumptions that we believe to be reasonable under the circumstances. Actual results may differ from these estimates. The critical accounting policies, estimates, and judgments that we believe to have the most significant impacts to our consolidated financial statements are described below. Inventory Inventory consists of finished goods, which are recorded at the lower of cost or net realizable value using the specific identification method. We establish a reserve for excess and slow-moving inventory we expect to write off based on historical trends. In addition, we estimate and accrue shrinkage as a percentage of inventory out to the client and damaged items at 100% of cost. Inventory shrinkage and damage estimates are made to reduce the inventory value for lost, stolen, or damaged items. If actual experience differs significantly from our estimates, our operating results could be adversely affected. Stock-Based Compensation We grant stock options to our employees, consultants, and members of our board of directors and recognize stock-based compensation expense based on the fair value of stock options at grant date. We estimate the fair value of stock options using the Black-Scholes option-pricing model. This model requires us to use certain estimates and assumptions such as: • Expected volatility of our common stock-based on the volatility of comparable publicly traded companies; • Expected term of our stock options-as we do not have sufficient historical experience for determining the expected term of the stock option awards granted, we base our expected term on the simplified method, generally calculated as the mid-point between the vesting date and the end of the contractual term; • Expected dividend yield-as we have not paid and do not anticipate paying dividends on our common stock, our expected dividend yield is 0%; and • Risk-free interest rates-based on the U.S. Treasury zero coupon notes in effect at the grant date with maturities equal to the expected terms of the options granted. If any of the assumptions used in the Black-Scholes option-pricing model changes significantly, stock-based compensation for future awards may differ materially compared with the awards granted previously. We record stock-based compensation expense net of estimated forfeitures so that expense is recorded for only those stock options that we expect to vest. We estimate forfeitures based on our historical forfeiture of stock options adjusted to reflect future changes in facts and circumstances, if any. We will revise our estimated forfeiture rate if actual forfeitures differ from our initial estimates. We have granted certain option awards that contain both service and performance conditions. The service condition for such awards is satisfied ratably over the 24-month period following the fourth anniversary of the grant date. The performance condition for such awards was satisfied if we consummated an IPO within 12 months of the grant date. Expense related to awards which contain both service and performance conditions is recognized using the accelerated attribution method. Since an IPO is not deemed probable until such event occurs, no compensation cost related to the performance condition was recognized prior to the consummation of our IPO in November 2017. Subsequently, we recorded stock-based compensation expense of $0.5 million related to periods prior to the IPO. Income Taxes We are subject to income taxes in the United States and the UK. We compute our provision for income taxes using the asset and liability method, under which deferred tax assets and liabilities are recognized for the expected future tax consequences of temporary differences between the financial reporting and tax bases of assets and liabilities and for tax credit carryforwards. Deferred tax assets and liabilities are measured using the currently enacted tax rates that are expected to apply to taxable income for the years in which those tax assets and liabilities are expected to be realized or settled. Significant judgment is required in determining our uncertain tax positions. We continuously review issues raised in connection with all ongoing examinations and open tax years to evaluate the adequacy of our tax liabilities. We evaluate uncertain tax positions under a two-step approach. The first step is to evaluate the uncertain tax position for recognition by determining if the weight of available evidence indicates that it is more likely than not that the position will be sustained upon examination based on its technical merits. The second step is, for those positions that meet the recognition criteria, to measure the tax benefit as the largest amount that is more than 50% likely of being realized. We believe our recorded tax liabilities are adequate to cover all open tax years based on our assessment. This assessment relies on estimates and assumptions and involves significant judgments about future events. To the extent that our view as to the outcome of these matters changes, we will adjust income tax expense in the period in which such determination is made. We classify interest and penalties related to income taxes as income tax expense. Revenue Recognition While our revenue recognition does not involve significant judgment, it represents an important accounting policy. Revenue is recognized net of sales taxes, discounts, and estimated refunds. For a Fix, we generate revenue when clients purchase merchandise, at which point we apply the nonrefundable upfront styling fee against the price of merchandise purchased. If none of the items within the Fix are purchased, we recognize the nonrefundable upfront styling fee as revenue at that time. For Style Pass clients, we recognize revenue at the earlier of the time the annual Style Pass fee is applied against the price of merchandise purchased or the expiry of the annual period. For a direct buy, we generate revenue when the item is shipped to the client. If a client would like to exchange an item, we recognize revenue at the time the exchanged item is shipped, which coincides with the transfer of control to the customer. Sales tax collected from clients is not considered revenue and is included in accrued liabilities until remitted to the taxing authorities. Discounts are recorded as a reduction to revenue when merchandise is purchased. We record a refund reserve based on our historical refund patterns. We sell gift cards to clients and establish a liability based on the face value of such gift cards. The liability is relieved and we recognize revenue upon redemption by our clients. If a gift card is not used, we will recognize estimated gift card breakage revenue proportionately to customer usage of gift cards over the expected gift card usage period, subject to requirements to remit balances to governmental agencies. Recent Accounting Pronouncements For recent accounting pronouncements, please see “Significant Accounting Policies” in Note 2 of the Notes to Consolidated Financial Statements included in this Annual Report.

<s>[INST] In addition, this discussion contains forwardlooking statements that reflect our plans, estimates, and beliefs, and involve risks and uncertainties. Our actual results and the timing of certain events could differ materially from those anticipated in or implied by these forwardlooking statements as a result of several factors, including those discussed in the section titled “Risk Factors” included under Part I, Item 1A and elsewhere in this Annual Report. See “Special Note Regarding ForwardLooking Statements” in this Annual Report. A discussion regarding our financial condition and results of operation for the fiscal year ended August 3, 2019, compared to the fiscal year ended July 28, 2018, is presented below. A discussion regarding our financial condition and results of operations for fiscal year ended July 28, 2018, compared to the fiscal year ended July 29, 2017, can be found under Item 7 in our Annual Report on Form 10K for the fiscal year ended July 28, 2018, filed with the SEC on October 3, 2018, which is available on the SEC’s website at www.sec.gov and on the SEC Filings section of the Investor Relations section of our website at: https://investors.stitchfix.com. Overview Since our founding in 2011, we have helped millions of men, women, and kids discover and buy what they love through personalized shipments of apparel, shoes, and accessories, handselected by Stitch Fix stylists and delivered to our clients’ homes. We call each of these shipments a Fix. Clients can choose to schedule automatic shipments or order a Fix on demand after they fill out a style profile on our website or mobile app. For each Fix, we charge clients a styling fee that is credited toward items they purchase. Alternatively, select U.S. clients may purchase an annual Style Pass, which offers unlimited styling for the year for a $49 fee that is also credited towards items they purchase. After receiving a Fix, our clients purchase the items they want to keep and return the other items, if any, at no additional charge. In addition, our Extras feature allows clients to select items such as socks, bras, underwear, and other intimates that are then added to the items their stylist selects for their Fix. In May 2019, we launched our service in the UK. In June 2019, we launched directbuy functionality to allow clients the flexibility of purchasing items outside of a Fix. The first offering of this directbuy functionality is Shop New Colors, which is available for Men’s and Women’s clients in the United States and allows clients to order previously purchased items in different colors, sizes, or prints. No styling fee is charged for direct purchases. We believe our success in serving clients has resulted in our rapid and profitable growth. We have achieved positive cash flows from operations on an annual basis since 2014, while continuing to make meaningful investments to drive growth. For the fiscal year ended August 3, 2019, we reported $1.6 billion of revenue representing yearoveryear growth of 28.6% from the fiscal year ended July 28, 2018. As of August 3, 2019, and July 28, 2018, we had active clients of 3,236,000 and 2,742,000, respectively, representing yearoveryear growth of 18.0%. Net income for the fiscal year ended August 3, 2019, was $36.9 million, a decrease of $8.0 million from the fiscal year ended July 28, 2018. Included in net income for the fiscal year ended July 28, 2018, was a $10.7 million gain on remeasurement of our preferred stock warrant liability prior to our initial public offering, or IPO, and a $6.7 million remeasurement expense on our net deferred tax assets related to the Tax Cuts and Jobs Act (the “Tax Act”) which was enacted on December 22, 2017. Key Metrics We report our financial results in accordance with generally accepted accounting principles in the United States (“GAAP”). However, management [/INST] Negative. </s>

Crinetics Pharmaceuticals, Inc.

2019-03-13

2018-12-31

Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations You should read the following discussion of our financial condition and results of operations in conjunction with the consolidated financial statements and the notes thereto included elsewhere in this Annual Report on Form 10-K. Overview We are a clinical stage pharmaceutical company focused on the discovery, development and commercialization of novel therapeutics for rare endocrine diseases and endocrine-related tumors. Endocrine pathways function to maintain homeostasis and commonly use peptide hormones acting through G-protein-coupled receptors (“GPCRs”) to regulate many aspects of physiology including growth, energy, metabolism, gastrointestinal function and stress responses. We have assembled a seasoned team with extensive expertise in drug discovery and development in endocrine GPCRs and built a highly productive drug discovery organization. We have discovered a pipeline of oral nonpeptide (small molecule) new chemical entities that target peptide GPCRs to treat a variety of rare endocrine diseases where treatment options have significant efficacy, safety and/or tolerability limitations. Our lead product candidate, CRN00808, is currently in clinical development for the treatment of acromegaly, and we are advancing additional product candidates through preclinical studies in parallel. Our vision is to build the leading endocrine company which consistently pioneers new therapeutics to help patients better control their disease and improve their daily lives. We focus on the discovery and development of oral nonpeptide therapeutics that target peptide GPCRs with well understood biological functions, validated biomarkers and the potential to substantially improve the treatment of endocrine diseases and/or endocrine-related tumors. Our pipeline consists of the following three product candidates and discovery program: • CRN00808, our lead product candidate, establishes a new class of oral selective nonpeptide somatostatin receptor 2 (“sst2”) biased agonists designed for the treatment of acromegaly and is the first agent in its class with reported clinical results. In March 2018, we reported initial results from a Phase 1, double-blind, randomized, placebo-controlled, single- and multiple-ascending dose trial to evaluate the safety, pharmacokinetics and pharmacodynamics of CRN00808 in 99 healthy volunteers. CRN00808 demonstrated clinical proof-of-concept by potently suppressing stimulated GH and baseline IGF-1 in these subjects. We submitted an Investigational New Drug (“IND”) application to the U.S. Food and Drug Administration (“FDA”) in August 2018. In late 2018, we initiated two global Phase 2 clinical trials of CRN00808 in acromegaly patients, the ACROBAT EVOLVE (“EVOLVE”) and ACROBAT EDGE (“EDGE”) studies. The EVOLVE trial is a double-blind, placebo-controlled, randomized withdrawal study designed to evaluate the safety, efficacy and pharmacokinetics of CRN00808, in subjects with acromegaly that respond to octreotide LAR or lanreotide depot monotherapy. The EDGE trial is an open label exploratory study designed to evaluate the safety, efficacy and pharmacokinetics of CRN00808 in subjects with acromegaly that are treated with somatostatin analog based treatment regimens but do not respond completely to monotherapy. The EVOLVE and EDGE studies will be conducted at centers in the United States and in certain European countries. • CRN01941 is an oral nonpeptide sst2 biased agonist designed for the treatment of neuroendocrine tumors, that originate from neuroendocrine cells commonly found in the gut, lung or pancreas. CRN01941 is currently in first-in-human enabling studies, and we expect to initiate a Phase 1 human proof-of-concept clinical trial in the first half of 2019. We expect results from this trial in late 2019/early 2020. • We are developing a new class of oral selective nonpeptide somatostatin receptor 5 (“sst5”) agonists designed to treat congenital hyperinsulinism (“CHI”). We conducted first-in-human enabling studies with our first product candidate, CRN02481. Due to a toxicity finding which we believe was specific to CRN02481, we are advancing new molecules through preclinical activities with the goal of selecting a new product candidate for CHI. • We have an ongoing discovery effort to identify and advance into development the first nonpeptide product candidate to antagonize peptide adrenocorticotrophic hormone (ACTH), designed for the treatment of Cushing’s disease. To date, we have devoted substantially all of our resources to drug discovery, conducting preclinical studies and clinical trials, obtaining and maintaining patents related to our product candidates, and the provision of general and administrative support for these operations. We recognize revenues from various research and development grants, but do not have any products approved for sale and have not generated any product sales. We have funded our operations primarily through the private placement of preferred stock, grant revenues and our initial public offering. Through December 31, 2018, we have raised gross proceeds of approximately $210.8 million to fund our operations from the issuance of common stock in our initial public offering (“IPO”) in July 2018 as well as, prior to our IPO, through issuance of convertible preferred stock. As of December 31, 2018, we had cash, cash equivalents and short-term investments of $163.9 million. We have incurred cumulative net losses since our inception and, as of December 31, 2018, we had an accumulated deficit of $43.4 million. Our net losses may fluctuate significantly from quarter-to-quarter and year-to-year, depending on the timing of our preclinical studies and clinical trials and our expenditures on other research and development activities. We expect our expenses and operating losses will increase substantially as we conduct our ongoing and planned clinical trials, continue our research and development activities and conduct preclinical studies, hire additional personnel, protect our intellectual property and incur additional costs associated with being a public company, including audit, legal, regulatory, and tax-related services associated with maintaining compliance with exchange listing and Securities and Exchange Commission (“SEC”) requirements, director and officer insurance premiums, and investor relations costs. We do not expect to generate any revenues from product sales unless and until we successfully complete development and obtain regulatory approval for one or more of our product candidates, which we expect will take a number of years. If we obtain regulatory approval for any of our product candidates, we expect to incur significant commercialization expenses related to product sales, marketing, manufacturing and distribution. Accordingly, until such time as we can generate significant revenue from sales of our product candidates, if ever, we expect to finance our cash needs through equity offerings, debt financings or other capital sources, including potentially collaborations, licenses and other similar arrangements. However, we may be unable to raise additional funds or enter into such other arrangements when needed on favorable terms or at all. Our failure to raise capital or enter into such other arrangements when needed would have a negative impact on our financial condition and could force us to delay, scale back or discontinue the development of our existing product candidates or our efforts to expand our product pipeline. Australian operations In January 2017, we established Crinetics Australia Pty Ltd (“CAPL”), a wholly-owned subsidiary which was formed to conduct various preclinical and clinical activities for our product and development candidates. We believe CAPL will be eligible for certain financial incentives made available by the Australian government for research and development expenses. Specifically, the Australian Taxation Office provides for a refundable tax credit in the form of a cash refund equal to 43.5% of qualified research and development expenditures under the Australian Research and Development Tax Incentive Program (the “Australian Tax Incentive”), to Australian companies that operate the majority of their research and development activities associated with such projects in Australia. A wholly-owned Australian subsidiary of a non-Australian parent company is eligible to receive the refundable tax credit, provided that the Australian subsidiary retains the rights to the data and intellectual property generated in Australia, and provided that the total revenues of the parent company and its consolidated subsidiaries during the period for which the refundable tax credit is claimed are less than $20.0 million Australian dollars. If we lose our ability to operate CAPL in Australia, or if we are ineligible or unable to receive the research and development tax credit, or the Australian government significantly reduces or eliminates the tax credit, the actual refund amounts we receive may differ from our estimates. Financial operations overview Grant revenues To date, we have not generated any revenues from the commercial sale of approved products, and we do not expect to generate revenues from the commercial sale of our product candidates for at least the foreseeable future, if ever. Revenues for 2018, 2017 and 2016 were derived from Small Business Innovation Research Grants (“SBIR Grants”) awarded to us by the National Institute of Diabetes and Digestive and Kidney Diseases of the National Institutes of Health. We do not currently expect future grant revenues to be a material source of funding. Research and development To date, our research and development expenses have related primarily to discovery efforts and preclinical and clinical development of our product candidates. Research and development expenses are recognized as incurred and payments made prior to the receipt of goods or services to be used in research and development are capitalized until the goods or services are received. Research and development expenses include: • salaries, payroll taxes, employee benefits, and stock-based compensation charges for those individuals involved in research and development efforts; • external research and development expenses incurred under agreements with contract research organizations, or CROs, investigative sites and consultants to conduct our clinical trials and preclinical and non-clinical studies; • laboratory supplies; • costs related to manufacturing our product candidates for clinical trials and preclinical studies, including fees paid to third-party manufacturers; • costs related to compliance with regulatory requirements; and • facilities, depreciation and other allocated expenses, which include direct and allocated expenses for rent, maintenance of facilities, insurance, equipment and other supplies. We recognize the Australian Tax Incentive as a reduction of research and development expense. The amounts are determined based on eligible research and development expenditures. The Australian Tax Incentive is recognized when there is reasonable assurance that the Australian Tax Incentive will be received, the relevant expenditure has been incurred, and the amount of the Australian Tax Incentive can be reliably measured. Our direct research and development expenses consist principally of external costs, such as fees paid to CROs, investigative sites and consultants in connection with our clinical trials, preclinical and non-clinical studies, and costs related to manufacturing clinical trial materials. The majority of our third-party expenses during 2018, 2017 and 2016 related to the research and development of CRN00808. We deploy our personnel and facility related resources across all of our research and development activities. Our clinical development costs may vary significantly based on factors such as: • per patient trial costs; • the number of trials required for approval; • the number of sites included in the trials; • the countries in which the trials are conducted; • the length of time required to enroll eligible patients; • the number of patients that participate in the trials; • number of doses that patients receive; • drop-out or discontinuation rates of patients • potential additional safety monitoring requested by regulatory agencies; • the duration of patient participation in the trials and follow-up; • the cost and timing of manufacturing our product candidates; • the phase of development of our product candidates; and • the efficacy and safety profile of our product candidates. We plan to substantially increase our research and development expenses for the foreseeable future as we continue the development of our product candidates and discovery of new product candidates. We cannot determine with certainty the timing of initiation, the duration or the completion costs of current or future preclinical studies and clinical trials of our product candidates due to the inherently unpredictable nature of preclinical and clinical development. Clinical and preclinical development timelines, the probability of success and development costs can differ materially from expectations. We anticipate that we will make determinations as to which product candidates to pursue and how much funding to direct to each product candidate on an ongoing basis in response to the results of ongoing and future preclinical studies and clinical trials, regulatory developments and our ongoing assessments as to each product candidate’s commercial potential. We will need to raise substantial additional capital in the future. In addition, we cannot forecast which product candidates may be subject to future collaborations, when such arrangements will be secured, if at all, and to what degree such arrangements would affect our development plans and capital requirements. General and administrative General and administrative expenses consist primarily of salaries and employee-related costs, including stock-based compensation, for personnel in executive, finance and other administrative functions. Other significant costs include facility-related costs, legal fees relating to intellectual property and corporate matters, professional fees for accounting and consulting services and insurance costs. We anticipate that our general and administrative expenses will increase in the future to support our continued research and development activities and, if any of our product candidates receive marketing approval, commercialization activities. We also anticipate increased expenses related to audit, legal, regulatory, and tax-related services associated with maintaining compliance with exchange listing and SEC requirements, director and officer insurance premiums, and investor relations costs associated with operating as a public company. Critical Accounting Policies and Estimates Our management’s discussion and analysis of our financial condition and results of operations are based on our consolidated financial statements, which have been prepared in accordance with U.S. generally accepted accounting principles (“U.S. GAAP”). The preparation of these financial statements requires us 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 consolidated financial statements. On an ongoing basis, we evaluate our estimates and judgments, including those related to revenue recognition, accrued expenses and stock-based compensation. We base our estimates on historical experience, known trends and events, and various other factors that we believe are reasonable under the circumstances, the results of which form the basis for making judgments about the carrying values of assets and liabilities that are not readily apparent from other sources. Actual results may differ from these estimates under different assumptions or conditions. While our significant accounting policies are described in more detail in Note 2 to our consolidated financial statements appearing elsewhere in this Annual Report on Form 10-K, we believe the following accounting policies and estimates to be most critical to the preparation of our consolidated financial statements. Grant revenues Under the terms of the SBIR Grants awarded, we are entitled to receive reimbursement of our allowable direct expenses, allocated overhead, general and administrative expenses and payment of other specified amounts. Revenues from development and support activities under the grants are recorded in the period in which the related costs are incurred for cost reimbursement grants. Revenue is recognized when earned and expenses are recognized when incurred. Any of the funding sources may request reimbursement for expenses or return of funds, or both, as a result of noncompliance by us with the terms of the grants. No reimbursement of expenses or return of funds for noncompliance has been requested or made since inception of the contract and grants. Australian research and development tax incentive CAPL is eligible to obtain a cash refund from the Australian Taxation Office for eligible research and development expenditures under the Australian Tax Incentive. The Australian Tax Incentive is recognized as a reduction to research and development expense when there is reasonable assurance that the Australian Tax Incentive will be received, the relevant expenditure has been incurred, and the amount can be reliably measured. Although we do not expect our estimates to be materially different from amounts actually received, if our estimates of the amounts and timing of the receipt of the Australian Tax Incentive differ from actual amounts received, it could result in us reporting amounts that are too high or too low in any particular period. Accrued expenses As part of the process of preparing our consolidated financial statements, we are required to estimate our accrued expenses as of each balance sheet date. This process involves reviewing open contracts and purchase orders, communicating with our personnel to identify services that have been performed on our behalf and estimating the level of service performed and the associated cost incurred for the service when we have not yet been invoiced or otherwise notified of the actual cost. We make estimates of our accrued expenses as of each balance sheet date based on facts and circumstances known to us at that time. We periodically confirm the accuracy of our estimates with the service providers and make adjustments if necessary. The significant estimates in our accrued research and development expenses include the costs incurred for services performed by our vendors in connection with research and development activities for which we have not yet been invoiced. We base our expenses related to research and development activities on our estimates of the services received and efforts expended pursuant to quotes and contracts with vendors that conduct research and development on our behalf. The financial terms of these agreements are subject to negotiation, vary from contract to contract and may result in uneven payment flows. There may be instances in which payments made to our vendors will exceed the level of services provided and result in a prepayment of the research and development expense. In accruing service fees, we estimate the time period over which services will be performed and the level of effort to be expended in each period. If the actual timing of the performance of services or the level of effort varies from our estimate, we adjust the accrual or prepaid expense accordingly. Advance payments for goods and services that will be used in future research and development activities are expensed when the activity has been performed or when the goods have been received rather than when the payment is made. Although we do not expect our estimates to be materially different from amounts actually incurred, if our estimates of the status and timing of services performed differ from the actual status and timing of services performed, it could result in us reporting amounts that are too high or too low in any particular period. To date, there have been no material differences between our estimates of such expenses and the amounts actually incurred. Stock-based compensation expense Stock-based compensation expense represents the cost of the estimated grant date fair value of employee stock option awards and employee stock purchase plan rights amortized over the requisite service period of the awards (usually the vesting period) on a straight-line basis. We account for awards to nonemployees using the fair value method. Awards to nonemployees are subject to periodic revaluation over their vesting terms and was not material for all periods presented. We estimate the fair value of all stock option grants using the Black-Scholes option pricing model and recognize forfeitures as they occur. Estimating the fair value of equity awards as of the grant date using valuation models, such as the Black-Scholes option pricing model, is affected by assumptions regarding a number of complex variables, including the expected stock price volatility, the risk-free interest rate, the expected term of stock options, the expected dividend yield and the fair value of the underlying common stock on the date of grant. Changes in the assumptions can materially affect the fair value and ultimately how much stock-based compensation expense is recognized. These inputs are subjective and generally require significant analysis and judgment to develop. Due to the lack of an adequate history of a public market for the trading of our common stock and a lack of adequate company-specific historical and implied volatility data, we have based our estimate of expected volatility on the historical volatility of a group of similar companies that are publicly traded. For these analyses, we have selected companies with comparable characteristics to ours, including enterprise value, risk profiles, and position within the industry, and with historical share price information sufficient to meet the expected life of the stock-based awards. We compute the historical volatility data using the daily close prices for the selected companies’ shares during the equivalent period of the calculated expected term of our stock-based awards. We will continue to apply this process until a sufficient amount of historical information regarding the volatility of our common stock price becomes available. We have estimated the expected life of our employee stock options using the “simplified” method, whereby the expected life equals the average of the vesting term and the original contractual term of the option. The risk-free interest rates for periods within the expected life of the option are based on the yields of zero-coupon U.S. treasury securities. Common stock valuations We are required to estimate the fair value of the common stock underlying our stock-based awards when performing fair value calculations, which is the most subjective input into the Black-Scholes option pricing model. Prior to our IPO, the fair value of the common stock underlying our stock-based awards was determined on each grant date by our board of directors, taking into account input from management and independent third-party valuation analyses. All options to purchase shares of our common stock are intended to be granted with an exercise price per share no less than the fair value per share of our common stock underlying those options on the date of grant, based on the information known to us on the date of grant. In the absence of a public trading market for our common stock, on each grant date we developed an estimate of the fair value of our common stock in order to determine an exercise price for the option grants. Our determinations of the fair value of our common stock were made using methodologies, approaches and assumptions consistent with the American Institute of Certified Public Accountants Audit and Accounting Practice Aid Series: Valuation of Privately Held Company Equity Securities Issued as Compensation (“the Practice Aid”). Our board of directors considered various objective and subjective factors, along with input from management, to determine the fair value of our common stock, including: • valuations of our common stock performed by independent third-party valuation specialists; • our stage of development and business strategy, including the status of research and development efforts of our product candidates, and the material risks related to our business and industry; • our results of operations and financial position, including our levels of available capital resources; • the valuation of publicly traded companies in the life sciences and biotechnology sectors, as well as recently completed mergers and acquisitions of peer companies; • the lack of marketability of our common stock as a private company; • the prices of our convertible preferred stock sold to investors in arm’s length transactions and the rights, preferences, and privileges of our convertible preferred stock relative to those of our common stock; • the likelihood of achieving a liquidity event for the holders of our common stock, such as an initial public offering or a sale of our company, given prevailing market conditions; • trends and developments in our industry; and • external market conditions affecting the life sciences and biotechnology industry sectors. Our valuations were prepared in accordance with the guidelines in the Practice Aid, which prescribes several valuation approaches for setting the value of an enterprise, such as the cost, income and market approaches, and various methodologies for allocating the value of an enterprise to its common stock. The cost approach establishes the value of an enterprise based on the cost of reproducing or replacing the property less depreciation and functional or economic obsolescence, if present. The income approach establishes the value of an enterprise based on the present value of future cash flows that are reasonably reflective of our company’s future operations, discounting to the present value with an appropriate risk adjusted discount rate or capitalization rate. The market approach is based on the assumption that the value of an asset is equal to the value of a substitute asset with the same characteristics. Each valuation methodology was considered in our valuations. In determining a fair value for our common stock, we estimated the enterprise value of our business using either the market approach or back-solve method. The back-solve method assigns an implied enterprise value based on the most recent round of funding or investment and allows for the incorporation of the implied future benefits and risks of the investment decision assigned by an outside investor. In accordance with the Practice Aid, we considered the various methods for allocating the enterprise value across our classes and series of capital stock to determine the fair value of our common stock at each valuation date. Until March 2018, we concluded that the Option Pricing Method (“OPM”), was most appropriate for each of the valuations of our common stock performed by independent third-party valuation specialists. We believed the OPM was the most appropriate given the expectation of various potential liquidity outcomes and the difficulty of selecting and supporting appropriate enterprise values given our early stage of development. Under the OPM, shares are valued by creating a series of call options with exercise prices based on the liquidation preferences and conversion terms of each equity class. The values of the preferred and common stock are inferred by analyzing these options. In May 2018, we changed to a hybrid OPM and Probability-Weighted Expected Return Method (“PWERM”). The PWERM is a scenario-based analysis that estimates the value per share based on the probability-weighted present value of expected future investment returns, considering each of the possible outcomes available to us, as well as the economic and control rights of each share class. Under this hybrid method, we considered the expected IPO liquidity scenario, but also used the OPM to capture all other scenarios in the event a near-term initial public offering did not occur. Results of Operations Comparison of the years ended December 31, 2018 and 2017 The following table summarizes our results of operations for the years ended December 31, 2018 and 2017 (in thousands): Grant revenues. Grant revenues were $2.4 million and $2.0 million for the years ended December 31, 2018 and 2017, respectively. The increase was primarily due to an increase in reimbursable research and development expenses under our SBIR Grants during 2018. Research and development expenses. Research and development expenses were $24.5 million and $9.2 million for the years ended December 31, 2018 and 2017, respectively. The increase was primarily due to increased manufacturing and development activities associated with our clinical and nonclinical activities for CRN00808 as well as our other preclinical programs, an increase in personnel related costs due to the hiring of additional development personnel, including $1.0 million of additional stock-based compensation, and increased facility costs due to the expansion of our leased facilities. General and administrative expenses. General and administrative expenses were $6.7 million and $1.9 million for the years ended December 31, 2018 and 2017, respectively. The increase was primarily due to increased personnel costs, including $1.1 million of additional stock-based compensation costs, as well as expenses to operate as a publicly-traded company. Other income (expense). Net other income was $1.6 million for the year ended December 31, 2018, compared with net other expense of $30,000 for the year ended December 31, 2017. The increase was primarily due to interest income earned on higher cash and investment balances due to the funds raised from investors in 2018. Other expense was $153,000 and $56,000 for the years ended December 31, 2018 and 2017, respectively, and is primarily comprised of losses on transactions denominated in foreign currencies. Comparison of the years ended December 31, 2017 and 2016 The following table summarizes our results of operations for the years ended December 31, 2017 and 2016 (in thousands): Grant revenues. Grant revenues were $2.0 million and $0.6 million for the years ended December 31, 2017 and 2016, respectively. The increase was primarily due to increased research and development activities related to our SBIR Grants. Research and development expenses. Research and development expenses were $9.2 million and $5.1 million for the years ended December 31, 2017 and 2016, respectively. The increase of $4.1 million was primarily due to increases in the following: $1.2 million of clinical study related expenses, $1.2 million of manufacturing expenses, $1.2 million of external non-clinical expenditures, and $0.7 million of personnel related expenses. In 2017, the expenses above were offset in part by an Australian Tax Incentive of $0.5 million. General and administrative expenses. General and administrative expenses were$1.9 million and $1.5 million for the years ended December 31, 2017 and 2016, respectively. The increase of $0.4 million was primarily due to increases in the following: $0.2 million of personnel related expenses, $0.1 million of professional services primarily related to patent activities and corporate legal fees, and $0.1 million of facility related expenses and other general and administrative expenses. Other income (expense). Other expense was $30,000 for the year ended December 31, 2017, compared with net other income of $25,000 for the year ended December 31, 2016, as a result of an increase in losses on transaction denominated in foreign currencies. Cash Flows We have incurred cumulative net losses and negative cash flows from operations since our inception and anticipate we will continue to incur net losses for the foreseeable future. As of December 31, 2018, we had an accumulated deficit of $43.4 million and cash, cash equivalents and short-term investments of $163.9 million. The following table provides information regarding our cash flows for each of the years in the three-year period ended December 31, 2018 (in thousands): Comparison of the years ended December 31, 2018 and 2017 Operating Activities. Net cash used in operating activities was $19.5 million and $9.5 million for the years ended December 31, 2018 and 2017, respectively. The net cash used in operating activities during the year ended December 31, 2018 was primarily due to our net loss of $27.1 million, adjusted for $2.4 million of noncash charges and a $5.3 million change in operating assets and liabilities. The increase in cash used in operations were primarily attributable to development and manufacturing activities associated with CRN0808 as well as our clinical and preclinical programs, and higher personnel costs. The noncash charges primarily related to $2.3 million of stock-based compensation charges and $0.5 million of depreciation expense. Net cash used in operating activities during the year ended December 31, 2017 was primarily due to our net loss of $9.2 million, adjusted for $0.4 million of noncash charges and a $0.7 million change in operating assets and liabilities. The noncash charges primarily related to $0.3 million of stock-based compensation charges and $0.1 million of depreciation expense. Investing activities. Investing activities represent activity associated with our investment securities and, to a lesser extent, the cash outflow associated with purchases of property and equipment. Such activities resulted in a net use of funds of approximately $119.5 million during 2018, compared to approximately $0.3 million used during the same period in 2017. Financing activities. Net cash provided by financing activities was $170.2 million for the year ended December 31, 2018, primarily due to the net proceeds of $63.3 million from the sale of Series B convertible preferred stock, the net proceeds of $106.5 million raised in our initial public offering in July and $0.5 million from the exercise of common stock options. Net cash provided by financing activities for the year ended December 31, 2017 was the result of net proceeds of $12.0 million from the sale of Series A convertible preferred stock and $0.1 million from the exercise of common stock options, offset by principal payments on an outstanding bank loan, which was repaid in full in 2017. Comparison of the years ended December 31, 2017 and 2016 Operating Activities. Net cash used in operating activities was $9.5 million and $5.5 million for the years ended December 31, 2017 and 2016, respectively. The net cash used in operating activities during the year ended December 31, 2017 was primarily due to our net loss of $9.2 million, adjusted for $0.4 million of noncash charges and a $0.7 million change in operating assets and liabilities. The noncash charges primarily related to $0.3 million of stock-based compensation charges and $0.1 million of depreciation expense. Net cash used in operating activities during the year ended December 31, 2016 was primarily due to our net loss of $6.0 million, adjusted for $0.4 million of noncash charges and a $0.2 million change in operating assets and liabilities. The noncash charges primarily related to $0.3 million of stock-based compensation charges and $0.1 million of depreciation expense. Investing activities. Net cash used in investing activities was due to property and equipment purchases in each period. Financing activities. Net cash provided by financing activities for the year ended December 31, 2017 was the result of net proceeds of $12.0 million from the sale of Series A convertible preferred stock and $0.1 million from the exercise of common stock options, offset by principal payments on an outstanding bank loan, which was repaid in full in 2017. Net cash used in financing activities was $0.1 million for the year ended December 31, 2016, primarily due to the principal payments on an outstanding bank loan. Liquidity and Capital Resources We believe that our existing cash, cash equivalents and short-term investments, together with investment income, and future payments due under our SBIR Grants, will be sufficient to satisfy our current and projected funding requirements through 2020. We expect these funds will allow us to complete our ongoing Phase 2 clinical trials for CRN00808 and our planned Phase 1 clinical trials for CRN01941. However, our forecast of the period of time through which our financial resources will be adequate to support our operations is a forward-looking statement that involves risks and uncertainties, and actual results could vary materially. We have based this estimate on assumptions that may prove to be wrong, and we could use our capital resources sooner than we expect. Additionally, the process of testing product candidates in clinical trials is costly, and the timing of progress and expenses in these trials is uncertain. Our future capital requirements will depend on many factors, including: • the type, number, scope, progress, expansions, results, costs and timing of, our preclinical studies and clinical trials of our product candidates which we are pursuing or may choose to pursue in the future; • the costs and timing of manufacturing for our product candidates, including commercial manufacturing if any product candidate is approved; • the costs, timing and outcome of regulatory review of our product candidates; • the costs of obtaining, maintaining and enforcing our patents and other intellectual property rights; • our efforts to enhance operational systems and hire additional personnel to satisfy our obligations as a public company, including enhanced internal controls over financial reporting; • the costs associated with hiring additional personnel and consultants as our preclinical and clinical activities increase; • the timing and the extent of any Australian Tax Incentive refund and future grant revenues that we receive; • the costs and timing of establishing or securing sales and marketing capabilities if any product candidate is approved; • our ability to achieve sufficient market acceptance, adequate coverage and reimbursement from third-party payors and adequate market share and revenue for any approved products; • the terms and timing of establishing and maintaining collaborations, licenses and other similar arrangements; and • costs associated with any products or technologies that we may in-license or acquire. Until such time, if ever, as we can generate substantial product revenues to support our cost structure, we expect to finance our cash needs through equity offerings, debt financings or other capital sources, including potentially collaborations, licenses and other similar arrangements. To the extent that we raise additional capital through the sale of equity or convertible debt securities, the ownership interest of our stockholders will be or could be diluted, and the terms of these securities may include liquidation or other preferences that adversely affect the rights of our common stockholders. Debt financing and preferred equity financing, if available, may involve agreements that include covenants limiting or restricting our ability to take specific actions, such as incurring additional debt, making capital expenditures or declaring dividends. If we raise funds through collaborations, licenses and other similar arrangements with third parties, we may have to relinquish valuable rights to our technologies, future revenue streams, research programs or product candidates or grant licenses on terms that may not be favorable to us and/or may reduce the value of our common stock. If we are unable to raise additional funds through equity or debt financings when needed, we may be required to delay, limit, reduce or terminate our product development or future commercialization efforts or grant rights to develop and market our product candidates even if we would otherwise prefer to develop and market such product candidates ourselves. Contractual Obligations and Commitments The following table summarizes our contractual obligations at December 31, 2018 (in thousands): (1) Our operating lease obligations relate to our corporate headquarters in San Diego, California. We enter into contracts in the normal course of business with clinical trial sites and clinical supply manufacturers and with vendors for preclinical studies, research supplies and other services and products for operating purposes. These contracts generally provide for termination after a notice period, and, therefore, are cancelable contracts and not included in the table above. Off-Balance Sheet Arrangements We did not have during the periods presented, and we do not currently have, any off-balance sheet arrangements, as defined under applicable SEC rules.

<s>[INST] You should read the following discussion of our financial condition and results of operations in conjunction with the consolidated financial statements and the notes thereto included elsewhere in this Annual Report on Form 10K. Overview We are a clinical stage pharmaceutical company focused on the discovery, development and commercialization of novel therapeutics for rare endocrine diseases and endocrinerelated tumors. Endocrine pathways function to maintain homeostasis and commonly use peptide hormones acting through Gproteincoupled receptors (“GPCRs”) to regulate many aspects of physiology including growth, energy, metabolism, gastrointestinal function and stress responses. We have assembled a seasoned team with extensive expertise in drug discovery and development in endocrine GPCRs and built a highly productive drug discovery organization. We have discovered a pipeline of oral nonpeptide (small molecule) new chemical entities that target peptide GPCRs to treat a variety of rare endocrine diseases where treatment options have significant efficacy, safety and/or tolerability limitations. Our lead product candidate, CRN00808, is currently in clinical development for the treatment of acromegaly, and we are advancing additional product candidates through preclinical studies in parallel. Our vision is to build the leading endocrine company which consistently pioneers new therapeutics to help patients better control their disease and improve their daily lives. We focus on the discovery and development of oral nonpeptide therapeutics that target peptide GPCRs with well understood biological functions, validated biomarkers and the potential to substantially improve the treatment of endocrine diseases and/or endocrinerelated tumors. Our pipeline consists of the following three product candidates and discovery program: CRN00808, our lead product candidate, establishes a new class of oral selective nonpeptide somatostatin receptor 2 (“sst2”) biased agonists designed for the treatment of acromegaly and is the first agent in its class with reported clinical results. In March 2018, we reported initial results from a Phase 1, doubleblind, randomized, placebocontrolled, single and multipleascending dose trial to evaluate the safety, pharmacokinetics and pharmacodynamics of CRN00808 in 99 healthy volunteers. CRN00808 demonstrated clinical proofofconcept by potently suppressing stimulated GH and baseline IGF1 in these subjects. We submitted an Investigational New Drug (“IND”) application to the U.S. Food and Drug Administration (“FDA”) in August 2018. In late 2018, we initiated two global Phase 2 clinical trials of CRN00808 in acromegaly patients, the ACROBAT EVOLVE (“EVOLVE”) and ACROBAT EDGE (“EDGE”) studies. The EVOLVE trial is a doubleblind, placebocontrolled, randomized withdrawal study designed to evaluate the safety, efficacy and pharmacokinetics of CRN00808, in subjects with acromegaly that respond to octreotide LAR or lanreotide depot monotherapy. The EDGE trial is an open label exploratory study designed to evaluate the safety, efficacy and pharmacokinetics of CRN00808 in subjects with acromegaly that are treated with somatostatin analog based treatment regimens but do not respond completely to monotherapy. The EVOLVE and EDGE studies will be conducted at centers in the United States and in certain European countries. CRN01941 is an oral nonpeptide sst2 biased agonist designed for the treatment of neuroendocrine tumors, that originate from neuroendocrine cells commonly found in the gut, lung or pancreas. CRN01941 is currently in firstinhuman enabling studies, and we expect to initiate a Phase 1 human proofofconcept clinical trial in the first half of 2019. We expect results from this trial in late 2019/early 2020. We are developing a new class of oral selective nonpeptide somatostatin re [/INST] Positive. </s>

Crinetics Pharmaceuticals, Inc.

2020-03-09

2019-12-31

Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations You should read the following discussion of our financial condition and results of operations in conjunction with the consolidated financial statements and the notes thereto included elsewhere in this Annual Report on Form 10-K. Overview We are a clinical stage pharmaceutical company focused on the discovery, development and commercialization of novel therapeutics for rare endocrine diseases and endocrine-related tumors. Endocrine pathways function to maintain homeostasis and commonly use peptide hormones acting through G protein coupled receptors, or GPCRs, to regulate many aspects of physiology including growth, energy, metabolism, gastrointestinal function and stress responses. We have assembled a seasoned team with extensive expertise in drug discovery and development in endocrine GPCRs and built a highly productive drug discovery organization. We have discovered a pipeline of oral nonpeptide (small molecule) new chemical entities that target peptide GPCRs to treat a variety of rare endocrine diseases where treatment options have significant efficacy, safety and/or tolerability limitations. Our lead product candidate, paltusotine (formerly CRN00808), is currently in clinical development for the treatment of acromegaly, and we are advancing additional product candidates through clinical and preclinical studies in parallel. Our vision is to build the leading endocrine company which consistently pioneers new therapeutics to help patients better control their disease and improve their daily lives. We focus on the discovery and development of oral nonpeptide therapeutics that target peptide GPCRs with well-understood biological functions, validated biomarkers and the potential to substantially improve the treatment of endocrine diseases and/or endocrine-related tumors. Our pipeline consists of the following two product candidates and preclinical programs: • Paltusotine, our lead product candidate, establishes a new class of oral selective nonpeptide somatostatin receptor type 2, or sst2, biased agonists designed for the treatment of acromegaly and neuroendocrine tumors, or NETs. We are currently conducting three global Phase 2 clinical trials of paltusotine in acromegaly patients, the ACROBAT EVOLVE, or EVOLVE, ACROBAT EDGE, or EDGE and ACROBAT ADVANCE, or ADVANCE, trials. The EVOLVE trial is a double-blind, placebo-controlled, randomized withdrawal study designed to evaluate the safety, efficacy and pharmacokinetics of paltusotine, in subjects with acromegaly whose disease is biochemically controlled by octreotide LAR or lanreotide depot monotherapy. The EDGE trial is an open label exploratory study designed to evaluate the safety, efficacy and pharmacokinetics of paltusotine in subjects with acromegaly that are treated with somatostatin analog based treatment regimens but whose disease is not biochemically controlled by monotherapy. The ADVANCE trial is an open label, long term extension study designed to evaluate the safety and efficacy of paltusotine in patients that have completed the EVOLVE or EDGE trials. We dosed the first patients in the EVOLVE and EDGE trials in March 2019. • CRN01941 is also an oral nonpeptide sst2 biased agonist initially in development for the treatment of NETs. We initiated a Phase 1 clinical trial in May 2019 to examine the safety, tolerability, pharmacokinetics, and pharmacodynamics of CRN01941 and expect results from this trial in early 2020. We intend to decide whether to advance CRN01941 or paltusotine into a later stage trial in NETs upon analysis of the cumulative data from the paltusotine and CRN01941 preclinical, nonclinical and clinical programs. • We are developing the first nonpeptide product candidate to antagonize peptide adrenocorticotrophic hormone, or ACTH, designed for the treatment of Cushing’s disease and other diseases caused by excess ACTH, including congenital adrenal hyperplasia and Ectopic ACTH Syndrome. We are currently conducting first-in-human enabling studies with our lead ACTH antagonist development candidate. • We are developing a new class of oral selective nonpeptide somatostatin type 5 receptor, or sst5, agonists designed to treat congenital hyperinsulinism, or CHI. We are currently conducting first-in-human enabling studies with our lead sst5 agonist development candidate. To date, we have devoted substantially all of our resources to drug discovery, conducting preclinical studies and clinical trials, obtaining and maintaining patents related to our product candidates, and the provision of general and administrative support for these operations. We recognize revenues from various research and development grants, but do not have any products approved for sale and have not generated any product sales. We have funded our operations to date primarily through our grant revenues, the private placement of our preferred stock, and our initial public offering, or IPO, in July 2018. As of December 31, 2019, we had unrestricted cash, cash equivalents and investment securities of $118.4 million. We have incurred cumulative net losses since our inception and, as of December 31, 2019, we had an accumulated deficit of $93.8 million. Our net losses may fluctuate significantly from quarter-to-quarter and year-to-year, depending on the timing of our clinical trials and preclinical studies and our expenditures on other research and development activities. We expect our expenses and operating losses will increase substantially as we conduct our ongoing and planned clinical trials, continue our research and development activities and conduct preclinical studies, hire additional personnel, protect our intellectual property and incur costs associated with being a public company, including audit, legal, regulatory, and tax-related services associated with maintaining compliance with exchange listing and Securities and Exchange Commission, or SEC, requirements, director and officer insurance premiums, and investor relations costs. We do not expect to generate any revenues from product sales unless and until we successfully complete development and obtain regulatory approval for one or more of our product candidates, which we expect will take a number of years. If we obtain regulatory approval for any of our product candidates, we expect to incur significant commercialization expenses related to product sales, marketing, manufacturing and distribution. Accordingly, until such time as we can generate significant revenue from sales of our product candidates, if ever, we expect to finance our cash needs through equity offerings, debt financings or other capital sources, including potentially collaborations, licenses and other similar arrangements. However, we may be unable to raise additional funds or enter into such other arrangements when needed on favorable terms or at all. Our failure to raise capital or enter into such other arrangements when needed would have a negative impact on our financial condition and could force us to delay, scale back or discontinue the development of our existing product candidates or our efforts to expand our product pipeline. Australian operations In January 2017, we established Crinetics Australia Pty Ltd, or CAPL, a wholly-owned subsidiary which was formed to conduct various preclinical and clinical activities for our product and development candidates. We believe CAPL will be eligible for certain financial incentives made available by the Australian government for research and development expenses. Specifically, the Australian Taxation Office provides for a refundable tax credit in the form of a cash refund equal to 43.5% of qualified research and development expenditures under the Australian Research and Development Tax Incentive Program, or the Australian Tax Incentive, to Australian companies that operate the majority of their research and development activities associated with such projects in Australia. A wholly-owned Australian subsidiary of a non-Australian parent company is eligible to receive the refundable tax credit, provided that the Australian subsidiary retains the rights to the data and intellectual property generated in Australia, and provided that the total revenues of the parent company and its consolidated subsidiaries during the period for which the refundable tax credit is claimed are less than $20.0 million Australian dollars. If we lose our ability to operate CAPL in Australia, or if we are ineligible or unable to receive the research and development tax credit, or the Australian government significantly reduces or eliminates the tax credit, the actual refund amounts we receive may differ from our estimates. Financial operations overview Grant revenues To date, we have not generated any revenues from the commercial sale of approved products, and we do not expect to generate revenues from the commercial sale of our product candidates for at least the foreseeable future, if ever. Revenues for 2019, 2018 and 2017 were derived from Small Business Innovation Research Grants, or SBIR Grants, awarded to us by the National Institute of Diabetes and Digestive and Kidney Diseases of the National Institutes of Health. We do not currently expect future grant revenues to be a material source of funding. Research and development To date, our research and development expenses have related primarily to discovery efforts and preclinical and clinical development of our product candidates. Research and development expenses are recognized as incurred and payments made prior to the receipt of goods or services to be used in research and development are capitalized until the goods or services are received. Research and development expenses include: • salaries, payroll taxes, employee benefits, and stock-based compensation charges for those individuals involved in research and development efforts; • external research and development expenses incurred under agreements with contract research organizations, or CROs, investigative sites and consultants to conduct our clinical trials and preclinical and non-clinical studies; • costs related to manufacturing our product candidates for clinical trials and preclinical studies, including fees paid to third-party manufacturers; • costs related to compliance with regulatory requirements; • laboratory supplies; and • facilities, depreciation and other allocated expenses for rent, facilities maintenance, insurance, equipment and other supplies. We recognize the Australian Tax Incentive as a reduction of research and development expense. The amounts are determined based on eligible research and development expenditures. The Australian Tax Incentive is recognized when there is reasonable assurance that the Australian Tax Incentive will be received, the relevant expenditure has been incurred, and the amount of the Australian Tax Incentive can be reliably measured. Our direct research and development expenses consist principally of external costs, such as fees paid to CROs, investigative sites and consultants in connection with our clinical trials, preclinical and non-clinical studies, and costs related to manufacturing clinical trial materials. The majority of our third-party expenses during 2019, 2018 and 2017 related to the research and development of paltusotine. We deploy our personnel and facility related resources across all of our research and development activities. Our clinical development costs may vary significantly based on factors such as: • per patient trial costs; • the number of trials required for approval; • the number of sites included in the trials; • the countries in which the trials are conducted; • the length of time required to enroll eligible patients; • the number of patients that participate in the trials; • number of doses that patients receive; • drop-out or discontinuation rates of patients; • potential additional safety monitoring requested by regulatory agencies; • the duration of patient participation in the trials and follow-up; • the cost and timing of manufacturing our product candidates; • the phase of development of our product candidates; and • the efficacy and safety profile of our product candidates. We plan to substantially increase our research and development expenses for the foreseeable future as we continue the development of our product candidates and the discovery of new product candidates. We cannot determine with certainty the timing of initiation, the duration or the completion costs of current or future preclinical studies and clinical trials of our product candidates due to the inherently unpredictable nature of preclinical and clinical development. Clinical and preclinical development timelines, the probability of success and development costs can differ materially from expectations. We anticipate that we will make determinations as to which product candidates to pursue and how much funding to direct to each product candidate on an ongoing basis in response to the results of ongoing and future preclinical studies and clinical trials, regulatory developments and our ongoing assessments as to each product candidate’s commercial potential. We will need to raise substantial additional capital in the future. In addition, we cannot forecast which product candidates may be subject to future collaborations, when such arrangements will be secured, if at all, and to what degree such arrangements would affect our development plans and capital requirements. General and administrative General and administrative expenses consist primarily of salaries and employee-related costs, including stock-based compensation, for personnel in executive, finance and other administrative functions. Other significant costs include facility-related costs, legal fees relating to intellectual property and corporate matters, professional fees for accounting and consulting services, insurance costs, and commercial planning expenses. We anticipate that our general and administrative expenses will increase in the future to support our continued research and development activities and, if any of our product candidates receive marketing approval, commercialization activities. We also anticipate increased expenses related to audit, legal, regulatory, and tax-related services associated with maintaining compliance with exchange listing and SEC requirements, director and officer insurance premiums, and investor relations costs associated with operating as a public company. Critical Accounting Policies and Estimates Our management’s discussion and analysis of our financial condition and results of operations are based on our consolidated financial statements, which have been prepared in accordance with U.S. generally accepted accounting principles, or U.S. GAAP. The preparation of these financial statements requires us 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 consolidated financial statements. On an ongoing basis, we evaluate our estimates and judgments, including those related to revenue recognition, accrued expenses and stock-based compensation. We base our estimates on historical experience, known trends and events, and various other factors that we believe are reasonable under the circumstances, the results of which form the basis for making judgments about the carrying values of assets and liabilities that are not readily apparent from other sources. Actual results may differ from these estimates under different assumptions or conditions. While our significant accounting policies are described in more detail in Note 2 to our consolidated financial statements appearing elsewhere in this Annual Report on Form 10-K, we believe the following accounting policies and estimates to be most critical to the preparation of our consolidated financial statements. Australian research and development tax incentive CAPL is eligible to obtain a cash refund from the Australian Taxation Office for eligible research and development expenditures under the Australian Tax Incentive. The Australian Tax Incentive is recognized as a reduction to research and development expense when there is reasonable assurance that the Australian Tax Incentive will be received, the relevant expenditure has been incurred, and the amount can be reliably measured. Although we do not expect our estimates to be materially different from amounts actually received, if our estimates of the amounts and timing of the receipt of the Australian Tax Incentive differ from actual amounts received, it could result in us reporting amounts that are too high or too low in any particular period. Accrued expenses As part of the process of preparing our consolidated financial statements, we are required to estimate our accrued expenses as of each balance sheet date. This process involves reviewing open contracts and purchase orders, communicating with our personnel to identify services that have been performed on our behalf and estimating the level of service performed and the associated cost incurred for the service when we have not yet been invoiced or otherwise notified of the actual cost. We make estimates of our accrued expenses as of each balance sheet date based on facts and circumstances known to us at that time. We periodically confirm the accuracy of our estimates with the service providers and make adjustments if necessary. The significant estimates in our accrued research and development expenses include the costs incurred for services performed by our vendors in connection with research and development activities for which we have not yet been invoiced. We base our expenses related to research and development activities on our estimates of the services received and efforts expended pursuant to quotes and contracts with vendors that conduct research and development on our behalf. The financial terms of these agreements are subject to negotiation, vary from contract to contract and may result in uneven payment flows. There may be instances in which payments made to our vendors will exceed the level of services provided and result in a prepayment of the research and development expense. In accruing service fees, we estimate the time period over which services will be performed and the level of effort to be expended in each period. If the actual timing of the performance of services or the level of effort varies from our estimate, we adjust the accrual or prepaid expense accordingly. Advance payments for goods and services that will be used in future research and development activities are expensed when the activity has been performed or when the goods have been received rather than when the payment is made. Although we do not expect our estimates to be materially different from amounts actually incurred, if our estimates of the status and timing of services performed differ from the actual status and timing of services performed, it could result in us reporting amounts that are too high or too low in any particular period. To date, there have been no material differences between our estimates of such expenses and the amounts actually incurred. Operating Lease Effective January 1, 2019, the Company determines if an arrangement is a lease at the inception of the arrangement. Leases with a term longer than 12 months that are determined to be operating leases are included in operating lease assets, accrued expenses and other current liabilities and noncurrent operating lease liabilities in the consolidated balance sheets based on the present value of the minimum lease payments called for under the arrangement. Lease expense for minimum lease payments is recognized on a straight-line basis over the lease term. Stock-based compensation expense Stock-based compensation expense represents the cost of the estimated grant date fair value of stock option awards and employee stock purchase plan rights amortized over the requisite service period of the awards (usually the vesting period) on a straight-line basis. We estimate the fair value of all stock option grants using the Black-Scholes option pricing model and recognize forfeitures as they occur. Estimating the fair value of equity awards as of the grant date using valuation models, such as the Black-Scholes option pricing model, is affected by assumptions regarding a number of complex variables, including the expected stock price volatility, the risk-free interest rate, the expected term of stock options, the expected dividend yield and the fair value of the underlying common stock on the date of grant. Changes in the assumptions can materially affect the fair value and ultimately how much stock-based compensation expense is recognized. These inputs are subjective and generally require significant analysis and judgment to develop. Due to the lack of an adequate history of a public market for the trading of our common stock and a lack of adequate company-specific historical and implied volatility data, we have based our estimate of expected volatility on the historical volatility of a group of similar companies that are publicly traded. For these analyses, we have selected companies with comparable characteristics to ours, including enterprise value, risk profiles, and position within the industry, and with historical share price information sufficient to meet the expected life of the stock-based awards. We compute the historical volatility data using the daily close prices for the selected companies’ shares during the equivalent period of the calculated expected term of our stock-based awards. We will continue to apply this process until a sufficient amount of historical information regarding the volatility of our common stock price becomes available. We have estimated the expected life of our employee stock options using the “simplified” method, whereby the expected life equals the average of the vesting term and the original contractual term of the option. The risk-free interest rates for periods within the expected life of the option are based on the yields of zero-coupon U.S. treasury securities. Results of Operations Comparison of the years ended December 31, 2019 and 2018. The following table summarizes our results of operations for the years ended December 31, 2019 and 2018 (in thousands): Grant revenues. Grant revenues relate to reimbursable expenses incurred in connection with our SBIR Grants and totaled $1.2 million and $2.4 million for the years ended December 31, 2019 and 2018, respectively. Our 2019 revenues were primarily associated with research activities for one SBIR Grant, while our 2018 revenues were primarily related to research activities for two such grants. We do not expect grant revenues to be significant in future periods. Research and development expenses. Research and development expenses were $41.5 million and $24.5 million for the years ended December 31, 2019 and 2018, respectively. The increase was primarily due to increased spending on manufacturing and development activities of $9.9 million associated with our clinical and nonclinical activities for paltusotine as well as our other clinical and preclinical programs. Additionally, our 2019 results reflect an increase in costs of $4.5 million due to the hiring of additional personnel (which includes $2.1 million of additional stock-based compensation). General and administrative expenses. General and administrative expenses were $13.5 million and $6.7 million for the years ended December 31, 2019 and 2018, respectively. The increase was primarily due to increases in personnel-related costs of $3.2 million (which includes $1.9 million of additional stock-based compensation), spending on pre-commercialization activities and corporate legal services of $1.6 million, as well as expenses associated with operating as a publicly traded company. Other income (expense). Other income (expense), net was $3.4 million and $1.6 million for the years ended December 31, 2019 and 2018, respectively. The increase was primarily due to interest income earned on higher cash and investment balances due to the funds raised from investors in 2018. Comparison of the years ended December 31, 2018 and 2017. The following table summarizes our results of operations for the years ended December 31, 2018 and 2017 (in thousands): Grant revenues. Grant revenues were $2.4 million and $2.0 million for the years ended December 31, 2018 and 2017, respectively. The increase was primarily due to an increase in reimbursable research and development expenses under our SBIR Grants during 2018. Research and development expenses. Research and development expenses were $24.5 million and $9.2 million for the years ended December 31, 2018 and 2017, respectively. The increase was primarily due to increased spending on manufacturing and development activities associated with our clinical and nonclinical activities for paltusotine as well as our other preclinical programs, an increase in personnel related costs due to the hiring of additional development personnel, including $1.0 million of additional stock-based compensation, and increased facility costs due to the expansion of our leased facilities. General and administrative expenses. General and administrative expenses were $6.7 million and $1.9 million for the years ended December 31, 2018 and 2017, respectively. The increase was primarily due to increases in personnel-related costs, including $1.1 million of additional stock-based compensation, as well as expenses associated with operating as a publicly traded company. Other income (expense). Net other income was $1.6 million for the year ended December 31, 2018, compared with net other expense of $30,000 for the year ended December 31, 2017. The increase was primarily due to interest income earned on higher cash and investment balances due to the funds raised from investors in 2018. Cash Flows We have incurred cumulative net losses and negative cash flows from operations since our inception and anticipate we will continue to incur net losses for the foreseeable future. As of December 31, 2019, we had an accumulated deficit of $93.8 million and unrestricted cash, cash equivalents and investment securities of $118.4 million. The following table provides information regarding our cash flows for each of the years in the three-year period ended December 31, 2019 (in thousands): Comparison of the years ended December 31, 2019 and 2018 Operating Activities. Net cash used in operating activities was $46.4 million and $19.5 million for the years ended December 31, 2019 and 2018, respectively. The increase in cash used in operations was primarily attributable to development and manufacturing activities associated with paltusotine as well as our other clinical and preclinical programs, and higher personnel-related costs. The net cash used in operating activities during the year ended December 31, 2019 was primarily due to our net loss of $50.4 million and a $2.1 million change in operating assets and liabilities, adjusted for $6.2 million of noncash charges, including stock-based compensation and depreciation expense. Net cash used in operating activities during the year ended December 31, 2018 was primarily due to our net loss of $27.1 million, adjusted for $2.4 million of noncash charges, primarily for stock-based compensation and depreciation expense, and a $5.3 million change in operating assets and liabilities. Investing activities. Investing activities consist primarily of purchases and maturities of investment securities and, to a lesser extent, the cash outflow associated with purchases of property and equipment. Such activities resulted in a net inflow of funds of approximately $41.7 million during 2019, compared to approximately $119.5 million used during 2018. Financing activities. Net cash provided by financing activities was $67,000 and $170.2 million for the years ended December 31, 2019 and 2018, respectively. The net cash provided by financing activities during 2019 was the result of the exercise of stock options, net of stock repurchase activities. The net cash provided by financing activities during 2018 was primarily due to the net proceeds of $63.3 million from the sale of Series B convertible preferred stock, the net proceeds of $106.5 million raised in our initial public offering in July and $0.5 million from the exercise of common stock options. Comparison of the years ended December 31, 2018 and 2017 Operating Activities. Net cash used in operating activities was $19.5 million and $9.5 million for the years ended December 31, 2018 and 2017, respectively. The net cash used in operating activities during the year ended December 31, 2018 was primarily due to our net loss of $27.1 million, adjusted for $2.4 million of noncash charges and a $5.3 million change in operating assets and liabilities. The increase in cash used in operations were primarily attributable to development and manufacturing activities associated with paltusotine as well as our clinical and preclinical programs, and higher personnel costs. The noncash charges primarily related to $2.3 million of stock-based compensation charges and $0.5 million of depreciation expense. Net cash used in operating activities during the year ended December 31, 2017 was primarily due to our net loss of $9.2 million, adjusted for $0.4 million of noncash charges and a $0.7 million change in operating assets and liabilities. The noncash charges primarily related to $0.3 million of stock-based compensation charges and $0.1 million of depreciation expense. Investing activities. Investing activities represent activity associated with our investment securities and, to a lesser extent, the cash outflow associated with purchases of property and equipment. Such activities resulted in a net use of funds of approximately $119.5 million during 2018, compared to approximately $0.3 million used during the same period in 2017. Financing activities. Net cash provided by financing activities was $170.2 million for the year ended December 31, 2018, primarily due to the net proceeds of $63.3 million from the sale of Series B convertible preferred stock, the net proceeds of $106.5 million raised in our initial public offering in July and $0.5 million from the exercise of common stock options. Net cash provided by financing activities for the year ended December 31, 2017 was the result of net proceeds of $12.0 million from the sale of Series A convertible preferred stock and $0.1 million from the exercise of common stock options, offset by principal payments on an outstanding bank loan, which was repaid in full in 2017. Liquidity and Capital Resources We believe that our existing unrestricted cash, cash equivalents and investment securities, together with investment income, and future payments due under our SBIR Grants, will be sufficient to satisfy our current and projected funding requirements into the second half of 2021. We expect these funds will allow us to complete our ongoing Phase 2 clinical trials for paltusotine as well as continue advancing our pipeline programs. However, our forecast of the period of time through which our financial resources will be adequate to support our operations is a forward-looking statement that involves risks and uncertainties, and actual results could vary materially. We have based this estimate on assumptions that may prove to be wrong, and we could use our capital resources sooner than we expect. Additionally, the process of testing product candidates in clinical trials is costly, and the timing of progress and expenses in these trials is uncertain. Our future capital requirements will depend on many factors, including: • the type, number, scope, progress, expansions, results, costs and timing of, our preclinical studies and clinical trials of our product candidates which we are pursuing or may choose to pursue in the future; • the costs and timing of manufacturing for our product candidates, including commercial manufacturing if any product candidate is approved; • the costs, timing and outcome of regulatory review of our product candidates; • the costs of obtaining, maintaining and enforcing our patents and other intellectual property rights; • our efforts to enhance operational systems and hire additional personnel to satisfy our obligations as a public company, including enhanced internal controls over financial reporting; • the costs associated with hiring additional personnel and consultants as our preclinical and clinical activities increase; • the timing and the extent of any Australian Tax Incentive refund and future grant revenues that we receive; • the costs and timing of establishing or securing sales and marketing capabilities if any product candidate is approved; • our ability to achieve sufficient market acceptance, adequate coverage and reimbursement from third-party payors and adequate market share and revenue for any approved products; • the terms and timing of establishing and maintaining collaborations, licenses and other similar arrangements; and • costs associated with any products or technologies that we may in-license or acquire. Until such time, if ever, as we can generate substantial product revenues to support our cost structure, we expect to finance our cash needs through equity offerings, debt financings or other capital sources, including potentially collaborations, licenses and other similar arrangements. To the extent that we raise additional capital through the sale of equity or convertible debt securities, the ownership interest of our stockholders will be or could be diluted, and the terms of these securities may include liquidation or other preferences that adversely affect the rights of our common stockholders. Debt financing and preferred equity financing, if available, may involve agreements that include covenants limiting or restricting our ability to take specific actions, such as incurring additional debt, making capital expenditures or declaring dividends. If we raise funds through collaborations, licenses and other similar arrangements with third parties, we may have to relinquish valuable rights to our technologies, future revenue streams, research programs or product candidates or grant licenses on terms that may not be favorable to us and/or may reduce the value of our common stock. If we are unable to raise additional funds through equity or debt financings when needed, we may be required to delay, limit, reduce or terminate our product development or future commercialization efforts or grant rights to develop and market our product candidates even if we would otherwise prefer to develop and market such product candidates ourselves. In August 2019, we entered into a Sales Agreement, or the Sales Agreement, with SVB Leerink LLC and Cantor Fitzgerald & Co., or collectively, the Sales Agents, under which we may, from time to time, sell shares of our common stock having an aggregate offering price of up to $75.0 million through the Sales Agents. Sales of our common stock made pursuant to the Sales Agreement, if any, will be made directly on or through the Nasdaq Global Select Market under our effective shelf Registration Statement on Form S-3 filed on August 19, 2019 by means of ordinary brokers’ transactions at market prices. Additionally, under the terms of the Sales Agreement, we may also sell shares of our common stock through the Sales Agents, on the Nasdaq Global Select Market or otherwise, at negotiated prices or at prices related to the prevailing market price. We are not obligated to, and we cannot provide any assurances that we will, make any sales of the shares under the Sales Agreement. The Sales Agreement may be terminated by either Sales Agent (with respect to itself) or us at any time upon 10 days’ notice to the other parties, or by either Sales Agent, with respect to itself, at any time in certain circumstances, including the occurrence of a material adverse change. We will pay the Sales Agents a commission for their services in acting as agent in the sale of common stock in an amount equal to 3% of the gross sales price per share sold. As of December 31, 2019, no shares had been issued pursuant to the Sales Agreement. Between January 1, 2020 and March 6, 2020, the Company issued 275,764 shares of common stock in the ATM Offering for net proceeds of $6.4 million, after deducting commissions. Contractual Obligations and Commitments The following table summarizes our contractual obligations at December 31, 2019 (in thousands): (1) Our operating lease obligations relate to our corporate headquarters in San Diego, California. We enter into contracts in the normal course of business with clinical trial sites and clinical supply manufacturers and with vendors for preclinical studies, research supplies and other services and products for operating purposes. These contracts generally provide for termination after a notice period, and, therefore, are cancelable contracts and not included in the table above. Off-Balance Sheet Arrangements We did not have during the periods presented, and we do not currently have, any off-balance sheet arrangements, as defined under applicable SEC rules.

<s>[INST] You should read the following discussion of our financial condition and results of operations in conjunction with the consolidated financial statements and the notes thereto included elsewhere in this Annual Report on Form 10K. Overview We are a clinical stage pharmaceutical company focused on the discovery, development and commercialization of novel therapeutics for rare endocrine diseases and endocrinerelated tumors. Endocrine pathways function to maintain homeostasis and commonly use peptide hormones acting through G protein coupled receptors, or GPCRs, to regulate many aspects of physiology including growth, energy, metabolism, gastrointestinal function and stress responses. We have assembled a seasoned team with extensive expertise in drug discovery and development in endocrine GPCRs and built a highly productive drug discovery organization. We have discovered a pipeline of oral nonpeptide (small molecule) new chemical entities that target peptide GPCRs to treat a variety of rare endocrine diseases where treatment options have significant efficacy, safety and/or tolerability limitations. Our lead product candidate, paltusotine (formerly CRN00808), is currently in clinical development for the treatment of acromegaly, and we are advancing additional product candidates through clinical and preclinical studies in parallel. Our vision is to build the leading endocrine company which consistently pioneers new therapeutics to help patients better control their disease and improve their daily lives. We focus on the discovery and development of oral nonpeptide therapeutics that target peptide GPCRs with wellunderstood biological functions, validated biomarkers and the potential to substantially improve the treatment of endocrine diseases and/or endocrinerelated tumors. Our pipeline consists of the following two product candidates and preclinical programs: Paltusotine, our lead product candidate, establishes a new class of oral selective nonpeptide somatostatin receptor type 2, or sst2, biased agonists designed for the treatment of acromegaly and neuroendocrine tumors, or NETs. We are currently conducting three global Phase 2 clinical trials of paltusotine in acromegaly patients, the ACROBAT EVOLVE, or EVOLVE, ACROBAT EDGE, or EDGE and ACROBAT ADVANCE, or ADVANCE, trials. The EVOLVE trial is a doubleblind, placebocontrolled, randomized withdrawal study designed to evaluate the safety, efficacy and pharmacokinetics of paltusotine, in subjects with acromegaly whose disease is biochemically controlled by octreotide LAR or lanreotide depot monotherapy. The EDGE trial is an open label exploratory study designed to evaluate the safety, efficacy and pharmacokinetics of paltusotine in subjects with acromegaly that are treated with somatostatin analog based treatment regimens but whose disease is not biochemically controlled by monotherapy. The ADVANCE trial is an open label, long term extension study designed to evaluate the safety and efficacy of paltusotine in patients that have completed the EVOLVE or EDGE trials. We dosed the first patients in the EVOLVE and EDGE trials in March 2019. CRN01941 is also an oral nonpeptide sst2 biased agonist initially in development for the treatment of NETs. We initiated a Phase 1 clinical trial in May 2019 to examine the safety, tolerability, pharmacokinetics, and pharmacodynamics of CRN01941 and expect results from this trial in early 2020. We intend to decide whether to advance CRN01941 or paltusotine into a later stage trial in NETs upon analysis of the cumulative data from the paltusotine and CRN01941 preclinical, nonclinical and clinical programs. We are developing the first nonpeptide product candidate to antagonize peptide adrenocorticotrophic hormone, or ACTH, designed for the treatment of Cushing’s disease and other diseases caused by excess ACTH, including congenital adrenal hyperplasia and Ect [/INST] Negative. </s>

Bank7 Corp.

2019-03-29

2018-12-31

Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations The following discussion and analysis of our financial condition and results of operations should be read in conjunction with our consolidated financial statements and related notes included elsewhere in this report. Unless the context indicates otherwise, references in this management’s discussion and analysis to “we”, “our”, and “us,” refer to Bank7 Corp. and its consolidated subsidiaries. All references to “the Bank” refer to Bank7, our wholly owned subsidiary. General We are Bank7 Corp., a bank holding company headquartered in Oklahoma City, Oklahoma. Through our wholly-owned subsidiary, Bank7, we operate seven full-service branches in Oklahoma, the Dallas/Fort Worth, Texas metropolitan area and Kansas. We are focused on serving business owners and entrepreneurs by delivering fast, consistent and well-designed loan and deposit products to meet their financing needs. We intend to grow organically by selectively opening additional branches in our target markets and we will also pursue strategic acquisitions. As a bank holding company, we generate most of our revenue from interest income on loans and from short-term investments. The primary source of funding for our loans and short-term investments are deposits held by our subsidiary, Bank7. We measure our performance by our return on average assets, return on average equity, earnings per share, capital ratios, and our efficiency ratio, which is calculated by dividing noninterest expense by the sum of net interest income on a tax equivalent basis and noninterest income. As of December 31, 2018, we had total assets of $770.5 million, total loans of $599.9 million, total deposits of $675.9 million and total shareholders’ equity of $88.5 million. In September 2018, in conjunction with our initial public offering, the Company terminated its status as an S Corporation and elected to be treated as a C Corporation. As this termination occurred at the end of the third quarter, we have presented information as pre-tax and pro forma numbers in the non-GAAP reconciliation below. Our Initial Public Offering Our initial public offering, or IPO, closed on September 20, 2018 and a total of 2,900,000 shares of common stock were sold at $19.00 per share. After deducting underwriting discounts and offering expenses, the Company received total net proceeds of $50.1 million from the initial public offering and the exercise of the underwriter option. Upon completion of the IPO, the Company became a publicly traded company with our common stock listed on The NASDAQ Global Select Market under the symbol “BSVN”. Factors Affecting Comparability of Financial Results S Corporation Status Since our formation in 2004, we have elected to be taxed for U.S. federal income tax purposes as an S Corporation. As a result, our net income has not been subject to, and we have not paid, U.S. federal or state income taxes, and we have not been required to make any provision or recognize any liability for U.S. federal income tax in our financial statements. The consummation of our initial public offering resulted in the termination of our status as an S Corporation and in our taxation as a C Corporation for U.S. federal and state income tax purposes. Upon the termination of our status as an S Corporation, we commenced paying U.S. federal income tax on our pre-tax net income for each year (including the short year beginning on the date our status as an S Corporation terminated), and our financial statements reflect a provision for U.S. federal income tax. As a result of this change, the net income and earnings per share data presented in our historical financial statements and the other financial information set forth in this report (unless otherwise specified), which do not include any provision for U.S. federal income tax, will not be comparable with our future net income and earnings per share in periods after we commence to be taxed as a C Corporation, which will be calculated by including a provision for U.S. federal and state income tax. The termination of our status as an S Corporation may also affect our financial condition and cash flows. Historically, we have made periodic cash distributions to our shareholders in amounts estimated by us to be sufficient for such shareholders to pay their estimated individual U.S. federal income tax liability resulting from our taxable income that was “passed through” to them. However, these distributions have not been consistent, as sometimes the distributions have been in excess of the shareholder’s estimated individual U.S. federal income tax liability resulting from the ownership of our shares. In addition, these estimates have been based on individual U.S. federal income tax rates, which may differ from the rates imposed on the income of C Corporations. With the termination of our status as an S Corporation, no income will be “passed through” to any shareholders, but, as noted above, we will commence paying U.S. federal income tax. The amounts that we have historically distributed to the shareholders are not indicative of the amount of U.S. federal income tax that we will be required to pay after we commence to be taxed as a C Corporation. Depending on our effective tax rate and our future dividend rate, if any, our future cash flows and financial condition could be positively or adversely affected compared to our historical cash flows and financial condition. Furthermore, deferred tax assets and liabilities will be recognized for the future tax consequences attributable to differences between the financial statement carrying amounts of our existing assets and liabilities and their respective tax bases. Deferred tax assets and liabilities are measured using tax rates expected to apply to taxable income in the years in which those temporary differences are expected to be recovered or settled. The effect on deferred tax assets and liabilities of the change in tax rates resulting from becoming a C Corporation were recognized in income in the quarter the change took place. This difference between the financial statement carrying amounts of assets and liabilities and their respective tax bases was recorded as an initial net deferred tax asset of $863,000 (net of $13,000 uncertain tax liability). The net deferred tax asset recorded on our consolidated balance sheet as of December 31, 2018 totaled $1,069,000. The difference would have been recorded as a net deferred tax asset of $480,000 (net of $240,000 uncertain tax liability) if it had been recorded on our consolidated balance sheet as of December 31, 2017 and as a net deferred tax asset of $250,000 (net of $380,000 uncertain tax liability) if it had been recorded on our consolidated balance sheet as of December 31, 2016. Pro Forma Income Tax Expense and Net Income As a result of our status as an S Corporation, we had no U.S. federal income tax expense for the years ended December 31, 2017 or 2016. Further, we do not have U.S. federal income tax expense for the full year ended December 31, 2018, but rather only for the short year after conversion to C corporation status (as discussed earlier). The pro forma impact of being taxed as a C Corporation is illustrated in the following table: (1) A portion of our net income in each of these periods was derived from nontaxable investment income and other nondeductible expenses. (2) Based on a statutory federal income tax rate of 21% for the year ended December 31, 2018 and 35% for each of the years ended December 31, 2017 and December 31, 2016, plus the applicable statutory state income tax rate for each of the respective periods. State income tax expense would have been approximately: - $1.3 million for the year ended December 31, 2018 with an effective state tax rate of 4.9% - $1.3 million for the year ended December 31, 2017 with an effective state tax rate of 5.4% - $1.0 million for the year ended December 31, 2016 with an effective state tax rate of 5.7% 2018 Highlights For the year ended December 31, 2018, we reported pre-tax net income of $25.8 million compared to pre-tax net income of $23.8 million for the year ended December 31, 2017. The increase was related to strong loan growth combined with increased loan yields. For the year ended December 31, 2018, average loans totaled $583.8 million, an increase of $44.7 million or 8.3%, from December 31, 2017. For the year ended December 31, 2018, loan yields, excluding loan fee income, were 6.71%, an increase of 57 basis points from the same period in 2017. Loan yield excluding loan fee income is a non-GAAP measure. See “GAAP Reconciliation and Management Explanation of Non-GAAP Financial Measures” elsewhere in this report. Pre-tax return on average assets and return on average equity was 3.53% and 33.01%, respectively for the year ended December 31, 2018, as compared to 3.62% and 37.43%, respectively, for the same period in 2017. Our efficiency ratio for the year ended December 31, 2018 was 37.04% as compared to 37.24% for the year ended December 31, 2017. As of December 31, 2018, total loans were $599.9 million, an increase of $36.9 million, or 6.6%, from December 31, 2017. Total deposits were $675.9 million as of December 31, 2018, an increase of $50.1 million, or 8.0%, from December 31, 2017. Tangible book value per share was $8.49 as of December 31, 2018, a decrease of $0.70, or 7.6%, from December 31, 2017. Tangible book value per share is a non-GAAP financial measure. See “GAAP Reconciliation and Management Explanation of Non-GAAP Financial Measures” elsewhere in this report. Results of Operations Years Ended December 31, 2018, December 31, 2017, and December 31, 2016 Net Interest Income and Net Interest Margin The following table presents, for the periods indicated, information about: (i) weighted average balances, the total dollar amount of interest income from interest-earning assets, and the resultant average yields; (ii) average balances, the total dollar amount of interest expense on interest-bearing liabilities, and the resultant average rates; (iii) net interest income; and (iv) the net interest margin. (1) Includes income and weighted average balances for fed funds sold, interest-earning deposits in banks and other miscellaneous interest-earning assets. (2) Includes income and weighted average balances for FHLB and FRB stock. (3) Average loan balances include monthly average nonaccrual loans of $991,000, $2.6 million and $4.7 million for the years ended December 31, 2018, 2017 and 2016, respectively. (4) Net interest spread is the average yield on interest-earning assets minus the average rate on interest-bearing liabilities. We continued to experience strong asset growth for the year ended December 31, 2018 compared to the year ended December 31, 2017: - Total interest income on loans increased $2.8 million, or 6.8%, to $44.3 million which was attributable to a $44.7 million increase in the average balance of loans to $583.8 million during the year ended 2018 as compared with the average balance of $539.1 million for the year ended 2017; - Loan fees totaled $5.1 million, a decrease of $3.2 million or 38.5% which was attributable to nonrecurring loan fee income earned during the year ended 2017 as compared to 2018; - Yields on our interest-earning assets totaled 6.48%, a decrease of 12 basis points which was attributable to the $3.2 million decrease in nonrecurring loan fee income earned during the year ended 2018; and - Net interest margin for the year ended 2018 and 2017 was 5.49% and 5.87%, respectively. For the year ended December 31, 2017 compared to the year ended December 31, 2016: - Total interest income on loans increased $9.2 million, or 28.5%, to $41.5 million which was attributable to a $58.1 million increase in the average balance of loans to $539.1 million during the year ended 2017 as compared to $480.9 million for the year ended 2016; - Loan fees totaled $8.3 million, an increase of $3.8 million or 83.5% which was attributable to nonrecurring loan fee income earned during the year ended 2017 as compared to 2016; - Yields on our interest-earning assets totaled 6.60%, an increase of 87 basis points which was attributable to the increase in average loans and nonrecurring loan fee income earned during the year ended 2017 as compared to 2016; and - Net interest margin for the year ended 2017 and 2016 was 5.87% and 5.16%, respectively. Interest income on short-term investments increased $1.1 million, or 77.54%, to $2.5 million for year ended December 31, 2018, due to an increase in the average balances of $27.4 million, or 25.11% and a yield increase of 54 basis points. Interest income on short-term investments increased $521,000, or 58.0%, to $1.4 million for year ended December 31, 2017, due to an increase in the average balances of $12.6 million, or 13.0%, and an increase in the federal funds rate during 2017. Interest expense on interest-bearing deposits totaled $7.0 million for the year ended December 31, 2018, compared to $4.5 million for 2017, an increase of $2.5 million, or 55.35%. The increase was related to average daily interest bearing deposit balances increasing by $17.6 million or 3.97% while the cost of interest-bearing deposits grew to 1.52% for the year ended December 31, 2018 from 1.02% for the year ended December 31, 2017. Interest expense on interest-bearing deposits totaled $4.5 million for year ended December 31, 2017, compared to $3.0 million for 2016, an increase of $1.5 million, or 50.0%. The increase was related to average daily deposit balances increasing by $57.5 million or 10.9% while the cost of interest-bearing deposits grew to 1.02% for the year ended December 31, 2017 from 0.75% for the year ended December 31, 2016. Net interest margin, including loan fee income, for the years ended December 31, 2018, 2017 and 2016 was 5.49%, 5.87% and 5.16%, respectively. Our net interest margin benefited from an increase in average loan balances with increased loan fee income in 2017, and decreased due to lower loan fee income in 2018. Excluding our loan fee income, net interest margin for the years ended December 31, 2018, 2017 and 2016 was 4.78%, 4.59% and 4.37%, respectively. Net interest margin excluding loan fee income is a non-GAAP measure. See “GAAP Reconciliation and Management Explanation of Non-GAAP Financial Measures” elsewhere in this report. The following table sets forth the effects of changing rates and volumes on our net interest income during the period shown. Information is provided with respect to (i) effects on interest income attributable to changes in volume (change in volume multiplied by prior rate) and (ii) effects on interest income attributable to changes in rate (changes in rate multiplied by prior volume). (1) Variances attributable to both volume and rate are allocated on a consistent basis between rate and volume based on the absolute value of the variances in each category. Provision for Loan Losses For the year ended December 31, 2018 compared to the year ended December 31, 2017: - The provision for loan losses decreased by $1 million, or 83.95%, to $200,000; and - The allowance as a percentage of loans decreased by 5 basis points to 1.31%. For the year ended December 31, 2017 compared to the year ended December 31, 2016: - The provision for loan losses decreased by $309,000, or 19.9%, to $1.2 million; and - The allowance as a percentage of loans decreased by 1 basis point to 1.36%. Noninterest Income Noninterest income for the year ended December 31, 2018 was $1.3 million compared to $1.4 million for the year ended December 31, 2017, a decrease of $104,000, or 7.25%. Noninterest income for the year ended December 31, 2017 was $1.4 million compared to $1.6 million for the year ended December 31, 2016, a decrease of and $208,000, or 12.7%. The following table sets forth the major components of our noninterest income for the years ended December 31, 2018, 2017 and 2016: Noninterest Expense Noninterest expense for the year ended December 31, 2018 was $15.0 compared to $14.5 million for the year ended December 31, 2017, an increase of $434,000, or 3.0%. Noninterest expense for the year ended December 31, 2017 was $14.5 compared to $13.1 million for the year ended December 31, 2016, an increase of $1.4 million, or 10.8%. The following table sets forth the major components of our noninterest expense for the years ended December 31, 2018, 2017 and 2016: For the year ended December 31, 2018 compared to the year ended December 31, 2017: - Salaries and employee benefits expense was $8.1 million compared to $7.6 million, an increase of $502,000, or 6.6%. The increase in 2018 was attributable to higher salaries and incentive compensation expense. - Furniture and equipment expense was $684,000 compared to $831,000, a decrease of $147,000, or 17.7%. The decrease in 2018 was primarily due to lower bank vehicle expenses compared to 2017. - Regulatory assessments totaled $542,000 compared to $450,000, an increase of $92,000, or 20.4%. The change came primarily from FDIC assessments that totaled $440,000 in 2018 compared to $394,000 in 2017, an increase of $46,000, or 11.7%. The increase is due to a higher assessment associated with an increase in deposits accounts due to organic growth and expansion into the Texas market. - Travel, lodging and entertainment expense was $699,000 compared to $1.0 million, a decrease of $342,000, or 32.9%. The decrease in 2018 was primarily due to lower aircraft expenses as the aircraft was sold at the end of the third quarter of 2018. For the year ended December 31, 2017 compared to the year ended December 31, 2016: - Salaries and employee benefits expense was $7.6 million compared to $6.5 million, an increase of $1.1 million, or 16.8%. The increase in 2017 was attributable to our expansion in the Dallas/Fort Worth metropolitan area as our number of full-time equivalent employees totaled 80 at December 31, 2017 compared to 72 at December 31, 2016. - Furniture and equipment expense was $831,000 compared to $693,000, an increase of $138,000, or 19.9%. This increase in 2017 was primarily due to higher bank vehicle expenses compared to 2016. - Regulatory assessments totaled $450,000 compared to $638,000, a decrease of $188,000, or 29.5%. The change came primarily from FDIC assessments that totaled $394,000 in 2017 and $550,000 in 2016, a decrease of $156,000, or 28.4%, respectively. The primary reason for the decrease in assessments in 2017 was less reliance on non-reciprocal deposits related to non-core funding. - Travel, lodging and entertainment expense for 2017 was $1.0 million compared to $542,000, an increase of $499,000, or 92.1%. The increase in 2017 was primarily due to aircraft expenses and increased travel to the new branch in the Dallas/Fort Worth metropolitan area. Financial Condition The following discussion of our financial condition compares December 31, 2018, 2017, and 2016. Total Assets Total assets increased $66.9 million, or 9.5%, to $770.5 million as of December 31, 2018, as compared to $703.6 million as of December 31, 2017 and $613.8 million as of December 31, 2016. The increasing trend in total assets is primarily attributable to strong organic loan and retail deposit growth within the Oklahoma City market and expansion into the Dallas/Fort Worth metropolitan area. Securities We had no securities portfolio as of December 31, 2018, December 31, 2017 and December 31, 2016. Loan Portfolio Our loans represent the largest portion of our earning assets. The quality and diversification of the loan portfolio is an important consideration when reviewing our financial condition. As of December 31, 2018, 2017 and 2016, our gross loans were $601.9 million, $564.6 million and $503.8 million, respectively. The following table presents the balance and associated percentage of each major category in our loan portfolio as of December 31, 2018, December 31, 2017 and December 31, 2016: We have established internal concentration limits in the loan portfolio for CRE loans, hospitality loans, energy loans, and construction loans, among others. All loan types are within our established limits. We use underwriting guidelines to assess each borrower’s historical cash flow to determine debt service, and we further stress test the debt service under higher interest rate scenarios. Financial and performance covenants are used in commercial lending to allow us to react to a borrower’s deteriorating financial condition, should that occur. The following tables show the contractual maturities of our gross loans as of the periods below: Allowance for Loan and Lease Losses The allowance is based on management’s estimate of probable losses inherent in the loan portfolio. In the opinion of management, the allowance is adequate to absorb estimated losses in the portfolio as of each balance sheet date. While management uses available information to analyze losses on loans, future additions to the allowance may be necessary based on changes in economic conditions. In addition, various regulatory agencies, as an integral part of their examination process, periodically review the Company’s allowance. In analyzing the adequacy of the allowance, a comprehensive loan grading system to determine risk potential in loans is utilized together with the results of internal credit reviews. To determine the adequacy of the allowance, the loan portfolio is broken into segments based on loan type. Historical loss experience factors by segment, adjusted for changes in trends and conditions, are used to determine an indicated allowance for each portfolio segment. These factors are evaluated and updated based on the composition of the specific loan segment. Other considerations include volumes and trends of delinquencies, nonaccrual loans, levels of bankruptcies, criticized and classified loan trends, expected losses on real estate secured loans, new credit products and policies, economic conditions, concentrations of credit risk and the experience and abilities of our lending personnel. In addition to the segment evaluations, impaired loans with a balance of $250,000 or more are individually evaluated based on facts and circumstances of the loan to determine if a specific allowance amount may be necessary. Specific allowances may also be established for loans whose outstanding balances are below the $250,000 threshold when it is determined that the risk associated with the loan differs significantly from the risk factor amounts established for its loan segment. The allowance was $7.8 million at December 31, 2018, $7.7 million at December 31, 2017 and $6.9 million at December 31, 2016. The increasing trend was related to, and in conjunction with, loan growth. The following table provides an analysis of the activity in our allowance for the periods indicated: While the entire allowance is available to absorb losses from any and all loans, the following table represents management’s allocation of the allowance by loan category, and the percentage of allowance in each category, for the periods indicated: Nonperforming Assets Loans are considered delinquent when principal or interest payments are past due 30 days or more. Delinquent loans may remain on accrual status between 30 days and 90 days past due. Loans on which the accrual of interest has been discontinued are designated as nonaccrual loans. Typically, the accrual of interest on loans is discontinued when principal or interest payments are past due 90 days or when, in the opinion of management, there is a reasonable doubt as to collectability of the obligation. When loans are placed on nonaccrual status, all interest previously accrued but not collected is reversed against current period interest income. Income on a nonaccrual loan is subsequently recognized only to the extent that cash is received and the loan’s principal balance is deemed collectible. Loans are restored to accrual status when loans become well-secured and management believes full collectability of principal and interest is probable. A loan is considered impaired when it is probable that we will be unable to collect all amounts due according to the contractual terms of the loan agreement. Impaired loans include loans on nonaccrual status and loans modified in a troubled debt restructuring, or TDR. Income from a loan on nonaccrual status is recognized to the extent cash is received and when the loan’s principal balance is deemed collectible. Depending on a particular loan’s circumstances, we measure impairment of a loan based upon either the present value of expected future cash flows discounted at the loan’s effective interest rate, the loan’s observable market price, or the fair value of the collateral less estimated costs to sell if the loan is collateral dependent. A loan is considered collateral dependent when repayment of the loan is based solely on the liquidation of the collateral. Fair value, where possible, is determined by independent appraisals, typically on an annual basis. Between appraisal periods, the fair value may be adjusted based on specific events, such as if deterioration of quality of the collateral comes to our attention as part of our problem loan monitoring process, or if discussions with the borrower lead us to believe the last appraised value no longer reflects the actual market for the collateral. The impairment amount on a collateral dependent loan is charged off to the allowance if deemed not collectible and the impairment amount on a loan that is not collateral dependent is set up as a specific reserve. In cases where a borrower experiences financial difficulties and we make certain concessionary modifications to contractual terms, the loan is classified as a TDR. Included in certain loan categories of impaired loans are TDRs on which we have granted certain material concessions to the borrower as a result of the borrower experiencing financial difficulties. The concessions granted by us may include, but are not limited to: (1) a modification in which the maturity date, timing of payments or frequency of payments is modified, (2) an interest rate lower than the current market rate for new loans with similar risk, or (3) a combination of the first two concessions. If a borrower on a restructured accruing loan has demonstrated performance under the previous terms, is not experiencing financial difficulty and shows the capacity to continue to perform under the restructured terms, the loan will remain on accrual status. Otherwise, the loan will be placed on nonaccrual status until the borrower demonstrates a sustained period of performance, which generally requires six consecutive months of payments. Loans identified as TDRs are evaluated for impairment using the present value of the expected cash flows or the estimated fair value of the collateral, if the loan is collateral dependent. The fair value is determined, when possible, by an appraisal of the property less estimated costs related to liquidation of the collateral. The appraisal amount may also be adjusted for current market conditions. Adjustments to reflect the present value of the expected cash flows or the estimated fair value of collateral dependent loans are a component in determining an appropriate allowance, and as such, may result in increases or decreases to the provision for loan losses in current and future earnings. Real estate we acquire as a result of foreclosure or by deed-in-lieu of foreclosure is classified as other real estate owned, or OREO, until sold, and is initially recorded at fair value less costs to sell when acquired, establishing a new cost basis. Nonperforming loans include nonaccrual loans, loans past due 90 days or more and still accruing interest and loans modified under TDRs that are not performing in accordance with their modified terms. Nonperforming assets consist of nonperforming loans plus OREO. Loans accounted for on a nonaccrual basis were $2.6 million as of December 31, 2018, $1.2 million as of December 31, 2017 and $661,000 as of December 31, 2016. The gross balance of loans accounted for on a nonaccrual basis at December 31, 2018 was $2.6 million; however, this amount includes one relationship with a balance of $2.0 million, of which 75% is guaranteed by the Small Business Administration (“SBA”). OREO was $110,000 as of December 31, 2018 and $100,000 as of December 31, 2017 and December 31, 2016. The following table presents information regarding nonperforming assets as of the dates indicated. The following tables present an aging analysis of loans as of the dates indicated. In addition to the past due and nonaccrual criteria, the Company also evaluates loans according to its internal risk grading system. Loans are segregated between pass, watch, special mention, and substandard categories. The definitions of those categories are as follows: In addition to the past due and nonaccrual criteria, the Company also evaluates loans according to its internal risk grading system. Loans are segregated between pass, watch, special mention, and substandard categories. The definitions of those categories are as follows: Pass: These loans generally conform to Bank policies, are characterized by policy-conforming advance rates on collateral, and have well-defined repayment sources. In addition, these credits are extended to borrowers and guarantors with a strong balance sheet and either substantial liquidity or a reliable income history. Watch: These loans are still considered “Pass” credits; however, various factors such as industry stress, material changes in cash flow or financial conditions, or deficiencies in loan documentation, or other risk issues determined by the lending officer, Commercial Loan Committee or CQC warrant a heightened sense and frequency of monitoring. Special mention: These loans have observable weaknesses or evidence imprudent handling or structural issues. The weaknesses require close attention, and the remediation of those weaknesses is necessary. No risk of probable loss exists. Credits in this category are expected to quickly migrate to “Watch” or “Substandard” as this is viewed as a transitory loan grade. Substandard: These loans are not adequately protected by the sound worth and debt service capacity of the borrower, but may be well-secured. The loans have defined weaknesses relative to cash flow, collateral, financial condition or other factors that might jeopardize repayment of all of the principal and interest on a timely basis. There is the possibility that a future loss will occur if weaknesses are not remediated. Substandard loans totaled $9.1 million as of December 31, 2018, an increase of $4.6 million compared to December 31, 2017. The increase primarily related to one commercial real estate relationship, one commercial and industrial relationship, and one agricultural relationship, comprised of six notes totaling $8.4 million with no specific reserve. During the year ended December 31, 2018, loans classified as substandard had payoffs or paydowns totaling $1.8 million. Outstanding loan balances categorized by internal risk grades as of the periods indicated are summarized as follows: Troubled Debt Restructurings TDRs are defined as those loans in which a bank, for economic or legal reasons related to a borrower’s financial difficulties, grants a concession to the borrower that it would not otherwise consider. A loan is considered impaired when, based on current information and events, it is probable that the Company will be unable to collect all amounts due from the borrower in accordance with original contractual terms of the loan. Loans with insignificant delays or insignificant short-falls in the amount of payments expected to be collected are not considered to be impaired. Loans defined as individually impaired, based on applicable accounting guidance, include larger balance nonperforming loans and TDRs. The following table presents loans restructured as TDRs as of December 31, 2018, December 31, 2017 and December 31, 2016. There were no payment defaults with respect to loans modified as TDRs as of December 31, 2018, 2017, and 2016. Impairment analyses are prepared on TDRs in conjunction with the normal allowance process. TDRs restructured during the years ended December 31, 2018, 2017 and 2016 required $0, $300,000 and $0 in specific reserves, respectively. There were no charge-offs on TDRs for the years ended December 31, 2018, 2017 or 2016. The following table presents total TDRs, both in accrual and nonaccrual status as of the periods indicated: Deposits We gather deposits primarily through our seven branch locations and online though our website. We offer a variety of deposit products including demand deposit accounts and interest-bearing products, such as savings accounts and certificates of deposit. We put continued effort into gathering noninterest-bearing demand deposit accounts through loan production cross-selling, customer referrals, marketing efforts and various involvement with community networks. Some of our interest-bearing deposits were obtained through brokered transactions. We participate in the CDARS program, where customer funds are placed into multiple certificates of deposit, each in an amount under the standard FDIC insurance maximum of $250,000, and placed at a network of banks across the United States. Total deposits as of December 31, 2018, 2017 and 2016 were $675.9 million, $625.8 million and $549.6 million, respectively. The following table sets forth deposit balances by certain categories as of the dates indicated and the percentage of each deposit category to total deposits. The following table summarizes our average deposit balances and weighted average rates for the years ended December 31, 2018, 2017 and 2016: The following tables set forth the maturity of time deposits as of the dates indicated below: Other Borrowed Funds The Company had debt outstanding with The Bankers Bank of $5.6 million at December 31, 2017, secured by certain shares of common stock of the Bank held by the Company. The purpose of this transaction was to facilitate the purchase of The Montezuma State Bank in 2014 and to inject capital into the Bank. The remaining principal balance of the note, as well as the accrued interest payable, was paid in full in September 2018. Liquidity Liquidity refers to the measure of our ability to meet the cash flow requirements of depositors and borrowers, while at the same time meeting our operating, capital and strategic cash flow needs, all at a reasonable cost. We continuously monitor our liquidity position to ensure that assets and liabilities are managed in a manner that will meet all short-term and long-term cash requirements. We manage our liquidity position to meet the daily cash flow needs of customers, while maintaining an appropriate balance between assets and liabilities to meet the return on investment objectives of our shareholders. Our liquidity position is supported by management of liquid assets and access to alternative sources of funds. Our liquid assets include cash, interest-bearing deposits in correspondent banks and fed funds sold. Other available sources of liquidity include wholesale deposits and borrowings from correspondent banks and FHLB advances. Our short-term and long-term liquidity requirements are primarily met through cash flow from operations, redeployment of prepaying and maturing balances in our loan portfolios, and increases in customer deposits. Other alternative sources of funds will supplement these primary sources to the extent necessary to meet additional liquidity requirements on either a short-term or long-term basis. As of December 31, 2018, we had no unsecured fed funds lines with correspondent depository institutions with no amounts advanced. In addition, based on the values of loans pledged as collateral, we had borrowing availability with the FHLB of $66.3 million as of December 31, 2018 and $22.6 million as of December 31, 2017. Capital Requirements The Bank is subject to various regulatory capital requirements administered by the federal and state banking regulators. Failure to meet regulatory capital requirements may result in certain mandatory and possible additional discretionary actions by regulators that, if undertaken, could have a direct material effect on our financial statements. Under capital adequacy guidelines and the regulatory framework for “prompt corrective action” (described below), the Bank must meet specific capital guidelines that involve quantitative measures of our assets, liabilities and certain off-balance sheet items as calculated under regulatory accounting policies. The capital amounts and classifications are subject to qualitative judgments by the federal banking regulators about components, risk weightings and other factors. Qualitative measures established by regulation to ensure capital adequacy required the Bank to maintain minimum amounts and ratios of Common Equity Tier 1, or CET1, capital, Tier 1 capital and total capital to risk-weighted assets and of Tier 1 capital to average consolidated assets, referred to as the “leverage ratio.” For further information, see “Supervision and Regulation - Regulatory Capital Requirements” and “Supervision and Regulation - Prompt Corrective Action Framework.” In the wake of the global financial crisis of 2008 and 2009, the role of capital has become fundamentally more important, as banking regulators have concluded that the amount and quality of capital held by banking organizations was insufficient to absorb losses during periods of severely distressed economic conditions. The Dodd-Frank Act and banking regulations promulgated by the U.S. federal banking regulators to implement Basel III have established strengthened capital standards for banks and bank holding companies and require more capital to be held in the form of common stock. These provisions, which generally became applicable to the Bank on January 1, 2015, impose meaningfully more stringent regulatory capital requirements than those applicable to the Bank prior to that date. In addition, the Basel III regulations implement a concept known as the “capital conservation buffer.” In general, banks, bank holding companies with more than $3.0 billion in assets and bank holding companies with publicly-traded equity are required to hold a buffer of CET1 capital equal to 2.5% of risk-weighted assets over each minimum capital ratio by January 1, 2019 in order to avoid being subject to limits on capital distributions (e.g., dividends, stock buybacks, etc.) and certain discretionary bonus payments to executive officers. For community banks, such as us, the capital conservation buffer requirement commenced on January 1, 2016, with a gradual phase-in. Full compliance with the capital conservation buffer is required by January 1, 2019. As of December 31, 2018, the FDIC categorized the Bank as “well-capitalized” under the prompt corrective action framework. There have been no conditions or events since December 31, 2018 that management believes would change this classification. The table below also summarizes the capital requirements applicable to the Bank in order to be considered “well-capitalized” from a regulatory perspective, as well as the Bank’s capital ratios as of December 31, 2018, 2017 and 2016. The Bank exceeded all regulatory capital requirements under Basel III and the Bank was considered to be “well-capitalized” as of the dates reflected in the tables below. Shareholders’ equity provides a source of permanent funding, allows for future growth and provides a cushion to withstand unforeseen adverse developments. Total shareholders’ equity increased to $88.5 million as of December 31, 2018, compared to $69.2 million as of December 31, 2017 and $55.1 million as of December 31, 2016. The increases were driven by retained capital from net income during the periods. Contractual Obligations The following tables contain supplemental information regarding our total contractual obligations as of December 31, 2018: We believe that we will be able to meet our contractual obligations as they come due through the maintenance of adequate cash levels. We expect to maintain adequate cash levels through profitability, loan repayment and maturity activity and continued deposit gathering activities. We have in place various borrowing mechanisms for both short-term and long-term liquidity needs. Off-Balance Sheet Arrangements We are a party to financial instruments with off-balance sheet risk in the normal course of business to meet the financing needs of our customers. These financial instruments include commitments to extend credit and standby letters of credit. Those instruments involve, to varying degrees, elements of credit and interest rate risk in excess of the amount recognized in the consolidated balance sheet. The contractual or notional amounts of those instruments reflect the extent of involvement we have in particular classes of financial instruments. Commitments to extend credit are agreements to lend to a customer as long as there is no violation of any condition established in the contract. Commitments generally have fixed expiration dates or other termination clauses and may require payment of a fee. Since many of the commitments are expected to expire without being drawn upon, the total commitment amount does not necessarily represent future cash requirements. We evaluate each customer’s creditworthiness on a case-by-case basis. The amount of collateral obtained, if we deemed necessary upon extension of credit, is based on management’s credit evaluation of the counterparty. The Company also estimates a reserve for potential losses associated with off-balance sheet commitments and letters of credit. It is included in other liabilities in the Company’s consolidated statements of condition, with any related provisions to the reserve included in non-interest expense in the consolidated statement of income. In determining the reserve for unfunded lending commitments, a process similar to the one used for the allowance is employed. Based on historical experience, loss factors, adjusted for expected funding, are applied to the Company’s off-balance sheet commitments and letters of credit to estimate the potential for losses. Standby letters of credit are conditional commitments issued by the Company to guarantee the performance of the customer to a third party. They are intended to be disbursed, subject to certain conditions, upon request of the borrower. The following table summarizes commitments as of the dates presented. Critical Accounting Policies and Estimates Our accounting and reporting policies conform to GAAP and conform to general practices within the industry in which we operate. To prepare financial statements in conformity with GAAP, management makes estimates, assumptions and judgments based on available information. These estimates, assumptions and judgments affect the amounts reported in the financial statements and accompanying notes. These estimates, assumptions and judgments are based on information available as of the date of the financial statements and, as this information changes, actual results could differ from the estimates, assumptions and judgments reflected in the financial statement. In particular, management has identified several accounting policies that, due to the estimates, assumptions and judgments inherent in those policies, are critical in understanding our financial statements. The JOBS Act permits us an extended transition period for complying with new or revised accounting standards affecting public companies. We have elected to take advantage of this extended transition period, which means that the financial statements included in this report, as well as any financial statements that we file in the future, will not be subject to all new or revised accounting standards generally applicable to public companies for the transition period for so long as we remain an emerging growth company or until we affirmatively and irrevocably opt out of the extended transition period under the JOBS Act. The following is a discussion of the critical accounting policies and significant estimates that we believe require us to make the most complex or subjective decisions or assessments. Additional information about these policies can be found in Note 1 of the Company’s consolidated financial statements as of December 31, 2018. Allowance for Loan and Lease Losses The allowance is based on management’s estimate of probable losses inherent in the loan portfolio. In the opinion of management, the allowance is adequate to absorb estimated losses in the portfolio as of each balance sheet date. While management uses available information to analyze losses on loans, future additions to the allowance may be necessary based on changes in economic conditions and changes in the composition of the loan portfolio. In addition, various regulatory agencies, as an integral part of their examination process, periodically review the Bank’s allowance. In analyzing the adequacy of the allowance, a comprehensive loan grading system to determine risk potential in loans is utilized together with the results of internal credit reviews. To determine the adequacy of the allowance, the loan portfolio is broken into segments based on loan type. Historical loss experience factors by segment, adjusted for changes in trends and conditions, are used to determine an indicated allowance for each portfolio segment. These factors are evaluated and updated based on the composition of the specific loan segment. Other considerations include volumes and trends of delinquencies, nonaccrual loans, levels of bankruptcies, criticized and classified loan trends, expected losses on real estate secured loans, new credit products and policies, economic conditions, concentrations of credit risk and the experience and abilities of our lending personnel. In addition to the segment evaluations, impaired loans with a balance of $250,000 or more are individually evaluated based on facts and circumstances of the loan to determine if a specific allowance amount may be necessary. Specific allowances may also be established for loans whose outstanding balances are below the $250,000 threshold when it is determined that the risk associated with the loan differs significantly from the risk factor amounts established for its loan segment. Certain loan segments were reclassified during the year. Each loan segment is made up of loan categories possessing similar risk characteristics. The Company’s re-alignment of the segments primarily consisted of reclassifying consumer-related and agricultural-related real estate loans from the real estate category to the consumer and agricultural categories, respectively. Management believes this accurately represents the risk profile of each loan segment. In addition, the real estate segment was renamed to commercial real estate, and the commercial segment was renamed to commercial & industrial. The prior period amounts have been revised to conform to the current period presentation. These reclassifications did not have a significant impact on the allowance for loan losses. Goodwill and Intangibles Goodwill from an acquisition is the value attributable to unidentifiable intangible elements acquired. At a minimum, annual evaluation of the value of goodwill is required. Management evaluated the carrying value of the Company’s goodwill as of December 31, 2018, 2017 and 2016, and determined that no impairment existed. An entity may assess qualitative factors to determine whether it is more likely than not that the fair value of a reporting unit is less than its carrying amount. Factors assessed include all relevant events and circumstances including macroeconomic conditions, industry and market conditions, cost factors that have a negative effect on earnings and cash flows, overall financial performance, other relevant entity or reporting unit specific events and, if applicable, a sustained decrease in share price. If after assessing the totality of events or circumstances, such as those described above, an entity determines that it is more likely than not that the fair value of a reporting unit is less than its carrying amount, then the entity is to perform a two-step impairment test. The first step of the impairment test compares the fair value of a reporting unit with its carrying amount, including goodwill. If the carrying amount of a reporting unit exceeds its fair value, the second step of the impairment test is to be performed to measure the amount of impairment loss, if any, when it is more likely than not that goodwill impairment exists. Other intangible assets consist of core deposit intangible assets and are amortized on a straight-line basis based on the estimated useful life of 10 years. Such assets are periodically evaluated as to the recoverability of their carrying values. Income Taxes The Company files a consolidated income tax return. Deferred taxes are recognized under the balance sheet method based upon the future tax consequences of temporary differences between the carrying amounts and tax basis of assets and liabilities, using the tax rates expected to apply to taxable income in the periods when the related temporary differences are expected to be realized. The amount of accrued current and deferred income taxes is based on estimates of taxes due or receivable from taxing authorities either currently or in the future. Changes in these accruals are reported as tax expense, and involve estimates of the various components included in determining taxable income, tax credits, other taxes and temporary differences. Changes periodically occur in the estimates due to changes in tax rates, tax laws and regulations and implementation of new tax planning strategies. The process of determining the accruals for income taxes necessarily involves the exercise of considerable judgment and consideration of numerous subjective factors. Management performs an analysis of the Company’s tax positions annually and believes it is more likely than not that all of its tax positions will be utilized in future years. Fair Value of Financial Instruments ASC Topic 820, Fair Value Measurement, defines fair value as the price that would be received to sell a financial asset or paid to transfer a financial liability in an orderly transaction between market participants at the measurement date. The degree of management judgment involved in determining the fair value of assets and liabilities is dependent upon the availability of quoted market prices or observable market parameters. For financial instruments that trade actively and have quoted market prices or observable market parameters, there is minimal subjectivity involved in measuring fair value. When observable market prices and parameters are not available, management judgment is necessary to estimate fair value. In addition, changes in market conditions may reduce the availability of quoted prices or the observable date.

<s>[INST] Unless the context indicates otherwise, references in this management’s discussion and analysis to “we”, “our”, and “us,” refer to Bank7 Corp. and its consolidated subsidiaries. All references to “the Bank” refer to Bank7, our wholly owned subsidiary. General We are Bank7 Corp., a bank holding company headquartered in Oklahoma City, Oklahoma. Through our whollyowned subsidiary, Bank7, we operate seven fullservice branches in Oklahoma, the Dallas/Fort Worth, Texas metropolitan area and Kansas. We are focused on serving business owners and entrepreneurs by delivering fast, consistent and welldesigned loan and deposit products to meet their financing needs. We intend to grow organically by selectively opening additional branches in our target markets and we will also pursue strategic acquisitions. As a bank holding company, we generate most of our revenue from interest income on loans and from shortterm investments. The primary source of funding for our loans and shortterm investments are deposits held by our subsidiary, Bank7. We measure our performance by our return on average assets, return on average equity, earnings per share, capital ratios, and our efficiency ratio, which is calculated by dividing noninterest expense by the sum of net interest income on a tax equivalent basis and noninterest income. As of December 31, 2018, we had total assets of $770.5 million, total loans of $599.9 million, total deposits of $675.9 million and total shareholders’ equity of $88.5 million. In September 2018, in conjunction with our initial public offering, the Company terminated its status as an S Corporation and elected to be treated as a C Corporation. As this termination occurred at the end of the third quarter, we have presented information as pretax and pro forma numbers in the nonGAAP reconciliation below. Our Initial Public Offering Our initial public offering, or IPO, closed on September 20, 2018 and a total of 2,900,000 shares of common stock were sold at $19.00 per share. After deducting underwriting discounts and offering expenses, the Company received total net proceeds of $50.1 million from the initial public offering and the exercise of the underwriter option. Upon completion of the IPO, the Company became a publicly traded company with our common stock listed on The NASDAQ Global Select Market under the symbol “BSVN”. Factors Affecting Comparability of Financial Results S Corporation Status Since our formation in 2004, we have elected to be taxed for U.S. federal income tax purposes as an S Corporation. As a result, our net income has not been subject to, and we have not paid, U.S. federal or state income taxes, and we have not been required to make any provision or recognize any liability for U.S. federal income tax in our financial statements. The consummation of our initial public offering resulted in the termination of our status as an S Corporation and in our taxation as a C Corporation for U.S. federal and state income tax purposes. Upon the termination of our status as an S Corporation, we commenced paying U.S. federal income tax on our pretax net income for each year (including the short year beginning on the date our status as an S Corporation terminated), and our financial statements reflect a provision for U.S. federal income tax. As a result of this change, the net income and earnings per share data presented in our historical financial statements and the other financial information set forth in this report (unless otherwise specified), which do not include any provision for U.S. federal income tax, will not be comparable with our future net income and earnings per share in periods after we commence to be taxed as a C Corporation, which will be calculated by including a provision for U.S. federal and state income tax. The termination of our status as an S Corporation may also affect our financial condition and cash flows. Historically, we have made periodic cash distributions to our shareholders in amounts estimated by us to be sufficient for such shareholders to pay their estimated individual U.S. federal income tax liability resulting from our taxable income that was “passed through” to them. However, these distributions have not been consistent, as sometimes the distributions have been in excess of the shareholder’s estimated individual U.S. federal income tax liability resulting [/INST] Negative. </s>

Bank7 Corp.

2020-03-30

2019-12-31

Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations The following discussion and analysis of our financial condition and results of operations should be read in conjunction with our consolidated financial statements and related notes included elsewhere in this report. Unless the context indicates otherwise, references in this management’s discussion and analysis to “we”, “our”, and “us,” refer to Bank7 Corp. and its consolidated subsidiaries. All references to “the Bank” refer to Bank7, our wholly owned subsidiary. General We are Bank7 Corp., a bank holding company headquartered in Oklahoma City, Oklahoma. Through our wholly-owned subsidiary, Bank7, we operate nine full-service branches in Oklahoma, the Dallas/Fort Worth, Texas metropolitan area and Kansas. We are focused on serving business owners and entrepreneurs by delivering fast, consistent and well-designed loan and deposit products to meet their financing needs. We intend to grow organically by selectively opening additional branches in our target markets and we will also pursue strategic acquisitions. As a bank holding company, we generate most of our revenue from interest income on loans and from short-term investments. The primary source of funding for our loans and short-term investments are deposits held by our subsidiary, Bank7. We measure our performance by our return on average assets, return on average equity, earnings per share, capital ratios, and our efficiency ratio, which is calculated by dividing noninterest expense by the sum of net interest income on a tax equivalent basis and noninterest income. As of December 31, 2019, we had total assets of $866.4 million, total loans of $707.3 million, total deposits of $757.5 million and total shareholders’ equity of $100.1 million. In September 2018, in conjunction with our initial public offering, the Company terminated its status as an S Corporation and elected to be treated as a C Corporation. As this termination occurred at the end of the third quarter, we have presented information as pre-tax and pro forma numbers in the non-GAAP reconciliation below. In December 2019, a novel strain of coronavirus was reported in Wuhan, China. The World Health Organization has declared the outbreak to constitute a “Public Health Emergency of International Concern.” The COVID-19 outbreak is disrupting supply chains and affecting production and sales across a range of industries. The extent of the impact of COVID-19 on our operational and financial performance will depend on certain developments, including the duration and spread of the outbreak, impact on our customers, employees and vendors all of which are uncertain and cannot be predicted. At this point, the extent to which COVID-19 may impact our financial condition or results of operations is uncertain. Our Initial Public Offering Our initial public offering, or IPO, closed on September 20, 2018 and a total of 2,900,000 shares of common stock were sold at $19.00 per share. After deducting underwriting discounts and offering expenses, the Company received total net proceeds of $50.1 million from the initial public offering and the exercise of the underwriter option. Upon completion of the IPO, the Company became a publicly traded company with our common stock listed on The NASDAQ Global Select Market under the symbol “BSVN”. Factors Affecting Comparability of Financial Results S Corporation Status Since our formation in 2004, we have elected to be taxed for U.S. federal income tax purposes as an S Corporation. As a result, our net income has not been subject to, and we have not paid, U.S. federal or state income taxes, and we have not been required to make any provision or recognize any liability for U.S. federal income tax in our financial statements. The consummation of our initial public offering resulted in the termination of our status as an S Corporation and in our taxation as a C Corporation for U.S. federal and state income tax purposes. Upon the termination of our status as an S Corporation, we commenced paying U.S. federal income tax on our pre-tax net income for each year (including the short year beginning on the date our status as an S Corporation terminated), and our financial statements reflect a provision for U.S. federal income tax. As a result of this change, the net income and earnings per share data presented in our historical financial statements and the other financial information set forth in this report (unless otherwise specified), which do not include any provision for U.S. federal income tax, will not be comparable with our future net income and earnings per share in periods after we commence to be taxed as a C Corporation, which will be calculated by including a provision for U.S. federal and state income tax. The termination of our status as an S Corporation may also affect our financial condition and cash flows. Historically, we have made periodic cash distributions to our shareholders in amounts estimated by us to be sufficient for such shareholders to pay their estimated individual U.S. federal income tax liability resulting from our taxable income that was “passed through” to them. However, these distributions have not been consistent, as sometimes the distributions have been in excess of the shareholder’s estimated individual U.S. federal income tax liability resulting from the ownership of our shares. In addition, these estimates have been based on individual U.S. federal income tax rates, which may differ from the rates imposed on the income of C Corporations. With the termination of our status as an S Corporation, no income will be “passed through” to any shareholders, but, as noted above, we will commence paying U.S. federal income tax. The amounts that we have historically distributed to the shareholders are not indicative of the amount of U.S. federal income tax that we will be required to pay after we commence to be taxed as a C Corporation. Depending on our effective tax rate and our future dividend rate, if any, our future cash flows and financial condition could be positively or adversely affected compared to our historical cash flows and financial condition. Furthermore, deferred tax assets and liabilities will be recognized for the future tax consequences attributable to differences between the financial statement carrying amounts of our existing assets and liabilities and their respective tax bases. Deferred tax assets and liabilities are measured using tax rates expected to apply to taxable income in the years in which those temporary differences are expected to be recovered or settled. The effect on deferred tax assets and liabilities of the change in tax rates resulting from becoming a C Corporation were recognized in income in the quarter the change took place. This difference between the financial statement carrying amounts of assets and liabilities and their respective tax bases was recorded as a net deferred tax asset of $1.1 million (net of $13,000 uncertain tax liability) on our consolidated balance sheet as of December 31, 2019. Pro Forma Income Tax Expense and Net Income As a result of our status as an S Corporation, we had no U.S. federal income tax expense for the year ended December 31, 2017. Further, we do not have U.S. federal income tax expense for the full year ended December 31, 2018, but rather only for the short year after conversion to C corporation status (as discussed earlier). The pro forma impact of being taxed as a C Corporation is illustrated in the following table: (1) A portion of our net income in each of these periods was derived from nontaxable investment income and other nondeductible expenses. (2) Based on a statutory federal income tax rate of 21%, 21%, and 35% for the years ended December 31, 2019, 2018 and 2017, respectively, plus the applicable statutory state income tax rate for each of the respective periods. State income tax expense would have been approximately: - $1.2 million for the year ended December 31, 2019 with an effective state tax rate of 4.4% - $1.3 million for the year ended December 31, 2018 with an effective state tax rate of 4.9% - $1.3 million for the year ended December 31, 2017 with an effective state tax rate of 5.4% 2019 Highlights For the year ended December 31, 2019, we reported pre-tax net income of $15.0 million compared to pre-tax net income of $25.8 million for the year ended December 31, 2018. The decrease was related to compensation expense from the one-time, non-cash executive stock transaction. For the year ended December 31, 2019, average loans totaled $636.3 million, an increase of $52.5 million or 9.0%, from December 31, 2018. For the year ended December 31, 2019, loan yields, excluding loan fee income, were 6.88%, an increase of 17 basis points from the same period in 2018. Loan yield excluding loan fee income is a non-GAAP measure. See “GAAP Reconciliation and Management Explanation of Non-GAAP Financial Measures” elsewhere in this report. Pre-tax return on average assets and return on average equity was 1.88% and 15.44%, respectively for the year ended December 31, 2019, as compared to 3.53% and 33.01%, respectively, for the same period in 2018. Our efficiency ratio for the year ended December 31, 2019 was 65.39% as compared to 37.04% for the year ended December 31, 2018. As of December 31, 2019, total loans were $707.3 million, an increase of $107.4 million, or 17.9%, from December 31, 2018. Total deposits were $757.5 million as of December 31, 2019, an increase of $81.6 million, or 12.1%, from December 31, 2018. Tangible book value per share was $9.78 as of December 31, 2019, an increase of $1.29, or 15.2%, from December 31, 2018. Tangible book value per share is a non-GAAP financial measure. See “GAAP Reconciliation and Management Explanation of Non-GAAP Financial Measures” elsewhere in this report. Results of Operations Years Ended December 31, 2019, December 31, 2018, and December 31, 2017 Net Interest Income and Net Interest Margin The following table presents, for the periods indicated, information about: (i) weighted average balances, the total dollar amount of interest income from interest-earning assets, and the resultant average yields; (ii) average balances, the total dollar amount of interest expense on interest-bearing liabilities, and the resultant average rates; (iii) net interest income; and (iv) the net interest margin. (1) Includes income and weighted average balances for fed funds sold, interest-earning deposits in banks and other miscellaneous interest-earning assets. (2) Includes income and weighted average balances for FHLB and FRB stock. (3) Average loan balances include monthly average nonaccrual loans of $2.1 million, $991,000 and $2.6 million for the years ended December 31, 2019, 2018 and 2017, respectively. (4) Net interest spread is the average yield on interest-earning assets minus the average rate on interest-bearing liabilities. We continued to experience strong asset growth for the year ended December 31, 2019 compared to the year ended December 31, 2018: - Total interest income on loans increased $3.9 million, or 8.9%, to $48.2 million which was attributable to a $52.5 million increase in the average balance of loans to $636.3 million during the year ended 2019 as compared with the average balance of $583.8 million for the year ended 2018; - Loan fees totaled $4.4 million, a decrease of $678,000 or 13.2% which was attributable to nonrecurring loan fee income earned during the year ended 2018 as compared to 2019; - Yields on our interest-earning assets totaled 6.55%, an increase of 7 basis points; and - Net interest margin for the year ended 2019 and 2018 was 5.35% and 5.49%, respectively. For the year ended December 31, 2018 compared to the year ended December 31, 2017: - Total interest income on loans increased $2.8 million, or 6.8%, to $44.3 million which was attributable to a $44.7 million increase in the average balance of loans to $583.8 million during the year ended 2018 as compared with the average balance of $539.1 million for the year ended 2017; - Loan fees totaled $5.1 million, a decrease of $3.2 million or 38.5% which was attributable to nonrecurring loan fee income earned during the year ended 2017 as compared to 2018; - Yields on our interest-earning assets totaled 6.48%, a decrease of 12 basis points which was attributable to the $3.2 million decrease in nonrecurring loan fee income earned during the year ended 2018; and - Net interest margin for the year ended 2018 and 2017 was 5.49% and 5.87%, respectively. Interest income on short-term investments increased $938,000, or 37.21%, to $3.5 million for year ended December 31, 2019, due to an increase in the average balances of $14.5 million, or 10.63% and a yield increase of 44 basis points. Interest income on short-term investments increased $1.1 million, or 77.54%, to $2.5 million for the year ended December 31, 2018, due to an increase in the average balances of $27.4 million, or 25.11%, and a yield increase of 54 basis points. Interest expense on interest-bearing deposits totaled $9.5 million for the year ended December 31, 2019, compared to $7.0 million for 2018, an increase of $2.5 million, or 36.06%. The increase was related to average daily interest bearing deposit balances increasing by $43.0 million or 9.34% while the cost of interest-bearing deposits grew to 1.89% for the year ended December 31, 2019 from 1.52% for the year ended December 31, 2018. Interest expense on interest-bearing deposits totaled $7.0 million for the year ended December 31, 2018, compared to $4.5 million for 2017, an increase of $2.5 million, or 55.35%. The increase was related to average daily interest bearing deposit balances increasing by $17.6 million or 3.97% while the cost of interest-bearing deposits grew to 1.52% for the year ended December 31, 2018 from 1.02% for the year ended December 31, 2017. Net interest margin, including loan fee income, for the years ended December 31, 2019, 2018 and 2017 was 5.35%, 5.49% and 5.87%, respectively. Our net interest margin has decreased from 2017 and 2018 levels due to larger loan fee income in prior years. Excluding our loan fee income, net interest margin for the years ended December 31, 2019, 2018 and 2017 was 4.78%, 4.78% and 4.59%, respectively. Net interest margin excluding loan fee income is a non-GAAP measure. See “GAAP Reconciliation and Management Explanation of Non-GAAP Financial Measures” elsewhere in this report. The following table sets forth the effects of changing rates and volumes on our net interest income during the period shown. Information is provided with respect to (i) effects on interest income attributable to changes in volume (change in volume multiplied by prior rate) and (ii) effects on interest income attributable to changes in rate (changes in rate multiplied by prior volume). (1) Variances attributable to both volume and rate are allocated on a consistent basis between rate and volume based on the absolute value of the variances in each category. Provision for Loan Losses For the year ended December 31, 2019 compared to the year ended December 31, 2018: - The provision for loan losses decreased by $200,000, or 100%, to $0; and - The allowance as a percentage of loans decreased by 20 basis points to 1.11%. For the year ended December 31, 2018 compared to the year ended December 31, 2017: - The provision for loan losses decreased by $1 million, or 83.95%, to $200,000; and - The allowance as a percentage of loans decreased by 5 basis points to 1.31%. Noninterest Income Noninterest income for the year ended December 31, 2019 was $1.3 million compared to $1.3 million for the year ended December 31, 2018, a decrease of $23,000, or 1.73%. Noninterest income for the year ended December 31, 2018 was $1.3 million compared to $1.4 million for the year ended December 31, 2017, a decrease of $104,000, or 7.25%. The following table sets forth the major components of our noninterest income for the years ended December 31, 2019, 2018 and 2017: Noninterest Expense Noninterest expense for the year ended December 31, 2019 was $28.4 compared to $15.0 million for the year ended December 31, 2018, an increase of $13.5 million or 90.0%. Noninterest expense for the year ended December 31, 2018 was $15.0 compared to $14.5 million for the year ended December 31, 2017, an increase of $434,000, or 3.0%. The following table sets forth the major components of our noninterest expense for the years ended December 31, 2019, 2018 and 2017: For the year ended December 31, 2019 compared to the year ended December 31, 2018: - Salaries and employee benefits expense was $21.3 million compared to $8.1 million, an increase of $13.2 million, or 162.1%. The increase in 2019 was attributable to our one-time non-cash executive stock transaction. - Occupancy expense was $1.7 million compared to $1.1 million, an increase of $572,000, or 51.8%. The increase in 2019 was primarily due to the renovation of our headquarters and the expansion into two new markets. - Accounting, legal and professional fees were $757,000 compared to $305,000, an increase of $452,000, or 148.2%. The increase was primarily due to 2019 being our first full year as a public company. For the year ended December 31, 2018 compared to the year ended December 31, 2017: - Salaries and employee benefits expense was $8.1 million compared to $7.6 million, an increase of $502,000, or 6.6%. The increase in 2018 was attributable to higher salaries and incentive compensation expense. - Furniture and equipment expense was $684,000 compared to $831,000, a decrease of $147,000, or 17.7%. The decrease in 2018 was primarily due to lower bank vehicle expenses compared to 2017. - Regulatory assessments totaled $542,000 compared to $450,000, an increase of $92,000, or 20.4%. The change came primarily from FDIC assessments that totaled $440,000 in 2018 compared to $394,000 in 2017, an increase of $46,000, or 11.7%. The increase is due to a higher assessment associated with an increase in deposits accounts due to organic growth and expansion into the Texas market. - Travel, lodging and entertainment expense was $699,000 compared to $1.0 million, a decrease of $342,000, or 32.9%. The decrease in 2018 was primarily due to lower aircraft expenses as the aircraft was sold at the end of the third quarter of 2018. Financial Condition The following discussion of our financial condition compares December 31, 2019, 2018, and 2017. Total Assets Total assets increased $95.9 million, or 12.4%, to $886.4 million as of December 31, 2019, as compared to $770.5 million as of December 31, 2018 and $703.6 million as of December 31, 2017. The increasing trend in total assets is primarily attributable to strong organic loan and retail deposit growth within the Oklahoma City market and expansion into the Dallas/Fort Worth metropolitan area. Loan Portfolio Our loans represent the largest portion of our earning assets. The quality and diversification of the loan portfolio is an important consideration when reviewing our financial condition. As of December 31, 2019, 2018 and 2017, our gross loans were $708.7 million, $601.9 million and $564.6 million, respectively. The following table presents the balance and associated percentage of each major category in our loan portfolio as of December 31, 2019, December 31, 2018 and December 31, 2017: We have established internal concentration limits in the loan portfolio for CRE loans, hospitality loans, energy loans, and construction loans, among others. All loan types are within our established limits. We use underwriting guidelines to assess each borrower’s historical cash flow to determine debt service, and we further stress test the debt service under higher interest rate scenarios. Financial and performance covenants are used in commercial lending to allow us to react to a borrower’s deteriorating financial condition, should that occur. The following tables show the contractual maturities of our gross loans as of the periods below: Allowance for Loan and Lease Losses The allowance is based on management’s estimate of probable losses inherent in the loan portfolio. In the opinion of management, the allowance is adequate to absorb estimated losses in the portfolio as of each balance sheet date. While management uses available information to analyze losses on loans, future additions to the allowance may be necessary based on changes in economic conditions. In addition, various regulatory agencies, as an integral part of their examination process, periodically review the Company’s allowance. In analyzing the adequacy of the allowance, a comprehensive loan grading system to determine risk potential in loans is utilized together with the results of internal credit reviews. To determine the adequacy of the allowance, the loan portfolio is broken into segments based on loan type. Historical loss experience factors by segment, adjusted for changes in trends and conditions, are used to determine an indicated allowance for each portfolio segment. These factors are evaluated and updated based on the composition of the specific loan segment. Other considerations include volumes and trends of delinquencies, nonaccrual loans, levels of bankruptcies, criticized and classified loan trends, expected losses on real estate secured loans, new credit products and policies, economic conditions, concentrations of credit risk and the experience and abilities of our lending personnel. In addition to the segment evaluations, impaired loans with a balance of $250,000 or more are individually evaluated based on facts and circumstances of the loan to determine if a specific allowance amount may be necessary. Specific allowances may also be established for loans whose outstanding balances are below the $250,000 threshold when it is determined that the risk associated with the loan differs significantly from the risk factor amounts established for its loan segment. The allowance was $7.8 million at December 31, 2019, $7.8 million at December 31, 2018 and $7.7 million at December 31, 2017. The increasing trend was related to, and in conjunction with, loan growth. The following table provides an analysis of the activity in our allowance for the periods indicated: While the entire allowance is available to absorb losses from any and all loans, the following table represents management’s allocation of the allowance by loan category, and the percentage of allowance in each category, for the periods indicated: Nonperforming Assets Loans are considered delinquent when principal or interest payments are past due 30 days or more. Delinquent loans may remain on accrual status between 30 days and 90 days past due. Loans on which the accrual of interest has been discontinued are designated as nonaccrual loans. Typically, the accrual of interest on loans is discontinued when principal or interest payments are past due 90 days or when, in the opinion of management, there is a reasonable doubt as to collectability of the obligation. When loans are placed on nonaccrual status, all interest previously accrued but not collected is reversed against current period interest income. Income on a nonaccrual loan is subsequently recognized only to the extent that cash is received and the loan’s principal balance is deemed collectible. Loans are restored to accrual status when loans become well-secured and management believes full collectability of principal and interest is probable. A loan is considered impaired when it is probable that we will be unable to collect all amounts due according to the contractual terms of the loan agreement. Impaired loans include loans on nonaccrual status and loans modified in a troubled debt restructuring, or TDR. Income from a loan on nonaccrual status is recognized to the extent cash is received and when the loan’s principal balance is deemed collectible. Depending on a particular loan’s circumstances, we measure impairment of a loan based upon either the present value of expected future cash flows discounted at the loan’s effective interest rate, the loan’s observable market price, or the fair value of the collateral less estimated costs to sell if the loan is collateral dependent. A loan is considered collateral dependent when repayment of the loan is based solely on the liquidation of the collateral. Fair value, where possible, is determined by independent appraisals, typically on an annual basis. Between appraisal periods, the fair value may be adjusted based on specific events, such as if deterioration of quality of the collateral comes to our attention as part of our problem loan monitoring process, or if discussions with the borrower lead us to believe the last appraised value no longer reflects the actual market for the collateral. The impairment amount on a collateral dependent loan is charged off to the allowance if deemed not collectible and the impairment amount on a loan that is not collateral dependent is set up as a specific reserve. In cases where a borrower experiences financial difficulties and we make certain concessionary modifications to contractual terms, the loan is classified as a TDR. Included in certain loan categories of impaired loans are TDRs on which we have granted certain material concessions to the borrower as a result of the borrower experiencing financial difficulties. The concessions granted by us may include, but are not limited to: (1) a modification in which the maturity date, timing of payments or frequency of payments is modified, (2) an interest rate lower than the current market rate for new loans with similar risk, or (3) a combination of the first two concessions. If a borrower on a restructured accruing loan has demonstrated performance under the previous terms, is not experiencing financial difficulty and shows the capacity to continue to perform under the restructured terms, the loan will remain on accrual status. Otherwise, the loan will be placed on nonaccrual status until the borrower demonstrates a sustained period of performance, which generally requires six consecutive months of payments. Loans identified as TDRs are evaluated for impairment using the present value of the expected cash flows or the estimated fair value of the collateral, if the loan is collateral dependent. The fair value is determined, when possible, by an appraisal of the property less estimated costs related to liquidation of the collateral. The appraisal amount may also be adjusted for current market conditions. Adjustments to reflect the present value of the expected cash flows or the estimated fair value of collateral dependent loans are a component in determining an appropriate allowance, and as such, may result in increases or decreases to the provision for loan losses in current and future earnings. Real estate we acquire as a result of foreclosure or by deed-in-lieu of foreclosure is classified as other real estate owned, or OREO, until sold, and is initially recorded at fair value less costs to sell when acquired, establishing a new cost basis. Nonperforming loans include nonaccrual loans, loans past due 90 days or more and still accruing interest and loans modified under TDRs that are not performing in accordance with their modified terms. Nonperforming assets consist of nonperforming loans plus OREO. Loans accounted for on a nonaccrual basis were $1.8 million as of December 31, 2019, $2.6 million as of December 31, 2018 and $1.2 million as of December 31, 2017. The gross balance of loans accounted for on a nonaccrual basis at December 31, 2019 was $1.8 million; however, this amount includes one relationship with a balance of $1.8 million, of which 75% is guaranteed by the Small Business Administration (“SBA”). OREO was $0 as of December 31, 2019, $110,000 as of December 31, 2018 and $100,000 as of December 31, 2017. The following table presents information regarding nonperforming assets as of the dates indicated. The following tables present an aging analysis of loans as of the dates indicated. In addition to the past due and nonaccrual criteria, the Company also evaluates loans according to its internal risk grading system. Loans are segregated between pass, watch, special mention, and substandard categories. The definitions of those categories are as follows: In addition to the past due and nonaccrual criteria, the Company also evaluates loans according to its internal risk grading system. Loans are segregated between pass, watch, special mention, and substandard categories. The definitions of those categories are as follows: Pass: These loans generally conform to Bank policies, are characterized by policy-conforming advance rates on collateral, and have well-defined repayment sources. In addition, these credits are extended to borrowers and guarantors with a strong balance sheet and either substantial liquidity or a reliable income history. Watch: These loans are still considered “Pass” credits; however, various factors such as industry stress, material changes in cash flow or financial conditions, or deficiencies in loan documentation, or other risk issues determined by the lending officer, Commercial Loan Committee or CQC warrant a heightened sense and frequency of monitoring. Special mention: These loans have observable weaknesses or evidence imprudent handling or structural issues. The weaknesses require close attention, and the remediation of those weaknesses is necessary. No risk of probable loss exists. Credits in this category are expected to quickly migrate to “Watch” or “Substandard” as this is viewed as a transitory loan grade. Substandard: These loans are not adequately protected by the sound worth and debt service capacity of the borrower, but may be well-secured. The loans have defined weaknesses relative to cash flow, collateral, financial condition or other factors that might jeopardize repayment of all of the principal and interest on a timely basis. There is the possibility that a future loss will occur if weaknesses are not remediated. Substandard loans totaled $11.1 million as of December 31, 2019, an increase of $2.0 million compared to December 31, 2018. The increase primarily related to one agricultural relationship comprised of four notes totaling $1.8 million with no specific reserve, one agricultural relationship comprised of three notes totaling $555,000 with no specific reserve, one mixed relationship comprised of eight notes totaling $4.2 million with no specific reserve, and one mixed relationship comprised of four notes totaling $2.8 million with no specific reserve. Outstanding loan balances categorized by internal risk grades as of the periods indicated are summarized as follows: Troubled Debt Restructurings TDRs are defined as those loans in which a bank, for economic or legal reasons related to a borrower’s financial difficulties, grants a concession to the borrower that it would not otherwise consider. A loan is considered impaired when, based on current information and events, it is probable that the Company will be unable to collect all amounts due from the borrower in accordance with original contractual terms of the loan. Loans with insignificant delays or insignificant short-falls in the amount of payments expected to be collected are not considered to be impaired. Loans defined as individually impaired, based on applicable accounting guidance, include larger balance nonperforming loans and TDRs. The following table presents loans restructured as TDRs as of December 31, 2019, December 31, 2018 and December 31, 2017. There were no payment defaults with respect to loans modified as TDRs as of December 31, 2019, 2018, and 2017. Impairment analyses are prepared on TDRs in conjunction with the normal allowance process. TDRs restructured during the years ended December 31, 2019, 2018 and 2017 required $26,000, $0 and $300,000 in specific reserves, respectively. There were no charge-offs on TDRs for the years ended December 31, 2019, 2018 or 2017. The following table presents total TDRs, both in accrual and nonaccrual status as of the periods indicated: Deposits We gather deposits primarily through our seven branch locations and online though our website. We offer a variety of deposit products including demand deposit accounts and interest-bearing products, such as savings accounts and certificates of deposit. We put continued effort into gathering noninterest-bearing demand deposit accounts through loan production cross-selling, customer referrals, marketing efforts and various involvement with community networks. Some of our interest-bearing deposits were obtained through brokered transactions. We participate in the CDARS program, where customer funds are placed into multiple certificates of deposit, each in an amount under the standard FDIC insurance maximum of $250,000, and placed at a network of banks across the United States. Total deposits as of December 31, 2019, 2018 and 2017 were $757.5 million, $675.9 million and $625.8 million, respectively. The following table sets forth deposit balances by certain categories as of the dates indicated and the percentage of each deposit category to total deposits. The following table summarizes our average deposit balances and weighted average rates for the years ended December 31, 2019, 2018 and 2017: The following tables set forth the maturity of time deposits as of the dates indicated below: Other Borrowed Funds The Company had debt outstanding with The Bankers Bank of $5.6 million at December 31, 2017, secured by certain shares of common stock of the Bank held by the Company. The purpose of this transaction was to facilitate the purchase of The Montezuma State Bank in 2014 and to inject capital into the Bank. The remaining principal balance of the note, as well as the accrued interest payable, was paid in full in September 2018. Liquidity Liquidity refers to the measure of our ability to meet the cash flow requirements of depositors and borrowers, while at the same time meeting our operating, capital and strategic cash flow needs, all at a reasonable cost. We continuously monitor our liquidity position to ensure that assets and liabilities are managed in a manner that will meet all short-term and long-term cash requirements. We manage our liquidity position to meet the daily cash flow needs of customers, while maintaining an appropriate balance between assets and liabilities to meet the return on investment objectives of our shareholders. Our liquidity position is supported by management of liquid assets and access to alternative sources of funds. Our liquid assets include cash, interest-bearing deposits in correspondent banks and fed funds sold. Other available sources of liquidity include wholesale deposits and borrowings from correspondent banks and FHLB advances. Our short-term and long-term liquidity requirements are primarily met through cash flow from operations, redeployment of prepaying and maturing balances in our loan portfolios, and increases in customer deposits. Other alternative sources of funds will supplement these primary sources to the extent necessary to meet additional liquidity requirements on either a short-term or long-term basis. As of December 31, 2019, we had no unsecured fed funds lines with correspondent depository institutions with no amounts advanced. In addition, based on the values of loans pledged as collateral, we had borrowing availability with the FHLB of $71.7 million as of December 31, 2019 and $66.3 million as of December 31, 2018. Capital Requirements The Bank is subject to various regulatory capital requirements administered by the federal and state banking regulators. Failure to meet regulatory capital requirements may result in certain mandatory and possible additional discretionary actions by regulators that, if undertaken, could have a direct material effect on our financial statements. Under capital adequacy guidelines and the regulatory framework for “prompt corrective action” (described below), the Bank must meet specific capital guidelines that involve quantitative measures of our assets, liabilities and certain off-balance sheet items as calculated under regulatory accounting policies. The capital amounts and classifications are subject to qualitative judgments by the federal banking regulators about components, risk weightings and other factors. Qualitative measures established by regulation to ensure capital adequacy required the Bank to maintain minimum amounts and ratios of Common Equity Tier 1, or CET1, capital, Tier 1 capital and total capital to risk-weighted assets and of Tier 1 capital to average consolidated assets, referred to as the “leverage ratio.” For further information, see “Supervision and Regulation - Regulatory Capital Requirements” and “Supervision and Regulation - Prompt Corrective Action Framework.” In the wake of the global financial crisis of 2008 and 2009, the role of capital has become fundamentally more important, as banking regulators have concluded that the amount and quality of capital held by banking organizations was insufficient to absorb losses during periods of severely distressed economic conditions. The Dodd-Frank Act and banking regulations promulgated by the U.S. federal banking regulators to implement Basel III have established strengthened capital standards for banks and bank holding companies and require more capital to be held in the form of common stock. These provisions, which generally became applicable to the Bank on January 1, 2015, impose meaningfully more stringent regulatory capital requirements than those applicable to the Bank prior to that date. In addition, the Basel III regulations implement a concept known as the “capital conservation buffer.” In general, banks, bank holding companies with more than $3.0 billion in assets and bank holding companies with publicly-traded equity are required to hold a buffer of CET1 capital equal to 2.5% of risk-weighted assets over each minimum capital ratio by January 1, 2019 in order to avoid being subject to limits on capital distributions (e.g., dividends, stock buybacks, etc.) and certain discretionary bonus payments to executive officers. For community banks, such as us, the capital conservation buffer requirement commenced on January 1, 2016, with a gradual phase-in. Full compliance with the capital conservation buffer was required by January 1, 2019. As of December 31, 2019, the FDIC categorized the Bank as “well-capitalized” under the prompt corrective action framework. There have been no conditions or events since December 31, 2019 that management believes would change this classification. The table below also summarizes the capital requirements applicable to the Bank in order to be considered “well-capitalized” from a regulatory perspective, as well as the Bank’s capital ratios as of December 31, 2019, 2018 and 2017. The Bank exceeded all regulatory capital requirements under Basel III and the Bank was considered to be “well-capitalized” as of the dates reflected in the tables below. Shareholders’ equity provides a source of permanent funding, allows for future growth and provides a cushion to withstand unforeseen adverse developments. Total shareholders’ equity increased to $100.1 million as of December 31, 2019, compared to $88.5 million as of December 31, 2018 and $69.2 million as of December 31, 2017. The increases were driven by retained capital from net income during the periods. Contractual Obligations The following tables contain supplemental information regarding our total contractual obligations as of December 31, 2019: We believe that we will be able to meet our contractual obligations as they come due through the maintenance of adequate cash levels. We expect to maintain adequate cash levels through profitability, loan repayment and maturity activity and continued deposit gathering activities. We have in place various borrowing mechanisms for both short-term and long-term liquidity needs. Off-Balance Sheet Arrangements We are a party to financial instruments with off-balance sheet risk in the normal course of business to meet the financing needs of our customers. These financial instruments include commitments to extend credit and standby letters of credit. Those instruments involve, to varying degrees, elements of credit and interest rate risk in excess of the amount recognized in the consolidated balance sheet. The contractual or notional amounts of those instruments reflect the extent of involvement we have in particular classes of financial instruments. To control this credit risk, the Company uses the same underwriting standards as it uses for loans recorded on the balance sheet. Loan commitments are agreements to lend to a customer, as long as there is no violation of any condition established in the contract. Standby letters of credit are conditional commitments issued by the Company to guarantee the performance of the customer to a third party. They are intended to be disbursed, subject to certain conditions, upon request of the borrower. The following table summarizes commitments as of the dates presented. Critical Accounting Policies and Estimates Our accounting and reporting policies conform to GAAP and conform to general practices within the industry in which we operate. To prepare financial statements in conformity with GAAP, management makes estimates, assumptions and judgments based on available information. These estimates, assumptions and judgments affect the amounts reported in the financial statements and accompanying notes. These estimates, assumptions and judgments are based on information available as of the date of the financial statements and, as this information changes, actual results could differ from the estimates, assumptions and judgments reflected in the financial statement. In particular, management has identified several accounting policies that, due to the estimates, assumptions and judgments inherent in those policies, are critical in understanding our financial statements. The JOBS Act permits us an extended transition period for complying with new or revised accounting standards affecting public companies. We have elected to take advantage of this extended transition period, which means that the financial statements included in this report, as well as any financial statements that we file in the future, will not be subject to all new or revised accounting standards generally applicable to public companies for the transition period for so long as we remain an emerging growth company or until we affirmatively and irrevocably opt out of the extended transition period under the JOBS Act. The following is a discussion of the critical accounting policies and significant estimates that we believe require us to make the most complex or subjective decisions or assessments. Additional information about these policies can be found in Note 1 of the Company’s consolidated financial statements as of December 31, 2019. Allowance for Loan and Lease Losses The allowance is based on management’s estimate of probable losses inherent in the loan portfolio. In the opinion of management, the allowance is adequate to absorb estimated losses in the portfolio as of each balance sheet date. While management uses available information to analyze losses on loans, future additions to the allowance may be necessary based on changes in economic conditions and changes in the composition of the loan portfolio. In addition, various regulatory agencies, as an integral part of their examination process, periodically review the Bank’s allowance. In analyzing the adequacy of the allowance, a comprehensive loan grading system to determine risk potential in loans is utilized together with the results of internal credit reviews. To determine the adequacy of the allowance, the loan portfolio is broken into segments based on loan type. Historical loss experience factors by segment, adjusted for changes in trends and conditions, are used to determine an indicated allowance for each portfolio segment. These factors are evaluated and updated based on the composition of the specific loan segment. Other considerations include volumes and trends of delinquencies, nonaccrual loans, levels of bankruptcies, criticized and classified loan trends, expected losses on real estate secured loans, new credit products and policies, economic conditions, concentrations of credit risk and the experience and abilities of our lending personnel. In addition to the segment evaluations, impaired loans with a balance of $250,000 or more are individually evaluated based on facts and circumstances of the loan to determine if a specific allowance amount may be necessary. Specific allowances may also be established for loans whose outstanding balances are below the $250,000 threshold when it is determined that the risk associated with the loan differs significantly from the risk factor amounts established for its loan segment. Certain loan segments were reclassified during 2018. Each loan segment is made up of loan categories possessing similar risk characteristics. The Company’s re-alignment of the segments primarily consisted of reclassifying consumer-related and agricultural-related real estate loans from the real estate category to the consumer and agricultural categories, respectively. Management believes this accurately represents the risk profile of each loan segment. In addition, the real estate segment was renamed to commercial real estate, and the commercial segment was renamed to commercial & industrial. The prior period amounts have been revised to conform to the current period presentation. These reclassifications did not have a significant impact on the allowance for loan losses. Goodwill and Intangibles Goodwill from an acquisition is the value attributable to unidentifiable intangible elements acquired. At a minimum, annual evaluation of the value of goodwill is required. Management evaluated the carrying value of the Company’s goodwill as of December 31, 2019, 2018 and 2017, and determined that no impairment existed. An entity may assess qualitative factors to determine whether it is more likely than not that the fair value of a reporting unit is less than its carrying amount. Factors assessed include all relevant events and circumstances including macroeconomic conditions, industry and market conditions, cost factors that have a negative effect on earnings and cash flows, overall financial performance, other relevant entity or reporting unit specific events and, if applicable, a sustained decrease in share price. If after assessing the totality of events or circumstances, such as those described above, an entity determines that it is more likely than not that the fair value of a reporting unit is less than its carrying amount, then the entity is to perform a two-step impairment test. The first step of the impairment test compares the fair value of a reporting unit with its carrying amount, including goodwill. If the carrying amount of a reporting unit exceeds its fair value, the second step of the impairment test is to be performed to measure the amount of impairment loss, if any, when it is more likely than not that goodwill impairment exists. Other intangible assets consist of core deposit intangible assets and are amortized on a straight-line basis based on the estimated useful life of 10 years. Such assets are periodically evaluated as to the recoverability of their carrying values. Income Taxes The Company files a consolidated income tax return. Deferred taxes are recognized under the balance sheet method based upon the future tax consequences of temporary differences between the carrying amounts and tax basis of assets and liabilities, using the tax rates expected to apply to taxable income in the periods when the related temporary differences are expected to be realized. The amount of accrued current and deferred income taxes is based on estimates of taxes due or receivable from taxing authorities either currently or in the future. Changes in these accruals are reported as tax expense, and involve estimates of the various components included in determining taxable income, tax credits, other taxes and temporary differences. Changes periodically occur in the estimates due to changes in tax rates, tax laws and regulations and implementation of new tax planning strategies. The process of determining the accruals for income taxes necessarily involves the exercise of considerable judgment and consideration of numerous subjective factors. Management performs an analysis of the Company’s tax positions annually and believes it is more likely than not that all of its tax positions will be utilized in future years. Fair Value of Financial Instruments ASC Topic 820, Fair Value Measurement, defines fair value as the price that would be received to sell a financial asset or paid to transfer a financial liability in an orderly transaction between market participants at the measurement date. The degree of management judgment involved in determining the fair value of assets and liabilities is dependent upon the availability of quoted market prices or observable market parameters. For financial instruments that trade actively and have quoted market prices or observable market parameters, there is minimal subjectivity involved in measuring fair value. When observable market prices and parameters are not available, management judgment is necessary to estimate fair value. In addition, changes in market conditions may reduce the availability of quoted prices or the observable date.

<s>[INST] Unless the context indicates otherwise, references in this management’s discussion and analysis to “we”, “our”, and “us,” refer to Bank7 Corp. and its consolidated subsidiaries. All references to “the Bank” refer to Bank7, our wholly owned subsidiary. General We are Bank7 Corp., a bank holding company headquartered in Oklahoma City, Oklahoma. Through our whollyowned subsidiary, Bank7, we operate nine fullservice branches in Oklahoma, the Dallas/Fort Worth, Texas metropolitan area and Kansas. We are focused on serving business owners and entrepreneurs by delivering fast, consistent and welldesigned loan and deposit products to meet their financing needs. We intend to grow organically by selectively opening additional branches in our target markets and we will also pursue strategic acquisitions. As a bank holding company, we generate most of our revenue from interest income on loans and from shortterm investments. The primary source of funding for our loans and shortterm investments are deposits held by our subsidiary, Bank7. We measure our performance by our return on average assets, return on average equity, earnings per share, capital ratios, and our efficiency ratio, which is calculated by dividing noninterest expense by the sum of net interest income on a tax equivalent basis and noninterest income. As of December 31, 2019, we had total assets of $866.4 million, total loans of $707.3 million, total deposits of $757.5 million and total shareholders’ equity of $100.1 million. In September 2018, in conjunction with our initial public offering, the Company terminated its status as an S Corporation and elected to be treated as a C Corporation. As this termination occurred at the end of the third quarter, we have presented information as pretax and pro forma numbers in the nonGAAP reconciliation below. In December 2019, a novel strain of coronavirus was reported in Wuhan, China. The World Health Organization has declared the outbreak to constitute a “Public Health Emergency of International Concern.” The COVID19 outbreak is disrupting supply chains and affecting production and sales across a range of industries. The extent of the impact of COVID19 on our operational and financial performance will depend on certain developments, including the duration and spread of the outbreak, impact on our customers, employees and vendors all of which are uncertain and cannot be predicted. At this point, the extent to which COVID19 may impact our financial condition or results of operations is uncertain. Our Initial Public Offering Our initial public offering, or IPO, closed on September 20, 2018 and a total of 2,900,000 shares of common stock were sold at $19.00 per share. After deducting underwriting discounts and offering expenses, the Company received total net proceeds of $50.1 million from the initial public offering and the exercise of the underwriter option. Upon completion of the IPO, the Company became a publicly traded company with our common stock listed on The NASDAQ Global Select Market under the symbol “BSVN”. Factors Affecting Comparability of Financial Results S Corporation Status Since our formation in 2004, we have elected to be taxed for U.S. federal income tax purposes as an S Corporation. As a result, our net income has not been subject to, and we have not paid, U.S. federal or state income taxes, and we have not been required to make any provision or recognize any liability for U.S. federal income tax in our financial statements. The consummation of our initial public offering resulted in the termination of our status as an S Corporation and in our taxation as a C Corporation for U.S. federal and state income tax purposes. Upon the termination of our status as an S Corporation, we commenced paying U.S. federal income tax on our pretax net income for each year (including the short year beginning on the date our status as an S Corporation terminated), and our financial statements reflect a provision for U.S. federal income tax. As a result of this change, the net income and earnings per share data presented in our historical financial statements and the other financial information set forth in this report (unless otherwise specified), which do not include any provision for U.S. federal income tax, will not be comparable with our future net income and ear [/INST] Negative. </s>

Forty Seven, Inc.

2019-03-28

2018-12-31

Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations. You should read the following discussion and analysis of our financial condition and results of operations in conjunction with our financial statements and related notes included in Part II, Item 8 of this Annual Report on Form 10-K. This Annual Report on Form 10-K contains forward-looking statements within the meaning of Section 27A of the Securities Exchange Act of 1933, as amended, or the Securities Act, and Section 21E of the Securities Exchange Act of 1934, as amended (“the Exchange Act”). Forward-looking statements are identified by words such as “believe,” “will,” “may,” “estimate,” “continue,” “anticipate,” “intend,” “should,” “plan,” “expect,” “predict,” “could,” “potentially” or the negative of these terms or similar expressions. You should read these statements carefully because they discuss future expectations, contain projections of future results of operations or financial condition, or state other “forward-looking” information. These statements relate to our future plans, objectives, expectations, intentions and financial performance and the assumptions that underlie these statements. These forward-looking statements are subject to certain risks and uncertainties that could cause actual results to differ materially from those anticipated in the forward-looking statements. Factors that might cause such a difference include, but are not limited to, those discussed in this report in Part I, Item 1A - “Risk Factors,” and elsewhere in this report. Forward-looking statements are based on our management’s beliefs and assumptions and on information currently available to our management. These statements, like all statements in this report, speak only as of their date, and we undertake no obligation to update or revise these statements in light of future developments. We caution investors that our business and financial performance are subject to substantial risks and uncertainties. Overview We are a clinical-stage immuno-oncology company focused on developing novel therapies to activate macrophages in the fight against cancer. We founded Forty Seven based on the insight that blocking CD47, a key signaling molecule that is overexpressed on cancer cells, renders tumors susceptible to macrophages. By harnessing macrophages, we believe that our lead product candidate, 5F9, can transform the treatment of cancer. 5F9 has demonstrated promising activity in six Phase 1b/2 clinical trials in which we have treated over 290 relapsed or refractory cancer patients with solid or hematologic tumors. In addition, we have two additional product candidates in preclinical development; FSI-189 an anti-SIRPα antibody and FSI-174 an anti-cKIT antibody. We hold worldwide rights to all of our product candidates. We focus our efforts on targeting the CD47 pathway as a way to engage macrophages in fighting tumors. Macrophages function as first responders, swallowing foreign and abnormal cells, including cancer cells, and mobilizing other components of the immune system including T cells and antibodies. Cancer cells use CD47, a “don’t eat me” signal, in order to evade detection by the immune system and subsequent destruction by macrophages. Overexpression of CD47 is common to nearly all types of tumors and is also correlated with poor prognosis in multiple cancers including acute myelogenous leukemia, or AML, colorectal cancer, or CRC, gastric cancer, lung cancer, Non-Hodgkin’s lymphoma, or NHL, and ovarian cancer. Despite the central role of macrophages as cell-eating scavengers and first responders, the pharmaceutical industry is only beginning to bring this key group of cells into the fight against cancer. Since our inception in 2014, we have devoted most of our resources to identifying and developing 5F9, advancing our preclinical programs, conducting clinical trials and providing general and administrative support for these operations. We have not recorded revenue from product sales or collaboration activities, or any other source. We have funded our operations to date primarily from the issuance and sale of our common stock in our initial public offering (IPO), the issuance and sale of our preferred stock and the receipt of government and private grants. We are eligible to receive up to $17.6 million in grants from the California Institute for Regenerative Medicine, or CIRM, and the Leukemia and Lymphoma Society, or LLS, of which $13.5 million has been received through December 31, 2018. On June 27, 2018, our Registration Statements on Form S-1 (File No. 333-225390 and 333-225933) relating to our IPO, were declared effective by the Securities Exchange Commission, or SEC. Pursuant to the Registration Statements, we issued and sold an aggregate of 8,090,250 shares of common stock (inclusive of 1,055,250 shares pursuant to the underwriters’ over-allotment option) at a price of $16.00 per share for aggregate cash proceeds of $116.3 million, net of underwriting discounts and commissions and estimated offering costs. We have incurred net losses in each year since inception. Our net losses were $70.4 million, $44.9 million and $19.5 million for 2018, 2017 and 2016, respectively. As of December 31, 2018, we had an accumulated deficit of $139.8 million. Substantially all of our net losses have resulted from costs incurred in connection with our research and development programs and from general and administrative costs associated with our operations. We expect to continue to incur significant expenses and increasing operating losses over at least the next several years. We expect our expenses will increase substantially in connection with our ongoing activities, as we: • advance product candidates through clinical trials; • pursue regulatory approval of product candidates; • operate as a public company; • continue our preclinical programs and clinical development efforts; • continue research activities for the discovery of new product candidates; and • manufacture supplies for our preclinical studies and clinical trials. Components of Results of Operations Research and Development Expenses Research and development expenses consist primarily of costs incurred for the development of our lead product candidate, 5F9, which include: • expenses incurred under agreements with third-party contract organizations, investigative clinical trial sites that conduct research and development activities on our behalf, and consultants; • costs related to production of clinical materials, including fees paid to contract manufacturers; • laboratory and vendor expenses related to the execution of preclinical and clinical trials; • employee-related expenses, which include salaries, benefits and stock-based compensation; and • facilities and other expenses, which include expenses for rent and maintenance of facilities, depreciation and amortization expense and other supplies. We expense all research and development costs in the periods in which they are incurred. Costs for certain development activities are recognized based on an evaluation of the progress to completion of specific tasks using information and data provided to us by our vendors, collaborators and third-party service providers. The cost of intangible assets that are purchased from others for a particular research and development project and that have no alternative future uses are considered research and development costs and are expensed as incurred. Nonrefundable advance payments for goods or services to be received in future periods for use in research and development activities are deferred and capitalized. The capitalized amounts are then expensed as the related goods are delivered and as services are performed. The largest component of our operating expenses has historically been our investment in research and development activities related to the clinical development of our lead product candidate, 5F9. We recognize the funds from research and development grants as a reduction of research and development expense when the related eligible research costs are incurred. Research and development grants received during 2018 and 2017 totaled $7.6 million and $5.9 million, respectively. In January 2018, we entered into a clinical trial collaboration and supply agreement with Ares Trading S.A, a subsidiary of Merck KGaA. Reimbursement under this collaboration agreement is recorded as a reduction to research and development expense. For the year ended December 31, 2018, we recognized $1.2 million as a reduction to research and development expenses under this collaboration agreement. We expect our research and development expenses to increase substantially for the foreseeable future as we continue to invest in research and development activities related to developing our product candidates, as our product candidates advance into later stages of development, and as we begin to conduct larger clinical trials. The process of conducting the necessary clinical research to obtain regulatory approval is costly and time-consuming, and the successful development of our product candidates is highly uncertain. As a result, we are unable to determine the duration and completion costs of our research and development projects or when and to what extent we will generate revenue from the commercialization and sale of any of our product candidates. General and Administrative Expenses General and administrative expenses consist primarily of personnel-related costs, facilities costs, depreciation and amortization expenses and professional services expenses, including legal, human resources, audit and accounting services. Personnel-related costs consist of salaries, benefits and stock-based compensation. Facilities costs consist of rent and maintenance of facilities. We expect our general and administrative expenses to increase for the foreseeable future due to anticipated increases in headcount to advance our product candidates and as a result of operating as a public company, including expenses related to compliance with the rules and regulations of the SEC, the Nasdaq Global Select Market, additional insurance expenses, investor relations activities and other administrative and professional services. Interest and Other Income, Net Interest and other income, net consists of interest earned on our cash equivalents and short-term investments and foreign currency transaction gains and losses incurred during the period. Results of Operations Years Ended December 31, 2018 and 2017 Research and Development Expenses The following tables summarize the period-over-period changes in research and development expenses for the periods indicated: Research and development expenses increased by $19.5 million, or 52%, to $56.7 million in 2018 from $37.2 million in 2017. The increase was primarily due to a $12.6 million increase in third party costs related to advancing our current clinical programs focused on CRC and NHL with our lead product candidate, 5F9, and associated contract manufacturing costs, partially offset by a $5.3 million reduction related to grant funding and cost sharing recognized under the CIRM and LLS grants and the Merck collaboration agreement during 2018. There was a total upfront license fee of $8.8 million increase related to the BliNK asset purchase and Synthon license agreement. In addition, personnel-related costs, including stock-based compensation, increased by $3.0 million as a result of increased headcount. General and Administrative Expenses General and administrative expenses increased by $7.3 million, or 90%, to $15.4 million in 2018 from $8.1 million in 2017. The increase was primarily due to a $4.0 million increase in personnel-related costs driven by an increase in headcount, a $1.9 million increase in accounting and consulting expenses incurred in connection with becoming a public company, a $0.5 million increase in insurance related expenses, a $0.5 million increase in other administrative and services costs, and a $0.3 million increase in facilities related expenses. Interest and Other Income, Net Interest and other income, net increased by $1.3 million to $1.7 million in 2018 from $0.4 million in 2017. The increase was primarily due to a $1.9 million increase in interest income from the investment of the net proceeds of the IPO completed during 2018, offset by a $0.3 million increase in other expenses due to the change in fair value of the embedded derivative, and a $0.2 million increase in losses on foreign currency transactions. Years Ended December 31, 2017 and 2016 Research and Development Expenses The following tables summarize the period-over-period changes in research and development expenses for the periods indicated: Research and development expenses increased by $22.7 million, or 157%, to $37.2 million in 2017 from $14.5 million in 2016. The increase was primarily due to a $19.0 million increase in third party costs related to advancing our current clinical programs focused on CRC and NHL with our lead product candidate, 5F9, and associated contract manufacturing costs, partially offset by a $3.9 million reduction related to grant funding recognized under the CIRM and LLS grants during 2017. There was also a $4.5 million increase in our other preclinical and discovery programs costs as we expanded our immuno-oncology efforts. In addition, personnel-related costs, including stock-based compensation, increased by $3.0 million as a result of increased headcount. General and Administrative Expenses General and administrative expenses increased by $3.0 million, or 58%, to $8.1 million in 2017 from $5.2 million in 2016. The increase was primarily due to a $1.4 million increase in accounting and consulting expenses, and a $1.3 million increase in personnel-related costs driven by an increase in headcount. Interest and Other Income, Net Interest and other income, net increased by $0.3 million to $0.4 million in 2017 from $0.1 million in 2016. The increase was primarily due to $0.3 million in interest income from the investment of the net proceeds from the issuance of our Series A-2 and Series B preferred stock financings completed during 2017. Liquidity, Capital Resources and Plan of Operations To date, we have incurred significant net losses and negative cash flows from operations. As of December 31, 2018, we had $139.0 million in cash, cash equivalents and short-term investments. Prior to our IPO, our operations have been financed primarily by net proceeds from the sale and issuance of our preferred stock. In connection with our IPO, we issued and sold an aggregate of 8,090,250 shares of common stock (inclusive of 1,055,250 shares of common stock from the exercise of the over-allotment option granted to the underwriters) at a price of $16.00 per share. We received proceeds of $116.3 million, net of underwriting discounts and commissions and estimated offering costs. Our primary use of cash is to fund operating expenses, which consist primarily of research and development expenditures related to our lead product candidate, 5F9, preclinical and discovery programs, and to a lesser extent, general and administrative expenditures. Cash used to fund operating expenses is impacted by the timing of when we pay these expenses, as reflected in the change in our outstanding accounts payable and accrued expenses. Based upon our current operating plan, we believe that our existing capital resources will enable us to fund our operating expenses and capital expenditure requirements for a period of at least one year from the date the audited financial statements are filed with the Securities and Exchange Commission (“SEC”). We have based this estimate on assumptions that may prove to be wrong, and we could utilize our available capital resources sooner than we currently expect. We will continue to require additional financing to advance our current product candidates through clinical development, to develop, acquire or in-license other potential product candidates and to fund operations for the foreseeable future. We will continue to seek funds through equity or debt financings, collaborative or other arrangements with corporate sources, or through other sources of financing. Adequate additional funding may not be available to us on acceptable terms, or at all. Any failure to raise capital as and when needed could have a negative impact on our financial condition and on our ability to pursue our business plans and strategies. Further, our operating plans may change, and we may need additional funds to meet operational needs and capital requirements for clinical trials and other research and development activities. We currently have no credit facility or committed sources of capital. Because of the numerous risks and uncertainties associated with the development and commercialization of our product candidates, we are unable to estimate the amounts of increased capital outlays and operating expenditures associated with our current and anticipated product development programs. If we need to raise additional capital to fund our operations, funding may not be available to us on acceptable terms, or at all. If we are unable to obtain adequate financing when needed, we may have to delay, reduce the scope of or suspend one or more of our clinical trials, research and development programs or commercialization efforts. We may seek to raise any necessary additional capital through a combination of public or private equity offerings, debt financings and collaborations or licensing arrangements. If we do raise additional capital through public or private equity offerings, the ownership interest of our existing stockholders will be diluted, and the terms of these securities may include liquidation or other preferences that adversely affect our stockholders’ rights. If we raise additional capital through debt financing, we may be subject to covenants limiting or restricting our ability to take specific actions, such as incurring additional debt, making capital expenditures or declaring dividends. If we are unable to raise capital, we will need to delay, reduce or terminate planned activities to reduce costs. Doing so will likely harm our ability to execute our business plans. Cash Flows The following table summarizes our cash flows for the periods indicated: Operating Activities In 2018, cash used in operating activities of $66.0 million was attributable to a net loss of $70.4 million, partially offset by a net change of $1.0 million in net operating assets and liabilities, and a net change of $3.4 million in non-cash charges. The non-cash charges consisted primarily of stock-based compensation of $3.4 million, depreciation and amortization of $0.4 million, a change in fair value of the embedded derivative of $0.3 million, offset by the net accretion of discount on marketable securities of $0.7 million. The change in operating assets and liabilities was primarily due to a $5.1 million increase in accounts payable and accrued liabilities resulting from increases in our research and development activities and accrued compensation. This was partially offset by a $2.4 million increase in prepaid expense and other current assets and a $0.7 million increase in other assets, driven by the timing of prepayments made for research and development activities, and a $1.0 million decrease in deferred grant funding due to research grant awards being recognized as eligible research costs were incurred. In 2017, cash used in operating activities of $36.9 million was attributable to a net loss of $44.9 million partially offset by $1.1 million in non-cash charges and a net change of $6.9 million in our net operating assets and liabilities. The non-cash charges consisted of stock-based compensation of $0.7 million and depreciation and amortization of $0.4 million. The change in operating assets and liabilities was primarily due to $4.6 million increase in accounts payable and accrued liabilities resulting from increases in our operating activities, primarily in research and development, and a $2.8 million increase in deferred grant funding due to research grant award payments received. This was partially offset by a $0.6 million decrease in prepaid expenses and other current assets resulting from the timing of prepayments made for research and development activities. In 2016, cash used in operating activities of $21.8 million was attributable to a net loss of $19.5 million and a net change of $2.7 million in our net operating assets and liabilities, partially offset by $0.4 million in non-cash charges. The non-cash charges consisted of stock-based compensation of $0.3 million and depreciation and amortization of $0.1 million. The change in operating assets and liabilities was primarily due to a $3.9 million decrease in prepaid expenses and a $1.7 million decrease in other assets resulting from the timing of prepayments made for research and development activities, partially offset by a $2.8 million increase in accounts payable and accrued liabilities primarily driven by increases in accrued compensation and our research and development activities. Investing Activities In 2018, cash used in investing activities was $64.2 million related to the purchase of short-term investments of $142.0 million, partially offset by the maturity of investments of $78.2 million. In 2017, cash used for investing activities was $63.9 million related primarily to the purchase of short-term investments of $79.7 million from the cash proceeds received from our preferred stock issuance, partially offset by the maturity of investments of $16.0 million. In 2016, cash used for investing activities was $1.1 million related to capital expenditures on the purchase of property and equipment. Financing Activities In 2018, cash provided by financing activities was $116.6 million related to the net proceeds of $116.3 million received from the initial public offering and $0.3 million from the issuance of common stock in connection with stock option exercises. In 2017, cash provided by financing activities was $115.5 million related to net proceeds of $115.2 million from the issuance of preferred stock and $0.3 million from the issuance of common stock in connection with stock option exercises. In 2016, cash provided by financing activities was $5.0 million related to net proceeds of $4.6 million from the issuance of preferred stock and $0.4 million from the issuance of common stock in connection with stock option exercises. Contractual Obligations and Commitments The following table summarizes our commitments to settle contractual obligations as of December 31, 2018: We enter into agreements in the normal course of business with contract research organizations for clinical trials and with vendors for preclinical studies and other services and products for operating purposes which are cancelable at any time by us, generally upon 30 days prior written notice. These payments are not included in this table of contractual obligations. In addition, we have not included the potential contingent payment obligations from the following agreements described below in this table of contractual obligations because the timing and likelihood of such payments is not known. These payments generally become due and payable only upon achievement of certain development, regulatory or commercial milestones. Contract Manufacturing Agreement In August 2016 and December 2017, we entered into development and manufacturing agreements with Lonza relating to the manufacturing of 5F9-related products. The August 2016 agreement was amended in November 2017 to provide for the manufacturing of our other preclinical program related products. The August 2016 agreement was further amended in November and December 2018 as it related to the scope of manufacturing services. Under the 2016 agreement, as amended, we were required to pay an annual suite reservation fee in each contract year, with the final annual suite reservation fee becoming payable in December 2018. We are required to pay the costs of ingredients, solvents and other components of 5F9 and our preclinical program-related products related to binding purchase commitments. There were no binding purchase commitments under the 2016 agreement as of December 31, 2018. Our payment obligations under the 2017 agreement begin in January 2019 and run through the expiration of the agreement, which is expected in December 2021, unless the agreement is extended for at least an additional year. Under the 2017 agreement, we must also pay an annual suite reservation fee in each contract year and the costs of ingredients, solvents and other components of 5F9-related products required for the performance of the manufacturing process or services. Our contractual payment obligations under the 2016 and 2017 agreements are included in the table of contractual obligations above. Asset Purchase Agreement In June 2018, we entered into an asset purchase agreement with BliNK Biomedical SAS, or BliNK, pursuant to which we acquired all of BliNK’s assets relating to its research and development program for antibodies directed against CD47. These assets predominately consist of certain patents and patent applications of BliNK and BliNK’s opposition at the EPO against the third-party patent European Patent No. EP 2 282 772 as an acquired business asset. We paid BliNK an initial upfront payment of $2.0 million and an additional $1.0 million upon the completion of certain agreed activities by BliNK relating to the transfer of the assets to us. For each product incorporating a program antibody that satisfies certain clinical and commercial milestones in the United States, the European Union and Japan, we will be required to make milestone payments of up to $43.0 million. Until we receive marketing approval for the first product, or for so long as we continue development of product candidates related to the acquired intellectual property, we will pay BliNK a minimum annual fee of $0.3 million. In addition, we will pay BliNK a royalty of a tiered single digit percentage on net sales of any approved products. We have the right to buy out our royalty obligations in full by paying BliNK an agreed lump sum amount prior to the occurrence of certain defined events. License Agreements In July 2018, we entered into a settlement and license agreement with Synthon Biopharmaceuticals B.V., or Synthon. Under the agreement, we agreed to discontinue our ongoing oppositions and challenges at the European Patent Office, or EPO, and the U.S. Patent and Trademark Office, or USPTO, directed towards certain patents licensed by Synthon from Stichting Sanquin Bloedvoorziening, or SSB, that relate to the use of anti-CD47 products in combination with other antibodies to treat cancer. We also agreed to request the withdrawal of such proceedings with the USPTO and EPO. In return Synthon agreed to grant us a non-exclusive, worldwide sublicense to certain patents they have licensed from SSB, including the SSB patents we were opposing at the USPTO and EPO to commercialize a single anti-CD47 product (such as 5F9 or an alternate anti-CD47 product) to treat cancer in combination with other antibodies. In December 2016 and April 2017, we filed third party observations in an opposition proceeding in the EPO with respect to European Patent No. EP 2 282 772 and in January 2018, petitioned for inter partes review of U.S. Patent No. 9,352,037 in the USPTO, each of which is related to the treatment of cancer with an anti-CD47 antibody or an anti-SIRPα antibody in combination with certain other antibodies. The opposition proceeding was rejected by the EPO and the original opponent appealed the decision. On June 4, 2018, we acquired the opposition against this European patent from the original opponent. Pursuant to the agreement, we and Synthon have each agreed to release the other party (and we have agreed to release SSB) from all claims and liabilities relating to the USPTO and EPO proceedings. The sublicense grant was subject to specified conditions, which have now been met. These conditions included our withdrawal of the proceedings opposing the above-mentioned SSB U. S. and European patents and the termination of these proceedings by the USPTO and the EPO. In connection with the release of claims by Synthon and us, SSB agreed to release us from all claims and liabilities under the USPTO and EPO proceedings and to grant us a direct license to the sublicensed patents in the event the license between SSB and Synthon is terminated. Our sublicense includes the right to further sublicense the applicable patent rights to our collaborators, corporate partners and service providers and covers one named product, which is 5F9. In addition, we have the right to replace 5F9 with a different anti-CD47 product in the event of a development failure of 5F9. We will also have an option to expand our rights to cover a follow-on anti-CD47 product in exchange for a specified option exercise fee. Synthon retains the right to use the licensed patents and to grant other third parties the right to do so. In exchange, for these sublicenses and option rights, we agreed to pay Synthon an aggregate of up to approximately 40.0 million Euros comprising an upfront payment upon the grant of the sublicense and the achievement of future regulatory and commercial milestones which comprise the significant majority of the aggregate payments. If we exercise our option right, we will pay Synthon additional amounts upon the achievement of certain regulatory and commercial milestones related to such follow-on anti-CD47 product. In addition, we will be required to pay Synthon an annual license fee and a royalty of a tiered, low single digit percentage on net sales of any approved licensed products. We have the right to buy out our royalty obligations for each licensed product in full by paying Synthon specified lump sum amounts prior to the occurrence of certain defined events. License and Collaboration Agreements In January 2018, we entered into a clinical trial collaboration and supply agreement with Merck, to evaluate 5F9 combined with Merck’s cancer immunotherapy, avelumab, in a Phase 1b clinical trial in patients with ovarian cancer. Pursuant to the agreement, the parties will jointly pay for the cost of the study. As of December 31, 2018, we recorded a receivable of $0.6 million from Merck for reimbursement of research and development costs incurred. In March 2017, we entered into an agreement with LLS regarding our NHL rituximab combination clinical trial and amended the agreement to include an additional study in June 2018. The LLS research grant stipulates various milestone-based payments with a total award of $4.2 million through December 2019. As of December 31, 2018, we had received $3.9 million under the award. We are required to pay LLS certain development and regulatory approval milestone payments, as well as a low single digit percentage royalty on net sales, up to a maximum of $15 million in total. The contingent milestone payments in our agreement with LLS were concluded to be an embedded derivative and we recorded a liability for the derivative of approximately $0.3 million, as part of other long-term liabilities as of December 31, 2018. In January 2017, we were awarded a research grant from CIRM supporting our CRC trial. The CIRM grant stipulates various milestone-based payments to us with the total award of $10.2 million over a period of four years. As of December 31, 2018, we had received $7.2 million under the award. In November 2017, we were awarded a second research grant from CIRM for a separate clinical trial study in AML. The total amount of the research grant awarded was $5.0 million in various milestone-based payments over a period of five years. During 2018, the award was amended to $3.2 million in various-milestone payments over a period of five years, as was provided for under the terms of the original award because we opted not to expand the patient population participating in the study. As of December 31, 2018, we had received $2.4 million under the award. Under the terms of the CIRM grants, we are obligated to pay royalties and licensing fees based on a low single digit royalty percentage on net sales of CIRM-funded product candidates or CIRM-funded technology. We have the option to decline any and all amounts awarded by CIRM. As an alternative to revenue sharing, we have the option to convert each award to a loan, which option must be exercised on or before ten business days after the FDA notifies us that it has accepted our application for marketing authorization. In the event we exercise our right to convert an award to a loan, we will be obligated to repay the loan within ten business days of making such election, including interest at the rate equal to the three-month LIBOR rate (2.8% as of December 31, 2018) plus zero to 30% per annum that varies depending on the stage of the research and the stage of development at the time the election is made. In the event that we terminate a CIRM-funded clinical trial, we will be obligated to repay the remaining CIRM funds on hand. In September 2016, we entered into a collaboration agreement with The University of Texas MD Anderson Cancer Center that grants us access to their immunotherapy platform. The platform provides instrumentation and technical support for cellular and molecular analysis of experimental therapies effects on the immune system in order to gain insight into mechanisms of action and to discover biomarkers to identify patients who are likely to respond to or develop adverse reactions to therapies. Pursuant to the terms of the collaboration agreement, we are required to make quarterly payments of $250,000 for three years, subject to our right to cancel the agreement at any time with 45 days’ notice. In November 2015, we entered into a technology license agreement with Stanford under which Stanford granted us exclusive licenses under certain patents and other intellectual property rights relating to our current product candidates, including 5F9 and non-exclusive licenses under certain other patents and other intellectual property rights to develop, manufacture and commercialize products for use in certain licensed fields, including oncology. We are required to make milestone payments up to $5.6 million in respect of the first three licensed products that successfully satisfy certain clinical and regulatory milestones in the United States, major European countries and Japan. The first such milestone payment of $75,000 was paid to Stanford in February 2018. In addition, we are required to pay Stanford a minimum annual fee and a royalty of a tiered single digit percentage on net sales of licensed products, reimburse patent-related expenses and share any non-royalty sublicensing income received related to the licensed technology. Off-Balance Sheet Arrangements During 2018, 2017 and 2016, we did not have any off-balance sheet arrangements as defined in Item 303 of Regulation S-K. Critical Accounting Policies Our management’s discussion and analysis of our financial condition and results of operations is based on our financial statements, which have been prepared in accordance with United States generally accepted accounting principles, or U.S. GAAP. The preparation of these financial statements requires us to make estimates and assumptions that affect the reported amounts of assets and liabilities and the disclosure of contingent assets and liabilities at the date of the financial statements, as well as the reported expenses incurred during the reporting periods. Our estimates are based on our historical experience and on various other factors that we believe are reasonable under the circumstances, the results of which form the basis for making judgments about the carrying value of assets and liabilities that are not readily apparent from other sources. Actual results may differ from these estimates under different assumptions or conditions. Accrued Research and Development Expenditures We record accrued expenses for estimated preclinical study and clinical trial expenses. Estimates are based on the services performed pursuant to contracts with research institutions and contract research organizations and clinical manufacturing organizations that conduct and manage preclinical studies and clinical trials on our behalf based on actual time and expenses incurred by them. Further, we accrue expenses related to clinical trials based on the level of patient enrollment and activity according to the related agreement. We monitor patient enrollment levels and related activity to the extent reasonably possible and make judgments and estimates in determining the accrued balance in each reporting period. If we underestimate or overestimate the level of services performed or the costs of these services, our actual expenses could differ from our estimates. To date, we have not experienced significant changes in our estimates of preclinical studies and clinical trial accruals. Stock-Based Compensation We recognize compensation costs related to stock-based awards granted, including stock options and employee stock purchase plan, based on the estimated fair value of the awards on the date of grant. We estimate the grant date fair value, and the resulting stock-based compensation, using the Black-Scholes option-pricing model. The grant date fair value of the stock-based awards is generally recognized on a straight-line basis over the requisite service period, which is generally the vesting period of the respective awards. The Black-Scholes option-pricing model requires the use of highly subjective assumptions to determine the fair value of stock-based awards. These assumptions include: • Expected Term-The expected term represents the period that stock-based awards are expected to be outstanding. The expected term for option grants is determined using the simplified method, as we do not have sufficient historical data to use any other method to estimate expected term. The simplified method deems the expected term to be the midpoint between the vesting date and the contractual life of the stock-based awards. • Expected Volatility-Since we have limited trading history for our common stock due to our short trading history, the expected volatility was estimated based on the average volatility for comparable publicly traded biotechnology companies over a period equal to the expected term of the stock option grants. The comparable companies were chosen based on their similar size, stage in the life cycle or area of specialty. • Risk-Free Interest Rate-The risk-free interest rate is based on the U.S. Treasury zero coupon issues in effect at the time of grant for periods corresponding with the expected term of option. • Expected Dividend-We have never paid dividends on our common stock and have no plans to pay dividends on our common stock. Therefore, we used an expected dividend yield of zero. We will continue to use judgment in evaluating the expected volatility and expected term utilized for our stock-based compensation calculations on a prospective basis. Recent Accounting Pronouncements Not Yet Adopted Please refer to Note 2 to our financial statements appearing under Part 2, Item 8 for a discussion of new accounting standards updates that may impact us. Emerging Growth Company Status In April 2012, the JOBS Act was enacted. Section 107 of the JOBS Act provides that an “emerging growth company” may take advantage of the extended transition period provided in Section 7(a)(2)(B) of the Securities Act for complying with new or revised accounting standards. Therefore, an emerging growth company can delay the adoption of certain accounting standards until those standards would otherwise apply to private companies. We have irrevocably elected not to avail ourselves of this exemption from new or revised accounting standards, and, therefore, will be subject to the same new or revised accounting standards as other public companies that are not emerging growth companies.

<s>[INST] You should read the following discussion and analysis of our financial condition and results of operations in conjunction with our financial statements and related notes included in Part II, Item 8 of this Annual Report on Form 10K. This Annual Report on Form 10K contains forwardlooking statements within the meaning of Section 27A of the Securities Exchange Act of 1933, as amended, or the Securities Act, and Section 21E of the Securities Exchange Act of 1934, as amended (“the Exchange Act”). Forwardlooking statements are identified by words such as “believe,” “will,” “may,” “estimate,” “continue,” “anticipate,” “intend,” “should,” “plan,” “expect,” “predict,” “could,” “potentially” or the negative of these terms or similar expressions. You should read these statements carefully because they discuss future expectations, contain projections of future results of operations or financial condition, or state other “forwardlooking” information. These statements relate to our future plans, objectives, expectations, intentions and financial performance and the assumptions that underlie these statements. These forwardlooking statements are subject to certain risks and uncertainties that could cause actual results to differ materially from those anticipated in the forwardlooking statements. Factors that might cause such a difference include, but are not limited to, those discussed in this report in Part I, Item 1A “Risk Factors,” and elsewhere in this report. Forwardlooking statements are based on our management’s beliefs and assumptions and on information currently available to our management. These statements, like all statements in this report, speak only as of their date, and we undertake no obligation to update or revise these statements in light of future developments. We caution investors that our business and financial performance are subject to substantial risks and uncertainties. Overview We are a clinicalstage immunooncology company focused on developing novel therapies to activate macrophages in the fight against cancer. We founded Forty Seven based on the insight that blocking CD47, a key signaling molecule that is overexpressed on cancer cells, renders tumors susceptible to macrophages. By harnessing macrophages, we believe that our lead product candidate, 5F9, can transform the treatment of cancer. 5F9 has demonstrated promising activity in six Phase 1b/2 clinical trials in which we have treated over 290 relapsed or refractory cancer patients with solid or hematologic tumors. In addition, we have two additional product candidates in preclinical development; FSI189 an antiSIRPα antibody and FSI174 an anticKIT antibody. We hold worldwide rights to all of our product candidates. We focus our efforts on targeting the CD47 pathway as a way to engage macrophages in fighting tumors. Macrophages function as first responders, swallowing foreign and abnormal cells, including cancer cells, and mobilizing other components of the immune system including T cells and antibodies. Cancer cells use CD47, a “don’t eat me” signal, in order to evade detection by the immune system and subsequent destruction by macrophages. Overexpression of CD47 is common to nearly all types of tumors and is also correlated with poor prognosis in multiple cancers including acute myelogenous leukemia, or AML, colorectal cancer, or CRC, gastric cancer, lung cancer, NonHodgkin’s lymphoma, or NHL, and ovarian cancer. Despite the central role of macrophages as celleating scavengers and first responders, the pharmaceutical industry is only beginning to bring this key group of cells into the fight against cancer. Since our inception in 2014, we have devoted most of our resources to identifying and developing 5F9, advancing our preclinical programs, conducting clinical trials and providing general and administrative support for these operations. We have not recorded revenue from product sales or collaboration activities, or any other source. We have funded our operations to date primarily from the issuance and sale of our common stock in our initial public offering (IPO), the issuance and sale of our preferred stock and the receipt of government and private grants. We are eligible to receive up to $17.6 million in grants from the California Institute for Regenerative Medicine, or [/INST] Positive. </s>

Forty Seven, Inc.

2020-03-20

2019-12-31

Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations. You should read the following discussion and analysis of our financial condition and results of operations in conjunction with our financial statements and related notes included in Part II, Item 8 of this Annual Report on Form 10-K. This Annual Report on Form 10-K contains forward-looking statements within the meaning of Section 27A of the Securities Exchange Act of 1933, as amended, or the Securities Act, and Section 21E of the Securities Exchange Act of 1934, as amended, or the Exchange Act. Forward-looking statements are identified by words such as “believe,” “will,” “may,” “estimate,” “continue,” “anticipate,” “intend,” “should,” “plan,” “expect,” “predict,” “could,” “potentially” or the negative of these terms or similar expressions. You should read these statements carefully because they discuss future expectations, contain projections of future results of operations or financial condition, or state other “forward-looking” information. These statements relate to our future plans, objectives, expectations, intentions and financial performance and the assumptions that underlie these statements. These forward-looking statements are subject to certain risks and uncertainties that could cause actual results to differ materially from those anticipated in the forward-looking statements. Factors that might cause such a difference include, but are not limited to, those discussed in this report in Part I, Item 1A - “Risk Factors,” and elsewhere in this report. Forward-looking statements are based on our management’s beliefs and assumptions and on information currently available to our management. These statements, like all statements in this report, speak only as of their date, and we undertake no obligation to update or revise these statements in light of future developments. We caution investors that our business and financial performance are subject to substantial risks and uncertainties. Overview We are a clinical-stage immuno-oncology company focused on developing novel therapies to activate macrophages in the fight against cancer. We founded Forty Seven based on the insight that blocking CD47, a key signaling molecule that is overexpressed on cancer cells, renders tumors susceptible to macrophages. By harnessing macrophages, we believe that our lead product candidate, magrolimab (formerly known as 5F9), can transform the treatment of cancer. Magrolimab has demonstrated promising activity in multiple Phase 1b/2 clinical trials in which we have treated over 400 cancer patients with solid or hematologic tumors. In March 2020, Forty Seven entered into a definitive agreement to be acquired by Gilead Sciences, Inc., which is expected to close during the second quarter of 2020. We are also preparing to advance two additional investigational compounds into clinical testing. FSI-174, an anti-cKIT antibody, is being developed alone or in combination with magrolimab as a novel, all-antibody conditioning regimen to address the limitations of current stem cell transplantation conditioning regimens. FSI-189, an anti-SIRPα antibody, is being developed for the treatment of cancer, as well as certain non-oncology conditions, including transplantation conditioning. We focus our efforts on targeting the CD47 pathway as a way to engage macrophages in fighting tumors. Macrophages function as first responders, swallowing foreign and abnormal cells, including cancer cells, and mobilizing other components of the immune system including T cells and antibodies. Cancer cells use CD47, a “don’t eat me” signal, in order to evade detection by the immune system and subsequent destruction by macrophages. Overexpression of CD47 is common to nearly all types of tumors including myelodysplastic syndrome, or MDS, acute myelogenous leukemia, or AML, Non-Hodgkin’s lymphoma, or NHL, colorectal cancer, or CRC, gastric cancer, lung cancer, and ovarian cancer with overexpression correlating with poor prognosis in many of these cancers. Despite the central role of macrophages as cell-eating scavengers and first responders, the pharmaceutical industry is only beginning to bring this key group of cells into the fight against cancer. Our company was founded in 2014 by leading scientists at Stanford University who uncovered the fundamental role of CD47 in cancer evasion. Preclinical work performed in the laboratory of our co-founder, Irving L. Weissman, at Stanford University and at Forty Seven demonstrated that: • Blocking the CD47 “don’t eat me” signaling pathway leads to elimination of many types of tumors and increased survival; • Boosting an “eat me” signal found on cancer cells using therapeutic antibodies results in a synergistic effect with blocking CD47; • Increasing “eat me” signal expression on cancer cells through cytotoxic and chemotherapeutic agents like azacitidine, which is synergistic with blocking CD47; and • Macrophages digest cancer cells in a process called phagocytosis and present tumor-specific antigens that can activate T cells against the cancer, thus creating the potential for synergy with T cell checkpoint inhibitors. Our lead product candidate, magrolimab, is a humanized IgG4 subclass monoclonal antibody against CD47 that is designed to interfere with recognition of CD47 by the SIRPα receptor on macrophages, thus blocking the “don’t eat me” signal. The design of magrolimab, combined with our proprietary dosing regimen, overcomes the toxicity limitations of previously tested anti-CD47 therapies developed by others. Across all study populations, magrolimab has been well tolerated with no maximum tolerated dose, or MTD, observed in any study despite dosing up to 45 mg/kg. The most common treatment-associated effects observed to date were the expected CD47-mechanism-based effects on red blood cells, which led to a temporary and reversible anemia. Other reported treatment-related adverse events include infusion reactions, headache, fatigue, chills, fever and nausea. The majority of these adverse events were mild to moderate in severity and were generally easily managed. To date, there are no approved therapies that target the CD47 checkpoint of the innate immune system. The targeting of CD47 to make cancer cells susceptible to macrophages, a component of the innate immune system, is analogous to the approach that has been applied with checkpoint inhibitors and T cells, a component of the adaptive immune system. Since their introduction in 2011, T cell checkpoint inhibitors have become frontline therapies for certain cancers and we estimate that they generated over $22 billion in sales in 2019. Despite the success of T cell checkpoint inhibitors, these therapies have been shown to be effective only in a subset of tumors, highlighting the need for additional therapies. Similar to the way cancer cells overexpress programmed death-ligand 1, or PD-L1, to avoid attack by T cells, cancer cells overexpress CD47 as a way to avoid destruction by macrophages. We believe targeting CD47 represents a compelling and analogous approach. Since our inception in 2014, we have devoted most of our resources to identifying and developing magrolimab, advancing our preclinical programs, conducting clinical trials and providing general and administrative support for these operations. To date, we have not generated any revenue from product sales. In July 2019, we recognized $15.7 million of license revenue under a license and collaboration arrangement. We have funded our operations to date primarily from the issuance and sales of our capital stock and the receipt of government and private grants and licensing revenue. We are eligible to receive up to $22.4 million in grants from the California Institute for Regenerative Medicine, or CIRM, and the Leukemia and Lymphoma Society, or LLS, of which $17.0 million has been received through December 31, 2019. We have incurred net losses in each year since inception. Our net losses were $87.6 and $70.4 million for the years ended December 31, 2019 and 2018, respectively. As of December 31, 2019, we had an accumulated deficit of $227.4 million. Substantially all of our net losses have resulted from costs incurred in connection with our research and development programs and from general and administrative costs associated with our operations. We expect to continue to incur significant expenses and increasing operating losses over at least the next several years. We expect our expenses will increase substantially in connection with our ongoing activities, as we: • advance product candidates through clinical trials; • pursue regulatory approval of product candidates; • operate as a public company; • continue our preclinical programs and clinical development efforts; • continue research activities for the discovery of new product candidates; and • manufacture supplies for our preclinical studies and clinical trials. Merger Agreement On March 1, 2020, we entered into the Merger Agreement with Gilead, pursuant to which we agreed to be acquired by Gilead in an all-cash transaction for an approximate value of $4.9 billion. On March 10, 2020, in accordance with the terms of the Merger Agreement, Purchaser commenced a tender offer, to acquire all of our outstanding shares of common stock, $0.0001 par value per share, at a price of $95.50 per share, to be paid net to the seller in cash, without interest and subject to any required withholding of taxes, upon the terms and conditions described in the Offer. The consummation of Purchaser’s pending Offer is subject to certain conditions, including the tender of shares representing at least one more than 50% of the total number of our shares of common stock outstanding at the time of the expiration of the Offer, the expiration or termination of the waiting period (or any extension thereof) applicable to the Offer under the Hart-Scott-Rodino Antitrust Improvements Act of 1976, as amended, and other customary conditions. The Merger Agreement provides, among other things, that following the consummation of the Offer and subject to the satisfaction or waiver of the conditions set forth in the Merger Agreement and in accordance with the relevant provisions of the DGCL and other applicable law, Purchaser will merge with and into the Company, the separate existence of Purchaser will cease and the Company will continue as the surviving corporation and as a wholly owned subsidiary of Parent. We expect the Merger to close during the second quarter of 2020, subject to the regulatory approvals and other customary closing conditions described above and in the Merger Agreement. Additional information about the Proposed Transaction is set forth in our filings with the Securities and Exchange Commission, or the SEC. Components of Results of Operations License Revenue To date, we have not generated any revenue from product sales and do not expect to generate any revenue from product sales for the foreseeable future. Under the exclusive license and collaboration agreement with Ono Pharmaceutical Co., Ltd., or the Ono Agreement, we have recognized as revenue the upfront nonrefundable payment related to a license grant. Under the Ono Agreement, we are eligible to receive milestone payments. These milestone payments are fully constrained, and not recognized currently in revenue, due to the uncertainty in achieving the milestones. We are also eligible to receive royalty payments related to the Ono Agreement which would be recognized as the underlying product sales occur. Research and Development Expenses Research and development expenses consist primarily of costs incurred for the development of our lead product candidate, magrolimab, and other product candidates, which include: • expenses incurred under agreements with third-party contract organizations and investigative clinical trial sites that conduct research and development activities on our behalf, and consultants; • costs related to production of clinical materials, including fees paid to contract manufacturers; • laboratory and vendor expenses related to the execution of preclinical and clinical trials; • employee-related expenses, which include salaries, benefits and stock-based compensation; and • facilities and other expenses, which include expenses for rent and maintenance of facilities, depreciation and amortization expense and other supplies. We expense all research and development costs in the periods in which they are incurred. Costs for certain development activities are recognized based on an evaluation of the progress to completion of specific tasks using information and data provided to us by our vendors, collaborators and third-party service providers. The costs of intangible assets that are purchased from others for a particular research and development project and that have no alternative future uses are considered research and development costs and are expensed when incurred. Nonrefundable advance payments for goods or services to be received in future periods for use in research and development activities are deferred and capitalized. The capitalized amounts are then expensed as the related goods are delivered and as services are performed. The largest component of our operating expenses has historically been our investment in research and development activities related to the clinical development of our lead product candidate, magrolimab, as well as other product candidates in preclinical development including FSI-189, an anti-SIRPα antibody, and FSI-174, an anti-cKIT antibody. We recognize the funds from research and development grants as a reduction of research and development expense when the related eligible research costs are incurred. Research and development grants received during 2019 and 2018 totaled $3.5 million and $7.6 million, respectively. In January 2018, we entered into a clinical trial collaboration and supply agreement with Ares Trading S.A, a subsidiary of Merck KGaA or Merck. Reimbursement under this collaboration agreement is recorded as a reduction to research and development expense. For the year ended December 31, 2019 and 2018, we recognized $1.7 million and $1.2 million, respectively, as a reduction to research and development expenses under this collaboration agreement. We entered into the Ono Agreement in July 2019 and a research collaboration agreement with bluebird bio, Inc., or bluebird in September 2019. Reimbursement under both collaboration agreements is recorded as a reduction to research and development expense. For the year ended December 31, 2019, we recognized $0.9 million and $1.2 million as a reduction to research and development expenses under the Ono Agreement and the bluebird agreement, respectively. We expect our research and development expenses to increase substantially for the foreseeable future as we continue to invest in research and development activities related to developing our product candidates, as our product candidates advance into later stages of development, and as we begin to conduct larger clinical trials. The process of conducting the necessary clinical research to obtain regulatory approval is costly and time-consuming, and the successful development of our product candidates is highly uncertain. As a result, we are unable to determine the duration and completion costs of our research and development projects or when and to what extent we will generate revenue from the commercialization and sale of any of our product candidates. General and Administrative Expenses General and administrative expenses consist primarily of personnel-related costs, facilities costs, depreciation and amortization expenses and professional services expenses, including legal, human resources, audit and accounting services. Personnel-related costs consist of salaries, benefits and stock-based compensation. Facilities costs consist of rent and maintenance of facilities. We expect our general and administrative expenses to increase for the foreseeable future due to anticipated increases in headcount to advance our product candidates and as a result of operating as a public company, including expenses related to compliance with the rules and regulations of the SEC, the Nasdaq Global Select Market, additional insurance expenses, investor relations activities and other administrative and professional services. Remeasurement Loss on Contingent Repayment Obligation Under the LLS agreement, as amended, we are required to make contingent milestone payments dependent upon the outcome of our research and development activities. The contingent repayment obligation represents the probability-adjusted and discounted future contingent milestone payments and is subject to remeasurement on a recurring basis at each reporting period. Remeasurement gains or losses arise from the revaluation of our contingent repayment obligation. Interest and Other Income, Net Interest and other income, net consists of interest earned on our cash equivalents and short-term investments and foreign currency transaction gains and losses incurred during the period. Results of Operations Years Ended December 31, 2019 and 2018 License Revenue License revenue increased $15.7 million compared to the year ended December 31, 2018. The increase in license revenue was due to the license granted under the Ono Agreement. Research and Development Expenses The following tables summarize the period-over-period changes in research and development expenses for the periods indicated: Research and development expenses increased by $27.1 million, or 48%, to $83.8 million in 2019 from $56.7 million in 2018. The increase was primarily due to a $17.2 million increase in third party costs related to advancing our current clinical programs focused on our lead product candidate, magrolimab, and associated contract manufacturing costs, a $11.1 million increase in our other preclinical and discovery programs costs as we expanded our immuno-oncology efforts, a $4.8 million increase in personnel-related costs, including stock-based compensation, and a $2.3 million increase in expenses related to a decrease in grant funding reimbursement due to decreased funding recognized under the CIRM and LLS grants partially offset by increased cost share reimbursement under the Merck, bluebird and Ono collaboration agreements. These increases were partially offset by a $8.2 million decrease in our license fees primarily due to the upfront license fees related to the BliNK asset purchase and Synthon license agreements recognized in 2018. General and Administrative Expenses General and administrative expenses increased by $5.0 million, or 32%, to $20.4 million in 2019 from $15.4 million in 2018. The increase was primarily due to a $3.0 million increase in personnel-related costs driven by an increase in headcount, a $1.0 million increase in accounting and consulting expenses incurred in connection with operating as a public company and a $0.9 million increase in directors and officer’s insurance expense. Remeasurement Loss on Contingent Repayment Obligation Remeasurement loss on the contingent repayment obligation increased by $2.2 million to $2.5 million in 2019 from $0.3 million in 2018, primarily driven by a higher estimated probability of success related to our clinical programs in MDS, DLBCL, AML and other pipeline programs, such as FSI-174. Interest and Other Income, Net Interest and other income, net increased by $1.4 million to $3.4 million in 2019 from $2.0 million in 2018. The increase was due to a $1.0 million increase in interest income from the investment of the net proceeds from our public offerings, and a $0.4 million increase in foreign currency gains primarily related to gains arising from the Ono Agreement. Liquidity, Capital Resources and Plan of Operations To date, we have incurred significant net losses and negative cash flows from operations. As of December 31, 2019, we had $329.1 million in cash, cash equivalents and short-term investments. In connection with our initial public offering, which closed on July 2, 2018, we issued and sold an aggregate of 8,090,250 shares of common stock (inclusive of 1,055,250 shares of common stock from the exercise of the over-allotment option granted to the underwriters) at a price of $16.00 per share. We received proceeds from the offering of $116.3 million, net of underwriting discounts and commissions and estimated offering costs. In July 2019, we completed an underwritten public offering of 10,781,250 shares of our common stock, including 1,406,250 shares sold pursuant to the underwriters’ exercise of their option to purchase additional shares, at a public offering price of $8.00 per share. We received proceeds from the offering of $80.5 million, net of underwriting discounts and commissions and offering costs. In July 2019, we entered into the Ono Agreement. Under the Ono Agreement, we received a one-time upfront nonrefundable payment from Ono of 1.7 billion Japanese Yen. In December 2019, we completed an additional underwritten public offering of 5,589,000 shares of our common stock, including 729,000 shares sold pursuant to the underwriters’ exercise of their option to purchase additional shares, at a public offering price of $35.00 per share. We received proceeds from the offering of $183.6 million, net of underwriting discounts and commissions and offering costs. Our primary use of cash is to fund operating expenses, which consist primarily of research and development expenditures related to our lead product candidate, magrolimab, other product candidates, preclinical and discovery programs, and to a lesser extent, general and administrative expenditures. Cash used to fund operating expenses is impacted by the timing of when we pay these expenses, as reflected in the change in our outstanding accounts payable and accrued expenses. Based upon our current operating plan and assumptions, we believe that our existing cash, cash equivalents and short-term investments, including the proceeds from our recently completed public offerings and upfront payment from Ono, will enable us to meet our financial needs into the first quarter of 2022. We have based this estimate on assumptions that may prove to be wrong, and we could utilize our available capital resources sooner than we currently expect. We will continue to require additional financing to advance our current product candidates through clinical development, to develop, acquire or in-license other potential product candidates and to fund operations for the foreseeable future. We will continue to seek funds through equity or debt financings, collaborative or other arrangements with corporate sources, or through other sources of financing. Adequate additional funding may not be available to us on acceptable terms, or at all. Any failure to raise capital as and when needed could have a negative impact on our financial condition and on our ability to pursue our business plans and strategies. Further, our operating plans may change, and we may need additional funds to meet operational needs and capital requirements for clinical trials and other research and development activities. We currently have no credit facility or committed sources of capital. Because of the numerous risks and uncertainties associated with the development and commercialization of our product candidates, we are unable to estimate the amounts of increased capital outlays and operating expenditures associated with our current and anticipated product development programs. If we need to raise additional capital to fund our operations, funding may not be available to us on acceptable terms, or at all. If we are unable to obtain adequate financing when needed, we may have to delay, reduce the scope of or suspend one or more of our clinical trials, research and development programs or commercialization efforts. We may seek to raise any necessary additional capital through a combination of public or private equity offerings, debt financings and collaborations or licensing arrangements. If we do raise additional capital through public or private equity offerings, the ownership interest of our existing stockholders will be diluted, and the terms of these securities may include liquidation or other preferences that adversely affect our stockholders’ rights. If we raise additional capital through debt financing, we may be subject to covenants limiting or restricting our ability to take specific actions, such as incurring additional debt, making capital expenditures or declaring dividends. If we are unable to raise capital, we will need to delay, reduce or terminate planned activities to reduce costs. Doing so will likely harm our ability to execute our business plans. Cash Flows The following table summarizes our cash flows for the periods indicated: Operating Activities In 2019, cash used in operating activities of $78.1 million was attributable to a net loss of $87.6 million, partially offset by $8.0 million in non-cash charges and a net change of $1.5 million in net operating assets and liabilities. The non-cash charges consisted primarily of stock-based compensation of $5.0 million, change in fair value of the LLS contingent repayment obligation of $2.6 million, amortization of right-of-use assets of $1.1 million and depreciation and amortization of $0.5 million, partially offset by $1.0 million related to the accretion of discounts on marketable securities. The change in operating assets and liabilities was due to a $3.9 million increase in accounts payable and accrued liabilities resulting from the timing of payments and a $1.0 million increase in deferred grant funding due to receipt of the research grant funding payments. These changes were partially offset by a $1.6 million increase in prepaid expense and other current assets driven by additional prepayments made for research and development activities and other receivables, a $1.2 million decrease in lease related liabilities due to lease payments and a $0.6 million increase in other noncurrent assets driven by timing of the research and development prepayments. In 2018, cash used in operating activities of $66.0 million was attributable to a net loss of $70.4 million, partially offset by a net change of $1.0 million in net operating assets and liabilities, and a net change of $3.4 million in non-cash charges. The non-cash charges consisted primarily of stock-based compensation of $3.4 million, depreciation and amortization of $0.4 million, a change in fair value of the contingent repayment obligation of $0.3 million, offset by the net accretion of discount on marketable securities of $0.7 million. The change in operating assets and liabilities was primarily due to a $5.1 million increase in accounts payable and accrued liabilities resulting from increases in our research and development activities and accrued compensation. This was partially offset by a $2.4 million increase in prepaid expense and other current assets and a $0.7 million increase in other assets, driven by the timing of prepayments made for research and development activities, and a $1.0 million decrease in deferred grant funding due to research grant awards being recognized as eligible research costs were incurred. Investing Activities In 2019, net cash provided by investing activities was $13.8 million related to the proceeds from maturities of investments of $176.2 million and the proceeds from the sale of investments of $4.0 million, partially offset by purchases of investments of $166.0 million and purchases of property and equipment of $0.4 million. In 2018, cash used in investing activities was $64.2 million related to purchases of short-term investments of $142.0 million and purchases of property and equipment of $0.4 million, partially offset by the maturity of investments of $78.2 million. Financing Activities In 2019, cash provided by financing activities was $267.3 million, and was primarily related to the net proceeds from public offerings of our common stock of $264.3 million, the proceeds received from the exercise of stock options of $2.1 million and the proceeds received from the issuance of common stock upon ESPP purchase of $0.9 million. In 2018, cash provided by financing activities was $116.6 million related to the net proceeds of $116.3 million received from the initial public offering and $0.3 million from the issuance of common stock in connection with stock option exercises. Contractual Obligations and Commitments The following table summarizes our commitments to settle contractual obligations as of December 31, 2019: We enter into agreements in the normal course of business with contract research organizations for clinical trials and with vendors for preclinical studies and other services and products for operating purposes which are cancelable at any time by us, generally upon 30 days prior written notice. These payments are not included in this table of contractual obligations. In addition, we have not included the potential contingent payment obligations from the following agreements described below in this table of contractual obligations because the timing and likelihood of such payments is not known. These payments generally become due and payable only upon achievement of certain development, regulatory or commercial milestones. Asset Purchase Agreement In June 2018, we entered into an asset purchase agreement with BliNK Biomedical SAS, or BliNK, pursuant to which we acquired all of BliNK’s assets relating to its research and development program for antibodies directed against CD47. These assets predominately consist of certain patents and patent applications of BliNK and BliNK’s opposition at the EPO against the third-party patent European Patent No. EP 2 282 772 as an acquired business asset. We paid BliNK an initial upfront payment of $2.0 million and an additional $1.0 million upon the completion of certain agreed activities by BliNK relating to the transfer of the assets to us. For each product incorporating a program antibody that satisfies certain clinical and commercial milestones in the United States, the European Union and Japan, we will be required to make milestone payments of up to $43.0 million. Until we receive marketing approval for the first product, or for so long as we continue development of product candidates related to the acquired intellectual property, we are required to pay BliNK a minimum annual fee of $0.3 million. In addition, we will pay BliNK a royalty of a tiered single digit percentage on net sales of any approved products. We have the right to buy out our royalty obligations in full by paying BliNK an agreed lump sum amount prior to the occurrence of certain defined events. License Agreements In July 2018, we entered into a settlement and license agreement with Synthon Biopharmaceuticals B.V., or Synthon. Under the agreement, we agreed to discontinue our ongoing oppositions and challenges at the European Patent Office, or the EPO, and the U.S. Patent and Trademark Office, or the USPTO, directed towards certain patents licensed by Synthon from Stichting Sanquin Bloedvoorziening, or SSB, that relate to the use of anti-CD47 products in combination with other antibodies to treat cancer. We also agreed to request the withdrawal of such proceedings with the USPTO and EPO. In return Synthon agreed to grant us a non-exclusive, worldwide sublicense to certain patents they have licensed from SSB, including the SSB patents we were opposing at the USPTO and EPO to commercialize a single anti-CD47 product (such as magrolimab or an alternate anti-CD47 product) to treat cancer in combination with other antibodies. In December 2016 and April 2017, we filed third party observations in an opposition proceeding in the EPO with respect to European Patent No. EP 2 282 772 and in January 2018, petitioned for inter partes review of U.S. Patent No. 9,352,037 in the USPTO, each of which is related to the treatment of cancer with an anti-CD47 antibody or an anti-SIRPα antibody in combination with certain other antibodies. The opposition proceeding was rejected by the EPO and the original opponent appealed the decision. On June 4, 2018, we acquired the opposition against this European patent from the original opponent. Pursuant to the agreement, we and Synthon have each agreed to release the other party (and we have agreed to release SSB) from all claims and liabilities relating to the USPTO and EPO proceedings. The sublicense grant was subject to specified conditions, which have now been met. These conditions included our withdrawal of the proceedings opposing the above-mentioned SSB U. S. and European patents and the termination of these proceedings by the USPTO and the EPO. In connection with the release of claims by Synthon and us, SSB agreed to release us from all claims and liabilities under the USPTO and EPO proceedings and to grant us a direct license to the sublicensed patents in the event the license between SSB and Synthon is terminated. Our sublicense includes the right to further sublicense the applicable patent rights to our collaborators, corporate partners and service providers and covers one named product, which is magrolimab. In addition, we have the right to replace magrolimab with a different anti-CD47 product in the event of a development failure of magrolimab. We will also have an option to expand our rights to cover a follow-on anti-CD47 product in exchange for a specified option exercise fee. Synthon retains the right to use the licensed patents and to grant other third parties the right to do so. In exchange, for these sublicenses and option rights, we agreed to pay Synthon an aggregate of up to approximately 40.0 million Euros comprising an upfront payment upon the grant of the sublicense and the achievement of future regulatory and commercial milestones which comprise the significant majority of the aggregate payments. If we exercise our option right, we will pay Synthon additional amounts upon the achievement of certain regulatory and commercial milestones related to such follow-on anti-CD47 product. In addition, we will be required to pay Synthon an annual license fee and a royalty of a tiered, low single digit percentage on net sales of any approved licensed products. We have the right to buy out our royalty obligations for each licensed product in full by paying Synthon specified lump sum amounts prior to the occurrence of certain defined events. License and Collaboration Agreements In September 2019, we entered into a research collaboration with bluebird to pursue clinical proof-of-concept for our novel antibody-based conditioning regimen, FSI-174 (anti-cKIT antibody) plus magrolimab (anti-CD47 antibody), with bluebird’s ex vivo lentiviral vector hematopoietic stem cell (LVV HSC) gene therapy platform. This collaboration will focus initially on diseases that have the potential to be corrected with transplantation of autologous gene-modified blood-forming stem cells. Pursuant to the agreement, each party will be responsible for 50% of the cost of the study. As of December 31, 2019, we recorded a receivable of $0.7 million from bluebird for reimbursement of research and development costs incurred. In January 2018, we entered into a clinical trial collaboration and supply agreement with Merck, to evaluate magrolimab combined with Merck’s cancer immunotherapy, avelumab, in a Phase 1b clinical trial in patients with ovarian cancer. Pursuant to the agreement, the parties will jointly pay for the cost of the study. As of December 31, 2019, we recorded a receivable of $0.3 million from Merck for reimbursement of research and development costs incurred. In November 2017, we entered into a master clinical trial collaboration agreement with Genentech to evaluate the safety, tolerability and preliminary efficacy of magrolimab combined with Genentech’s cancer immunotherapy, atezolizumab, a fully humanized monoclonal antibody targeting PD-L1, in two separate Phase 1b clinical trials (in patients with bladder cancer and AML, respectively). Pursuant to the agreement, we will supply magrolimab for the studies and will partially reimburse Genentech for its costs in connection with the bladder cancer study, and Genentech will supply atezolizumab for the studies and be solely responsible for all of its costs in connection with the AML study. In November 2015, we entered into a technology license agreement with Stanford under which Stanford granted us exclusive licenses under certain patents and other intellectual property rights relating to our current product candidates, including magrolimab and non-exclusive licenses under certain other patents and other intellectual property rights to develop, manufacture and commercialize products for use in certain licensed fields, including oncology. We are required to make milestone payments up to $5.6 million in respect of the first three licensed products that successfully satisfy certain clinical and regulatory milestones in the United States, major European countries and Japan. The first such milestone payment of $75,000 was paid to Stanford in February 2018. In addition, we are required to pay Stanford a minimum annual fee and a royalty of a tiered single digit percentage on net sales of licensed products, reimburse patent-related expenses and share any non-royalty sublicensing income received related to the licensed technology. Grant Funding Agreements In March 2017, we entered into an agreement with LLS regarding our NHL rituximab combination clinical trial, as amended in June 2018 to include an additional study. The LLS research grant stipulated various milestone-based payments with a total award of $4.2 million through December 2019 which we had received as of December 31, 2019. We are required to pay LLS certain development and regulatory approval milestone payments, as well as a low single digit percentage royalty on net sales, up to a maximum of $13.7 million in the aggregate. In July 2019, we entered into an amendment to our agreement with LLS to further advance the treatment of MDS. Under the amendment, we are eligible for up to $3.0 million in additional grant funding based on milestone payments from LLS upon the achievement of certain clinical or regulatory milestones in addition to the $4.2 million award that we received pursuant to the March 2017 agreement, as amended. As of December 31, 2019, we had not received any funding related to this grant. Pursuant to the amendment, we could be required in the future to pay amounts to LLS upon reaching certain development and regulatory approval milestones on the additional funding, up to a maximum of $6.0 million in the aggregate. We concluded that the contingent milestone payments in our agreement with LLS, as amended, represents a contingent repayment obligation. As of December 31, 2019, there was a liability for the contingent repayment obligation of approximately $2.9 million. In January 2017, we were awarded a research grant from CIRM supporting our CRC trial. The CIRM grant stipulates various milestone-based payments to us with the total award of $10.2 million over a period of four years. As of December 31, 2019, we had received $9.2 million under the award. In November 2017, we were awarded a second research grant from CIRM for a separate clinical trial study in AML. The total amount of the research grant awarded was $5.0 million in various milestone-based payments over a period of five years. During 2018, the award was amended to $3.2 million in various-milestone payments over a period of five years, as was provided for under the terms of the original award because we opted not to expand the patient population participating in the study. In July 2019, the award was further amended to include the patient population expansion that we previously opted out of in 2018. In connection with the same, the award was reinstated to $5.0 million consistent with the original award amount. As of December 31, 2019, we had received $3.6 million under the award. Under the terms of the CIRM grants, we are obligated to pay royalties and licensing fees based on a low single digit royalty percentage on net sales of CIRM-funded product candidates or CIRM-funded technology. We have the option to decline any and all amounts awarded by CIRM. As an alternative to revenue sharing, we have the option to convert each award to a loan, which option must be exercised on or before ten business days after the FDA notifies us that it has accepted our application for marketing authorization. In the event we exercise our right to convert an award to a loan, we will be obligated to repay the loan within ten business days of making such election, including interest at the rate equal to the three-month LIBOR rate (1.91% as of December 31, 2019) plus zero to 30% per annum that varies depending on the stage of the research and the stage of development at the time the election is made. In the event that we terminate a CIRM-funded clinical trial, we will be obligated to repay the remaining CIRM funds on hand. Off-Balance Sheet Arrangements During 2019 and 2018, we did not have any off-balance sheet arrangements as defined in Item 303 of Regulation S-K. Critical Accounting Policies Our management’s discussion and analysis of our financial condition and results of operations is based on our financial statements, which have been prepared in accordance with United States generally accepted accounting principles, or U.S. GAAP. The preparation of these financial statements requires us to make estimates and assumptions that affect the reported amounts of assets and liabilities and the disclosure of contingent assets and liabilities at the date of the financial statements, as well as the reported amounts of revenues and expenses incurred during the reporting periods. Our estimates are based on our historical experience and on various other factors that we believe are reasonable under the circumstances, the results of which form the basis for making judgments about the carrying value of assets and liabilities that are not readily apparent from other sources. Actual results may differ from these estimates under different assumptions or conditions. We believe that the assumptions and estimates associated with accrued research and development expenditures, stock-based compensation and revenue recognition have the most significant impact on our financial statements. Therefore, we consider these to be our critical accounting policies and estimates. Accrued Research and Development Expenditures We record accrued expenses for estimated preclinical study and clinical trial expenses. Estimates are based on the services performed pursuant to contracts with research institutions and contract research organizations and clinical manufacturing organizations that conduct and manage preclinical studies and clinical trials on our behalf based on actual time and expenses incurred by them. Further, we accrue expenses related to clinical trials based on the level of patient enrollment and activity according to the related agreement. We monitor patient enrollment levels and related activity to the extent reasonably possible and make judgments and estimates in determining the accrued balance in each reporting period. If we underestimate or overestimate the level of services performed or the costs of these services, our actual expenses could differ from our estimates. To date, we have not experienced significant changes in our estimates of preclinical studies and clinical trial accruals. Contingent Repayment Obligation We enter into research and license agreements that may include contingent milestone payments that are based upon reaching certain development and regulatory approval milestones. With respect to our agreement with the LLS, as amended, we have concluded that the contingent milestone payments result in a contingent repayment obligation. We estimate the fair value of the contingent repayment obligation using a valuation model designed to estimate the probability of the occurrence of such contingent milestone payments based on various assumptions and incorporating estimated success rates. Estimated payments are then discounted using present value techniques to arrive at an estimated fair value. The contingent repayment obligation is subject to revaluation at each balance sheet date, with revaluations recognized as a component of other income (expenses) in the Company’s statements of operations and comprehensive loss. The portion of the contingent repayment obligation that is subject to revaluation has a current cap of $4.2 million. The other portion of the contingent repayment obligation which is dependent upon future product sales is not included in the measurement as of December 31, 2019. Changes in the fair value of the contingent repayment obligation can result from changes to one or multiple inputs, including adjustments to the discount rate, changes in the assumed achievement or timing of development milestones, changes in the probability of the successful completion of stages of clinical trials, and changes in the probability of regulatory approval. These fair value measurements are based on significant inputs not observable in the market. Substantial judgment is used in determining these assumptions. Changes in assumptions could have a material impact on the recorded value and associated expense in any given period. In December 2019, the Company released positive clinical data which led to a change in estimate of the probability of success and the timing of achievement of regulatory milestones. This change in the estimate resulted in an increase of $2.5 million in the contingent repayment obligation. Stock-Based Compensation We recognize compensation costs related to stock-based awards granted, including stock options and employee stock purchase plan, based on the estimated fair value of the awards on the date of grant. We estimate the grant date fair value, and the resulting stock-based compensation, using the Black-Scholes option-pricing model. The grant date fair value of the stock-based awards is generally recognized on a straight-line basis over the requisite service period, which is generally the vesting period of the respective awards. The Black-Scholes option-pricing model requires the use of highly subjective assumptions to determine the fair value of stock-based awards. These assumptions include: • Expected Term-The expected term represents the period that stock-based awards are expected to be outstanding. The expected term for option grants is determined using the simplified method, as we do not have sufficient historical data to use any other method to estimate expected term. The simplified method deems the expected term to be the midpoint between the vesting date and the contractual life of the stock-based awards. • Expected Volatility-Since we have limited trading history for our common stock due to our short trading history, the expected volatility was estimated based on the average volatility for comparable publicly traded biotechnology companies over a period equal to the expected term of the stock option grants. The comparable companies were chosen based on their similar size, stage in the life cycle or area of specialty. • Risk-Free Interest Rate-The risk-free interest rate is based on the U.S. Treasury zero coupon issues in effect at the time of grant for periods corresponding with the expected term of option. • Expected Dividend-We have never paid dividends on our common stock and have no plans to pay dividends on our common stock. Therefore, we used an expected dividend yield of zero. We will continue to use judgment in evaluating the expected volatility and expected term utilized for our stock-based compensation calculations on a prospective basis. Revenue Recognition We enter into collaborative arrangements with partners that fall under the scope of Accounting Standards Codification Topic 808, Collaborative Arrangements (ASC 808). We analyze these collaboration arrangements to assess whether they are within the scope of ASC 808 to determine whether such arrangements involve joint operating activities performed by parties that are both active participants in the activities and exposed to significant risks and rewards dependent on the commercial success of such activities. This assessment is performed throughout the life of the arrangement based on changes in the responsibilities of all parties in the arrangement. The accounting for some of the activities under collaboration arrangements may be analogized to Accounting Standards Codification Topic 606, Revenue from Contracts with Customers (ASC 606) for distinct units of account that are reflective of a vendor-customer relationship. For units of account under the collaboration agreements which are not in the scope of ASC 606, we record the cost sharing or reimbursement activities as an adjustment or reduction to the research and development expenses. In determining the appropriate amount of revenue to be recognized as we fulfill our obligations under each of its agreements, we perform the following steps: (i) identification of the promised goods or services in the contract; (ii) determination of whether the promised goods or services are performance obligations including whether they are distinct in the context of the contract; (iii) measurement of the transaction price, including the constraint on variable consideration; (iv) allocation of the transaction price to the performance obligations based on estimated selling prices; and (v) recognition of revenue when (or as) we satisfy each performance obligation. If these arrangements contain a license to our intellectual property, we must use judgement to determine if the license is distinct from the other performance obligations identified in the arrangement. If the license is determined to be distinct, we recognize revenues attributed to the license when the license is transferred to the customer and the customer is able to use and benefit from the license. The transaction price may include non-refundable, upfront license fees, and potential development milestone payments. For the milestone payments, we must estimate whether the milestones are considered probable of being reached and estimate the amount, if any, to be included in the transaction price. Recent Accounting Pronouncements Not Yet Adopted Please refer to Note 2 to our financial statements appearing under Part II, Item 8 for a discussion of new accounting standards updates that may impact us.

<s>[INST] You should read the following discussion and analysis of our financial condition and results of operations in conjunction with our financial statements and related notes included in Part II, Item 8 of this Annual Report on Form 10K. This Annual Report on Form 10K contains forwardlooking statements within the meaning of Section 27A of the Securities Exchange Act of 1933, as amended, or the Securities Act, and Section 21E of the Securities Exchange Act of 1934, as amended, or the Exchange Act. Forwardlooking statements are identified by words such as “believe,” “will,” “may,” “estimate,” “continue,” “anticipate,” “intend,” “should,” “plan,” “expect,” “predict,” “could,” “potentially” or the negative of these terms or similar expressions. You should read these statements carefully because they discuss future expectations, contain projections of future results of operations or financial condition, or state other “forwardlooking” information. These statements relate to our future plans, objectives, expectations, intentions and financial performance and the assumptions that underlie these statements. These forwardlooking statements are subject to certain risks and uncertainties that could cause actual results to differ materially from those anticipated in the forwardlooking statements. Factors that might cause such a difference include, but are not limited to, those discussed in this report in Part I, Item 1A “Risk Factors,” and elsewhere in this report. Forwardlooking statements are based on our management’s beliefs and assumptions and on information currently available to our management. These statements, like all statements in this report, speak only as of their date, and we undertake no obligation to update or revise these statements in light of future developments. We caution investors that our business and financial performance are subject to substantial risks and uncertainties. Overview We are a clinicalstage immunooncology company focused on developing novel therapies to activate macrophages in the fight against cancer. We founded Forty Seven based on the insight that blocking CD47, a key signaling molecule that is overexpressed on cancer cells, renders tumors susceptible to macrophages. By harnessing macrophages, we believe that our lead product candidate, magrolimab (formerly known as 5F9), can transform the treatment of cancer. Magrolimab has demonstrated promising activity in multiple Phase 1b/2 clinical trials in which we have treated over 400 cancer patients with solid or hematologic tumors. In March 2020, Forty Seven entered into a definitive agreement to be acquired by Gilead Sciences, Inc., which is expected to close during the second quarter of 2020. We are also preparing to advance two additional investigational compounds into clinical testing. FSI174, an anticKIT antibody, is being developed alone or in combination with magrolimab as a novel, allantibody conditioning regimen to address the limitations of current stem cell transplantation conditioning regimens. FSI189, an antiSIRPα antibody, is being developed for the treatment of cancer, as well as certain nononcology conditions, including transplantation conditioning. We focus our efforts on targeting the CD47 pathway as a way to engage macrophages in fighting tumors. Macrophages function as first responders, swallowing foreign and abnormal cells, including cancer cells, and mobilizing other components of the immune system including T cells and antibodies. Cancer cells use CD47, a “don’t eat me” signal, in order to evade detection by the immune system and subsequent destruction by macrophages. Overexpression of CD47 is common to nearly all types of tumors including myelodysplastic syndrome, or MDS, acute myelogenous leukemia, or AML, NonHodgkin’s lymphoma, or NHL, colorectal cancer, or CRC, gastric cancer, lung cancer, and ovarian cancer with overexpression correlating with poor prognosis in many of these cancers. Despite the central role of macrophages as celleating scavengers and first responders, the pharmaceutical industry is only beginning to bring this key group of cells into the fight against cancer. Our company was founded in 2014 by leading scientists at Stanford University who uncovered the fundamental role of CD [/INST] Positive. </s>

DFB Healthcare Acquisitions Corp.

2019-03-29

2018-12-31

ITEM 7. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS The following discussion should be read in conjunction with our financial statements and related notes thereto included elsewhere in this report. Certain information contained in the discussion set forth below includes forward-looking statements. Our actual results may differ materially from those anticipated in these forward-looking statements as a result of many factors, including those set forth under “Cautionary Note Regarding Forward-Looking Statements,” “Item 1A. Risk Factors” and elsewhere in this report. Overview We are a blank check company incorporated as a Delaware corporation and formed for the purpose of effecting a merger, capital stock exchange, asset acquisition, stock purchase, reorganization or similar business combination with one or more businesses. Although we are not limited to a particular industry or sector for purposes of consummating a business combination, we have initially focused our search on the healthcare or healthcare related industries. Our sponsor is Deerfield/RAB Ventures, LLC, a Delaware limited liability company. The registration statement for our initial public offering was declared effective on February 15, 2018. On February 21, 2018, we consummated our initial public offering of 25,000,000 units sold to the public at the price of $10.00 per unit, generating gross proceeds of $250,000,000. Each unit consists of one share of common stock and one-third of one redeemable warrant which entitles the holder to purchase one share of common stock at an exercise price of $11.50 per share, subject to adjustment. The underwriters were granted a 45-day option to purchase up to 3,750,000 additional units to cover over-allotments, if any, at $10.00 per unit. The over-allotment option was not exercised prior to its expiration on April 2, 2018. Simultaneously with the consummation of our initial public offering, we consummated a private placement of 4,333,333 warrants at a price of $1.50 per private placement warrant, generating total proceeds of $6,500,000. In the private placement, our sponsor purchased 4,333,333 private placement warrants. Following our initial public offering and the private placement, and after deducting offering expenses, $250,000,000 (including $7,875,000 of deferred underwriting commissions) were placed in a trust account located in the United States at J.P. Morgan Chase Bank, N.A., with Continental Stock Transfer & Trust Company acting as trustee. If we are unable to complete a business combination by February 21, 2020, we will (i) cease all operations except for the purpose of winding up, (ii) as promptly as reasonably possible but not more than ten business days thereafter, redeem the public shares, at a per-share price, payable in cash, equal to the aggregate amount then on deposit in the trust account including interest (less up to $50,000 of interest to pay dissolution expenses, which interest shall be net of taxes payable by us and any amounts released to us to fund working capital requirements, which such working capital is subject to an annual limit of $250,000), divided by the number of then outstanding public shares, which redemption will completely extinguish public stockholders’ rights as stockholders (including the right to receive further liquidating distributions, if any), subject to applicable law, and (iii) as promptly as reasonably possible following such redemption, subject to the approval of our remaining stockholders and our board of directors, dissolve and liquidate, subject in each case to our obligations under Delaware law to provide for claims of creditors and the requirements of other applicable law. Results of Operations Our entire activity since November 22, 2017 (inception) through December 31, 2018 was in preparation for our initial public offering, and since our initial public offering, our activity has been limited to the search for a prospective initial business combination. We will not be generating any operating revenues until the closing and completion of our initial business combination. We have increased expenses as a result of being a public company (for legal, financial reporting, accounting and auditing compliance), as well as for due diligence expenses. We expect our expenses to increase substantially after this period. For the year ended December 31, 2018, we had net income of approximately $2.1 million, which consisted of approximately $4.1 million in interest income, offset by approximately $1.0 million in general and administrative costs, $198,000 in franchise tax expense, and $830,000 in income tax expense. For the year ended December 31, 2017, we had net loss of $693, which consisted solely of general and administrative costs. Liquidity and Going Concern As indicated in the accompanying financial statements, as of December 31, 2018, we had approximately $947,000 in our operating bank account, a working capital of approximately $406,000, and approximately $3.0 million of interest income available (which interest shall be net of taxes payable and any amounts, subject to an annual limit of $250,000 released to us to fund working capital requirements). Through December 31, 2018, our liquidity needs have been satisfied through receipt of a $25,000 capital contribution from our sponsor in exchange for the issuance of the founder shares to our sponsor, $270,531 in loans from our sponsor, the proceeds from the consummation of the private placement not held in the trust account, and interest withdrawn from the trust account of approximately $1.1 million during the year ended December 31, 2018 to pay for tax purposes only. We fully repaid the loans from our sponsor on February 21, 2018. Following our initial public offering and the private placement, $250,000,000 was placed in the trust account, including $7,875,000 of deferred underwriting commissions. We intend to use substantially all of the funds held in the trust account, including any amounts representing interest earned on the trust account (which interest shall be net of taxes payable by us and any amounts released to us to fund working capital requirements, subject to an annual limit of $250,000 and excluding deferred underwriting commissions) to complete our initial business combination. We may withdraw interest to pay taxes and fund working capital requirements (subject to an annual limit of $250,000 for withdrawals to fund working capital requirements). To the extent that our equity or debt is used, in whole or in part, as consideration to complete our initial business combination, the remaining proceeds held in the trust account will be used as working capital to finance the operations of the target business or businesses, make other acquisitions and pursue our growth strategies. In connection with our management’s assessment of going concern considerations in accordance with FASB’s Accounting Standards Update 2014-15, “Disclosures of Uncertainties about an Entity’s Ability to Continue as a Going Concern,” our management has determined that the mandatory liquidation and subsequent dissolution raises substantial doubt about our ability to continue as a going concern. No adjustments have been made to the carrying amounts of assets or liabilities should we be required to liquidate after February 21, 2020. Related Party Transactions Founder Shares In December 2017, our sponsor purchased an aggregate of 7,187,500 founder shares for an aggregate purchase price of $25,000. In December 2017 and January 2018, our sponsor transferred 100,000 founder shares to Mr. Wolfe and 30,000 founder shares to each of our independent directors. Following the expiration of the underwriters’ over-allotment option on April 2, 2018, the initial stockholders forfeited an aggregate of 937,500 founder shares, so that the founder shares would represent 20.0% of our issued and outstanding shares after our initial public offering. The initial stockholders agreed, subject to limited exceptions, not to transfer, assign or sell any of their founder shares until the earlier to occur of: (A) one year after the completion of the initial business combination or (B) subsequent to the initial business combination, (x) if the last sale price of the common stock equals or exceeds $12.00 per share (as adjusted for stock splits, stock dividends, reorganizations, recapitalizations and the like) for any 20 trading days within any 30-trading day period commencing at least 150 days after the initial Business Combination, or (y) the date on which we complete a liquidation, merger, capital stock exchange or other similar transaction that results in all of our stockholders having the right to exchange their shares of common stock for cash, securities or other property. Private Placement Warrants Concurrently with the closing of our initial public offering, our sponsor purchased an aggregate of 4,333,333 private placement warrants at a price of $1.50 per private placement warrant, generating gross proceeds of $6,500,000 in the private placement. Our sponsor had agreed that if the over-allotment option was exercised, our sponsor would have purchased up to an additional 500,000 private placement warrants at a price of $1.50 per private placement warrant, for additional gross proceeds of $750,000. Each private placement warrant is exercisable for one share of common stock at a price of $11.50 per share. The proceeds from the private placement warrants were added to the proceeds from our initial public offering held in the trust account. If we do not complete a business combination by February 21, 2020, the private placement warrants will expire worthless. The private placement warrants are non-redeemable and exercisable on a cashless basis so long as they are held by our sponsor or its permitted transferees. Our sponsor and our officers and directors agreed, subject to limited exceptions, not to transfer, assign or sell any of their private placement warrants until 30 days after the completion of the initial business combination. An affiliate of Deerfield Management, which is a significant owner of our sponsor, purchased 2,500,000 units in our initial public offering at $10.00 per unit. The underwriters did not receive any underwriting discounts or commissions on the units purchased by Deerfield Management’s affiliate. In addition, Deerfield Management has indicated an interest to purchase up to an aggregate of $100,000,000 of our shares of common stock in a private placement that would occur concurrently with the consummation of the initial business combination. The funds from such private placement would be used as part of the consideration to the sellers in the initial business combination, and any excess funds from such private placement would be used for working capital in the post-transaction company. However, because indications of interest are not binding agreements or commitments to purchase, Deerfield Management may determine not to purchase any such shares, or to purchase fewer shares than they have indicated an interest in purchasing. Furthermore, we are not under any obligation to sell any such shares. Related Party Loans Our sponsor loaned us an aggregate of $270,531 to cover expenses related to our initial public offering and working capital needs. The loan was non-interest bearing. We repaid this loan on February 21, 2018. In addition, in order to finance transaction costs in connection with a business combination, our sponsor or an affiliate of our sponsor, or certain of our officers and directors may, but are not obligated to, loan us funds as may be required. If we complete a business combination, we would repay the working capital loans out of the proceeds of the trust account released to us. Otherwise, the working capital loans would be repaid only out of funds held outside the trust account. In the event that a business combination does not close, we may use a portion of proceeds held outside the trust account to repay the working capital loans but no proceeds held in the trust account would be used to repay the working capital loans. Except for the foregoing, the terms of such working capital loans, if any, have not been determined and no written agreements exist with respect to such loans. The working capital loans would either be repaid upon consummation of a business combination, without interest, or, at the lender’s discretion, up to $1,500,000 of such working capital loans may be convertible into warrants of the post-business combination entity at a price of $1.50 per warrant. The warrants would be identical to the private placement warrants. To date, we have had no borrowings under the working capital loans. Critical Accounting Policies and Estimates This management’s discussion and analysis of our financial condition and results of operations is based on our financial statements, which have been prepared in accordance with GAAP. The preparation of these financial statements requires us 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. On an ongoing basis, we evaluate our estimates and judgments, including those related to fair value of financial instrument and accrued expenses. We base our estimates on historical experience, known trends and events and various other factors that we believe to be reasonable under the circumstances, the results of which form the basis for making judgments about the carrying values of assets and liabilities that are not readily apparent from other sources. Actual results may differ from these estimates under different assumptions or conditions. We have identified the following critical accounting policy: Common Stock Subject to Possible Redemption We account for our common stock subject to possible redemption in accordance with the guidance in Accounting Standards Codification Topic 480 “Distinguishing Liabilities from Equity.” Shares of common stock subject to mandatory redemption (if any) are classified as liability instruments and are measured at fair value. Conditionally redeemable shares of common stock (including shares of common stock that feature redemption rights that are either within the control of the holder or subject to redemption upon the occurrence of uncertain events not solely within our control) are classified as temporary equity. At all other times, shares of common stock are classified as stockholders’ equity. Our common stock features certain redemption rights that are considered to be outside of our control and subject to the occurrence of uncertain future events. Accordingly, shares of common stock subject to possible redemption are presented at redemption value as temporary equity, outside of the stockholders’ equity section of our balance sheet. Recent accounting pronouncements In August 2018, the SEC adopted the final rule under SEC Release No. 33-10532, “Disclosure Update and Simplification,” amending certain disclosure requirements that were redundant, duplicative, overlapping, outdated or superseded. In addition, the amendments expanded the disclosure requirements on the analysis of stockholders’ equity for financial statements. Under the amendments, an analysis of changes in each caption of stockholders’ equity presented in the balance sheet must be provided in a note or separate statement. The analysis should present a reconciliation of the beginning balance to the ending balance of each period for which a statement of income is required to be filed. We anticipate the first presentation of the revised presentation of changes in stockholders’ equity will be included in our Form 10-Q for the quarter ended March 31, 2019. Management does not believe that there are any other recently issued, but not yet effective, accounting standards, if currently adopted, would have a material effect on our financial statements. Off-Balance Sheet Arrangements As of December 31, 2018 and 2017, we did not have any off-balance sheet arrangements as defined in Item 303(a)(4)(ii) of Regulation S-K. We do not participate in transactions that create relationships with unconsolidated entities or financial partnerships, often referred to as variable interest entities, which would have been established for the purpose of facilitating off-balance sheet arrangements. We have not entered into any off-balance sheet financing arrangements, established any special purpose entities, guaranteed any debt or commitments of other entities, or purchased any non-financial assets. Contractual Obligations We do not have any long-term debt obligations, capital lease obligations, operating lease obligations, purchase obligations or long-term liabilities, other than an agreement to pay our sponsor a monthly fee of $10,000 for office space, utilities and administrative support and an agreement to pay $7,500 per month to Mr. Wolfe for his services prior to the consummation of the initial business combination. We began incurring these fees on February 16, 2018 and will continue to incur these fees until the earlier of the completion of our initial business combination or our liquidation. JOBS Act On April 5, 2012, the JOBS Act was signed into law. The JOBS Act contains provisions that, among other things, relax certain reporting requirements for qualifying public companies. We qualify as an “emerging growth company” and under the JOBS Act are allowed to comply with new or revised accounting pronouncements based on the effective date for private (not publicly traded) companies. We are electing to delay the adoption of new or revised accounting standards, and as a result, we may not comply with new or revised accounting standards on the relevant dates on which adoption of such standards is required for non-emerging growth companies. As a result, our financial statements may not be comparable to companies that comply with new or revised accounting pronouncements as of public company effective dates. Additionally, we are in the process of evaluating the benefits of relying on the other reduced reporting requirements provided by the JOBS Act. Subject to certain conditions set forth in the JOBS Act, if, as an “emerging growth company”, we choose to rely on such exemptions we may not be required to, among other things, (i) provide an auditor’s attestation report on our system of internal controls over financial reporting pursuant to Section 404, (ii) provide all of the compensation disclosure that may be required of non-emerging growth public companies under the Dodd-Frank Wall Street Reform and Consumer Protection Act, (iii) comply with any requirement that may be adopted by the PCAOB regarding mandatory audit firm rotation or a supplement to the auditor’s report providing additional information about the audit and the financial statements (auditor discussion and analysis), and (iv) disclose certain executive compensation related items such as the correlation between executive compensation and performance and comparisons of the chief executive officer’s compensation to median employee compensation. These exemptions will apply for a period of five years following the completion of our initial public offering or until we are no longer an “emerging growth company,” whichever is earlier.

<s>[INST] Overview We are a blank check company incorporated as a Delaware corporation and formed for the purpose of effecting a merger, capital stock exchange, asset acquisition, stock purchase, reorganization or similar business combination with one or more businesses. Although we are not limited to a particular industry or sector for purposes of consummating a business combination, we have initially focused our search on the healthcare or healthcare related industries. Our sponsor is Deerfield/RAB Ventures, LLC, a Delaware limited liability company. The registration statement for our initial public offering was declared effective on February 15, 2018. On February 21, 2018, we consummated our initial public offering of 25,000,000 units sold to the public at the price of $10.00 per unit, generating gross proceeds of $250,000,000. Each unit consists of one share of common stock and onethird of one redeemable warrant which entitles the holder to purchase one share of common stock at an exercise price of $11.50 per share, subject to adjustment. The underwriters were granted a 45day option to purchase up to 3,750,000 additional units to cover overallotments, if any, at $10.00 per unit. The overallotment option was not exercised prior to its expiration on April 2, 2018. Simultaneously with the consummation of our initial public offering, we consummated a private placement of 4,333,333 warrants at a price of $1.50 per private placement warrant, generating total proceeds of $6,500,000. In the private placement, our sponsor purchased 4,333,333 private placement warrants. Following our initial public offering and the private placement, and after deducting offering expenses, $250,000,000 (including $7,875,000 of deferred underwriting commissions) were placed in a trust account located in the United States at J.P. Morgan Chase Bank, N.A., with Continental Stock Transfer & Trust Company acting as trustee. If we are unable to complete a business combination by February 21, 2020, we will (i) cease all operations except for the purpose of winding up, (ii) as promptly as reasonably possible but not more than ten business days thereafter, redeem the public shares, at a pershare price, payable in cash, equal to the aggregate amount then on deposit in the trust account including interest (less up to $50,000 of interest to pay dissolution expenses, which interest shall be net of taxes payable by us and any amounts released to us to fund working capital requirements, which such working capital is subject to an annual limit of $250,000), divided by the number of then outstanding public shares, which redemption will completely extinguish public stockholders’ rights as stockholders (including the right to receive further liquidating distributions, if any), subject to applicable law, and (iii) as promptly as reasonably possible following such redemption, subject to the approval of our remaining stockholders and our board of directors, dissolve and liquidate, subject in each case to our obligations under Delaware law to provide for claims of creditors and the requirements of other applicable law. Results of Operations Our entire activity since November 22, 2017 (inception) through December 31, 2018 was in preparation for our initial public offering, and since our initial public offering, our activity has been limited to the search for a prospective initial business combination. We will not be generating any operating revenues until the closing and completion of our initial business combination. We have increased expenses as a result of being a public company (for legal, financial reporting, accounting and auditing compliance), as well as for due diligence expenses. We expect our expenses to increase substantially after this period. For the year ended December 31, 2018, we had net income of approximately $2.1 million, which consisted of approximately $4.1 million in interest income, offset by approximately $1.0 million in general and administrative costs, $198,000 in franchise tax expense, and [/INST] Negative. </s>

AdaptHealth Corp.

2020-03-06

2019-12-31

Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations The following discussion should be read in conjunction with AdaptHealth Corp.’s (“AdaptHealth” or the “Company”) consolidated financial statements and the accompanying notes included in this report. All amounts presented are in accordance with U.S. generally accepted accounting principles (“U.S. GAAP”), except as noted. In addition to historical information, this discussion contains forward-looking statements that involve risks, uncertainties and assumptions that could cause actual results to differ materially from management’s expectations. Factors that could cause such differences include, but are not limited to, those discussed in Item 1A, “Risk Factors”, of this report on Form 10-K. AdaptHealth Corp. Overview AdaptHealth is a leading provider of home healthcare equipment, supplies and related services in the United States. The Company focuses primarily on providing (i) sleep therapy equipment, supplies and related services (including CPAP and bi PAP services) to individuals suffering from obstructive sleep apnea, (ii) home medical equipment to patients discharged from acute care and other facilities, (iii) oxygen and related chronic therapy services in the home and (iv) other HME medical devices and supplies on behalf of chronically ill patients with diabetes care, wound care, urological, ostomy and nutritional supply needs. The Company services beneficiaries of Medicare, Medicaid and commercial insurance payors. As of December 31, 2019, AdaptHealth serviced approximately 1.2 million patients annually in 49 states through its network of 173 locations in 35 states. Following its acquisition of PCS from McKesson Corporation in January 2020, AdaptHealth services over approximately 1.4 million patients annually in all 50 states through its network of 187 locations in 38 states. The Company’s principal executive offices are located at 220 West Germantown Pike, Suite 250, Plymouth Meeting, Pennsylvania 19462. Trends and Factors Affecting AdaptHealth’s Future Performance Significant trends and factors that AdaptHealth believes may affect its future performance include: · Home Medical Equipment Growth. According to CMS, the HME industry has grown from $40 billion in 2010 to $56 billion in 2018 (representing a 4.3% CAGR), of which AdaptHealth’s total addressable market for its sleep therapy, oxygen services, mobility products and hospice HME business lines comprised approximately $12 billion to $15 billion in 2018. During that time Medicaid data shows a continued shift of long-term services and supports (LTSS) spending into the home, with 57% of that spending going to home and community-based services in 2016. According to CMS, the HME market is projected to continue to grow at a 6.1% CAGR over the next nine years. As a result of the acquisition of the diabetic, wound care, ostomy and urological supplies business of PCS in January 2020, the Company believes it has more than doubled its addressable market to more than $25 billion. · Aging U.S. Population. The population of adults aged 65 and older in the U.S., a significant group of end users of AdaptHealth’s products and services, is expected to continue to grow and thus grow AdaptHealth’s market opportunity. According to CMS, in the U.S., the population of adults between the ages of 65 and 84 is expected to grow at a 2.5% CAGR through 2030, while the population of adults over 85 is projected to grow at a 2.9% CAGR during that same time period. Not only is the elderly population expected to grow, but they are also expected to make up a larger percentage of the total U.S. population. According to the U.S. Census Bureau, the U.S. geriatric population was approximately 15% of the total population in 2014 and is expected to grow to approximately 24% of the total population by 2060. · Increasing Prevalence of Chronic Conditions. HME is necessary to help treat significant health issues affecting millions of Americans, such as chronic obstructive pulmonary disease, congestive heart failure, obstructive sleep apnea and diabetes. · Increasing Prevalence of and Preference for In-Home Treatments. The number of conditions that can be treated in the home continues to grow, with recent additions including chronic wound care, sleep testing, dialysis and chemotherapy. In home care is also increasingly becoming the preferred method of treatment, particularly for the elderly population. According to the AARP Public Policy Institute, 90% of patients over age 55 have indicated a preference to receive care in the home rather than in an institutional setting. · Home Care is the Lowest Cost Setting. Not only is in-home care typically just as effective as care delivered in an inpatient setting, but it has also proven to be more cost effective. This is especially important within the context of government pressures to lower the cost of care, pushing clinicians to seek care settings that are less costly than hospitals and inpatient facilities. On a daily basis, home healthcare has been estimated by Cain Brothers & Company, LLC to be approximately seven times less expensive than care provided in skilled nursing facilities, the closest acuity site of care. In-home care offers a significant cost reduction opportunity relative to facility based care without sacrificing quality. Certain additional items may impact the comparability of the historical results presented below with AdaptHealth’s future performance, such as the cost of being a public company. To operate as a public company, AdaptHealth will be required to continue to implement changes in certain aspects of its business and develop, manage, and train management level and other employees to comply with ongoing public company requirements, including compliance with Section 404 and the evaluation of the effectiveness of internal controls over financial reporting. AdaptHealth will also incur new expenses as a public company, including expenses associated with public reporting obligations, proxy statements and stockholder meetings, stock exchange fees, transfer agent fees, SEC and Financial Industry Regulatory Authority filing fees and offering expenses. Key Components of Operating Results Net Revenue. Net revenues are recorded for services that AdaptHealth provides to patients for home healthcare equipment and related services. AdaptHealth’s primary service lines are (i) sleep therapy equipment, supplies and related services (including CPAP and bi-PAP services) to individuals suffering from OSA, (ii) home medical equipment to patients discharged from acute care and other facilities and (iii) respiratory, including oxygen and related chronic therapy services in the home. Net revenues also include other services and supplies, primarily related to orthotics, enteral and hospice. Revenues are recorded either (x) at a point in time for the sale of supplies and disposables, or (y) over the service period for equipment rental (including, but not limited to, CPAP machines, hospital beds, wheelchairs and other equipment), at amounts estimated to be received from patients or under reimbursement arrangements with Medicare, Medicaid and other third-party payors, including private insurers. For the year ended December 31, 2019, approximately 60% and 40% of revenues were recognized at a point in time and over the service period, respectively. For the year ended December 31, 2018, approximately 55% and 45% of revenues were recognized at a point in time and over the service period, respectively. Net revenues are net of related provision for doubtful accounts and implicit price concessions. Provision for doubtful accounts consists of billed charges that are ultimately deemed uncollectible due to a patient’s or a third-party payor’s inability or unwillingness to pay. The amount is based on management’s best estimate of the net realizable value of accounts receivable. Variable consideration in the form of implicit price concessions that is not expected to be collected from customers are recorded as a direct reduction of net revenues. The Company adopted Financial Accounting Standards Board (“FASB”) Accounting Standards Codification (“ASC”) Topic 606, Revenue from Contracts with Customers (ASC 606), effective January 1, 2019, using the modified retrospective transition method. Results for reporting periods beginning after January 1, 2019 are presented under ASC 606, while comparative information has not been restated and continues to be reported under the accounting standards in effect for those periods. The Company’s adoption of ASC 606 primarily impacts the presentation of revenues due to the inclusion of variable consideration in the form of implicit price concessions contained in certain of its contracts with customers. Under ASC 606, amounts estimated to be uncollectible are generally considered implicit price concessions that are a direct reduction to net revenues. Prior to adoption of ASC 606, such amounts were classified as provision for doubtful accounts. Cost of Net Revenue. Cost of net revenues includes the cost of non-capitalized medical equipment and supplies, distribution expenses, labor costs, facilities rental costs, third-party revenue cycle management costs and depreciation for capitalized patient equipment. Distribution expenses represents the cost incurred to coordinate and deliver products and services to the patients. Included in distribution expenses are leasing, maintenance, licensing and fuel costs for the vehicle fleet; salaries, benefits and other costs related to drivers and dispatch personnel; and amounts paid to couriers. General and Administrative Expenses. General and administrative expenses consist of corporate support costs including information technology, human resources, finance, contracting, legal, compliance, equity-based compensation, transaction expenses and other administrative costs. Depreciation, Excluding Patient Equipment Depreciation. Depreciation expense includes depreciation charges for capital assets other than patient equipment (which is included as part of the cost of net revenues). Factors Affecting AdaptHealth’s Operating Results AdaptHealth’s operating results and financial performance are influenced by certain unique events during the periods discussed herein, including the following: Acquisitions AdaptHealth accounts for its acquisitions in accordance with FASB ASC Topic 805, Business Combinations, and the operations of the acquired entities are included in the historical results of AdaptHealth for the periods following the closing of the acquisition. The most significant of these acquisitions impacting the comparability of AdaptHealth’s operating results in 2019 compared to 2018 were PPS HME Holdings (“PP”S) acquired in May 2018, Verus Healthcare, Inc. (“Verus”) acquired in May 2018, Home Medical Express, Inc. (“HMEI”) acquired in July 2018, Med Way Medical, Inc. (“Med Way”) acquired in December 2018, Continued Care of Long Island, Inc. (“CCLI”) acquired in October 2018, SleepMed Therapies, Inc. (“SleepMed”) acquired in July 2019, and Gould’s Discount Medical, LLC (“Gould’s”) acquired in January 2019. Refer to Note 3, Acquisitions, included in our consolidated financial statements for the year ended December 31, 2019 included in this report for additional information regarding AdaptHealth’s acquisitions. Debt and Recapitalization On March 20, 2019, AdaptHealth entered into the Third Amended and Restated Credit and Guaranty Agreement and restructured its debt borrowings with its bank group. The debt restructuring consisted of $425 million in credit facilities, which includes a $300 million Initial Term Loan (the “Credit Facility Term Loan”), $50 million Delayed Draw Term Loan (the “Delayed Draw Loan”), and $75 million Revolving Credit Facility (the “New Revolver”), all with maturities in March 2024. The Credit Facility Term Loan may consist of Base Rate Loans or LIBOR Rate Loans (as defined in the agreement).” On March 20, 2019, AdaptHealth entered into a Note and Unit Purchase Agreement with certain affiliates of BlueMountain Capital Management, LLC. In connection with the agreement, membership interests in AdaptHealth Holdings were purchased for $20 million, and AdaptHealth also signed a promissory note agreement with a principal amount of $100 million (the “BM Note”). The outstanding principal amount under the BM Note was due on the tenth anniversary of the agreement and bore interest at the following rates (a) for the period starting on the closing date and ending on the seventh anniversary, a rate of 12% per annum, with 6% payable in cash and 6% payment in kind, and (b) for the period starting on the day after the seventh anniversary of the closing date and ending on the maturity date, a rate equal to the greater of (i) 15% per annum or (ii) the twelve-month LIBOR plus 12% per annum. The transactions consummated with respect to the Third Amended and Restated Credit and Guaranty Agreement and the Note and Unit Purchase Agreement are hereinafter referred to as the “2019 Recapitalization.” In connection with the closing of the Business Combination, the Company amended its credit facility primarily to (i) increase the amount available under the Delayed Draw Loan from $50 million to $100 million, and (ii) revise the Consolidated Total Leverage Ratio thresholds and lower the applicable margin to determine the variable quarterly interest rate under the credit facility. In addition, the Company repaid $50.0 million under the Credit Facility Term Loan using the proceeds received from the transactions completed as part of the Business Combination; such repayment was applied to the principal payments required to be paid through September 2023. In addition, the Company repaid $31.5 million that was outstanding under the New Revolver. Further, in connection with the closing of the Business Combination, the BM Note was replaced with a new amended and restated promissory note with a principal amount of $100 million. In addition, certain affiliates of BlueMountain Capital Management, LLC converted certain of its members’ equity interests to a $43.5 million promissory note. The new $100 million promissory note, together with the $43.5 million promissory note, are collectively referred to herein as the New Promissory Note. The outstanding principal amount under the New Promissory Note is due on November 8, 2029 and bears interest at the following rates (a) for the period starting on the closing date and ending on the seventh anniversary, a rate of 12% per annum, with 6% payable in cash and 6% Payment in Kind (“PIK”), and (b) for the period starting on the day after the seventh anniversary of the closing date and ending on the maturity date, a rate equal to the greater of (i) 15% per annum or (ii) the twelve-month LIBOR plus 12% per annum. The Company has the option to pay the PIK interest in cash. Seasonality AdaptHealth’s business is somewhat sensitive to seasonal fluctuations. Its patients are generally responsible for a greater percentage of the cost of their treatment or therapy during the early months of the year due to co-insurance, co-payments and deductibles, and therefore may defer treatment and services of certain therapies until meeting their annual deductibles. In addition, changes to employer insurance coverage often go into effect at the beginning of each calendar year which may impact eligibility requirements and delay or defer treatment. These factors may lead to lower net revenue and cash flow in the early part of the year versus the latter half of the year. Additionally, the increased incidence of respiratory infections during the winter season may result in initiation of additional respiratory services such as oxygen therapy for certain patient populations. AdaptHealth’s quarterly operating results may fluctuate significantly in the future depending on these and other factors. Key Business Metrics AdaptHealth focuses on net revenue, EBITDA, Adjusted EBITDA and Adjusted EBITDA less Patient Equipment Capex as it reviews its performance. Total net revenue is comprised of net sales revenue and net revenue from fixed monthly equipment reimbursements less a provision for doubtful accounts and implicit price concessions. Net sales revenue consists of revenue recognized at a point in time for the sale of supplies and disposables. Net revenue from fixed monthly equipment reimbursements consists of revenue recognized over the service period for equipment (including, but not limited to, CPAP machines, hospital beds, wheelchairs and other equipment). Results of Operations Comparison of Year Ended December 31, 2019 and Year Ended December 31, 2018. The following table summarizes AdaptHealth’s consolidated results of operations for the years ended December 31, 2019 and December 31, 2018: (1) The Company adopted ASC 606 effective January 1, 2019, the effects of which have not been reflected in prior periods. The Company’s adoption of ASC 606 primarily impacts the presentation of revenues due to the inclusion of variable consideration in the form of implicit price concessions contained in certain of its contracts with customers. Under ASC 606, amounts estimated to be uncollectible are generally considered implicit price concessions that are a direct reduction to net revenue. Prior to adoption of ASC 606, such amounts were classified as provision for doubtful accounts. For the year ended December 31, 2019, the Company recorded approximately $27.5 million of implicit price concessions as a direct reduction of net revenue that would have been recorded as provision for doubtful accounts prior to the adoption of ASC 606. Net Revenue. Net revenue for the year ended December 31, 2019 was $529.6 million compared to $345.3 million for the year ended December 31, 2018, an increase of $184.4 million or 53.4%. The increase in net revenue was driven primarily by acquisitions, which increased revenue by approximately $156.3 million. The remaining increase in net revenue was attributable to organic growth resulting from demographic growth in core markets and CPAP resupply sales and marketing initiatives. For the year ended December 31, 2019, sales revenue (recognized at a point in time) comprised approximately 60% of total net revenue, compared to approximately 55% of total net revenue for the year ended December 31, 2018. The increase in sales revenue was driven primarily by the Verus and SleepMed acquisitions, which are predominantly CPAP resupply businesses and therefore have a high sales revenue mix, as well as strong organic growth in this category. For the year ended December 31, 2019, revenue from fixed monthly equipment reimbursements comprised approximately 40% of total net revenue, compared to approximately 45% of total net revenue for the year ended December 31, 2018. Cost of Net Revenue. Cost of net revenue for the year ended December 31, 2019 was $440.4 million compared to $293.4 million for the year ended December 31, 2018, an increase of $147.0 million or 50.1%. Cost of net revenue as a percentage of net revenue was 83.1% of net revenue for the year ended December 31, 2019, compared to 85.0% of net revenue for the year ended December 31, 2018. The 1.9% decrease in cost of net revenue as a percentage of net revenue is due in part to lower labor expense due to an increased usage of a global workforce, offset by an increase to expense of approximately $0.9 million associated with earnout liability activity relating to acquisitions. The $147.0 million increase in cost of net revenue is primarily attributable to acquisition growth. General and Administrative Expenses. General and administrative expenses for the year ended December 31, 2019 were $56.5 million compared to $18.1 million for the year ended December 31, 2018, an increase of $38.4 million or 212.7%. General and administrative expenses as a percentage of net revenue was 10.7% for the year ended December 31, 2019, and 5.2% for the year ended December 31, 2018. General and administrative expenses for the year ended December 31, 2019 included $11.1 million in equity-based compensation expense, $15.6 million in transaction costs, $1.4 million in severance expenses and $0.3 million in other non-recurring expenses. General and administrative expenses for the year ended December 31, 2018 included $0.9 million in equity-based compensation expense, and $2.4 million in transaction costs. Excluding the impact of equity-based compensation expense, transaction costs, severance and other non-recurring expenses, general and administrative expenses as a percentage of net revenue was 5.3% and 4.3% for the years ended December 31, 2019 and 2018, respectively. The $38.4 million increase was primarily comprised of an increase in labor costs of $21.0 million which included a $10.2 million increase in equity-based compensation expense, and an increase in other general and administrative expenses of $17.4 million of which $13.1 million was transaction related. Excluding the impact attributable to equity-based compensation and transaction costs, the increase was a result of increased support costs related to acquisition growth as well as incremental costs associated with operating as a public company. Interest Expense. Interest expense for the year ended December 31, 2019 was $39.3 million compared to $7.5 million for the year ended December 31, 2018. The increase in interest expense was driven by higher long-term debt obligations to fund acquisitions as well as the 2019 Recapitalization. Additionally, during the year ended December 31, 2019, AdaptHealth recorded non-cash interest expense representing the change in fair value of its interest rate swap agreements of $11.4 million, as compared to non-cash interest income of $0.5 million recorded in the year ended December 31, 2018; such amounts would only be paid out if the interest rate swap agreements were terminated. On August 22, 2019, in accordance with the provisions of FASB ASC 815, Derivatives and Hedging, and FASB ASU No. 2017-12, Targeted Improvements to Accounting for Hedging Activities, AdaptHealth designated its swaps as effective cash flow hedges. Accordingly, subsequent to August 22, 2019, changes in the fair value of its interest rate swaps are recorded as a component of other comprehensive income in equity rather than interest expense. Loss on Extinguishment of Debt. Loss on extinguishment of debt for the year ended December 31, 2019 was $2.1 million which was a result of the write-off of deferred financing costs related to the 2019 Recapitalization. Loss on extinguishment of debt for the year ended December 31, 2018 was $1.4 million which was the result of the write-off of deferred financing costs and prepayment penalties incurred related to a debt restructuring that occurred in February 2018 offset by gain on debt extinguishment. Income Tax Expense. Income tax expense for the year ended December 31, 2019 was $1.1 million compared to income tax benefit of $2.1 million for the year ended December 31, 2018. The increase in income tax expense was primarily related to increased pre-tax income associated with the tax paying entities coupled with increased losses in entities that are not subject to tax at the entity level. During the year ended December 31, 2018, AdaptHealth reversed a previously established valuation allowance on deferred tax assets as a result of its profitability over the previous two years, resulting in an income tax benefit of $7.2 million recorded during that period. EBITDA, Adjusted EBITDA and Adjusted EBITDA less Patient Equipment Capex AdaptHealth uses EBITDA, Adjusted EBITDA and Adjusted EBITDA less Patient Equipment Capex, which are financial measures that are not prepared in accordance with generally accepted accounting principles in the United States, or U.S. GAAP, to analyze its financial results and believes that they are useful to investors, as a supplement to U.S. GAAP measures. In addition, AdaptHealth’s ability to incur additional indebtedness and make investments under its existing credit agreement is governed, in part, by its ability to satisfy tests based on a variation of Adjusted EBITDA less Patient Equipment Capex. AdaptHealth defines EBITDA as net income (loss) attributable to AdaptHealth Corp., plus net income attributable to noncontrolling interests, interest expense (income), income tax expense (benefit), and depreciation. AdaptHealth defines Adjusted EBITDA as EBITDA (as defined above), plus loss on extinguishment of debt, equity-based compensation expense, transaction costs, severance, earnout liability activity, and other non-recurring expenses. AdaptHealth defines Adjusted EBITDA less Patient Equipment Capex as Adjusted EBITDA (as defined above) less patient equipment acquired during the period without regard to whether the equipment was purchased or financed through lease transactions. AdaptHealth believes Adjusted EBITDA less Patient Equipment Capex is useful to investors in evaluating AdaptHealth’s financial performance. AdaptHealth’s business requires significant investment in equipment purchases to maintain its patient equipment inventory. Some equipment title transfers to patients’ ownership after a prescribed number of fixed monthly payments. Equipment that does not transfer wears out or oftentimes is not recovered after a patient’s use of the equipment terminates. AdaptHealth uses this metric as the profitability measure in its incentive compensation plans that have a profitability component and to evaluate acquisition opportunities, where it is most often used for purposes of contingent consideration arrangements. In addition, AdaptHealth’s debt agreements contain covenants that use a variation of Adjusted EBITDA less Patient Equipment Capex for purposes of determining debt covenant compliance. For purposes of this metric, patient equipment capital expenditure is measured as the value of the patient equipment received during the accounting period without regard to whether the equipment is purchased or financed through lease transactions. EBITDA, Adjusted EBITDA and Adjusted EBITDA less Patient Equipment Capex should not be considered as measures of financial performance under U.S. GAAP, and the items excluded from EBITDA, Adjusted EBITDA and Adjusted EBITDA less Patient Equipment Capex are significant components in understanding and assessing financial performance. Accordingly, these key business metrics have limitations as an analytical tool. They should not be considered as an alternative to net income or any other performance measures derived in accordance with U.S. GAAP or as an alternative to cash flows from operating activities as a measure of AdaptHealth’s liquidity. The following unaudited table presents the reconciliation of net income (loss) attributable to AdaptHealth, to EBITDA, Adjusted EBITDA and Adjusted EBITDA less Patient Equipment Capex for the years ended December 31, 2019 and 2018: (a) Represents write offs of deferred financing costs and prepayment penalty expense related to refinancing of debt offset by gain on debt extinguishment. (b) Represents amortization of equity-based compensation to employees, including expense resulting from accelerated vesting and modification of certain awards. (c) Represents transaction costs related to acquisitions, the 2019 Recapitalization, and the Business Combination. (d) Represents severance costs related to acquisition integration and internal AdaptHealth restructuring and workforce reduction activities. (e) Represents fair value adjustments and other charges associated with earnout liabilities from acquisitions. (f) Represents the value of the patient equipment received during the respective period without regard to whether the equipment is purchased or financed through lease transactions. Liquidity and Capital Resources AdaptHealth’s principal sources of liquidity are its operating cash flows, borrowings under its credit agreements and proceeds from equity issuances. AdaptHealth has used these funds to meet its capital requirements, which consist of salaries, labor, benefits and other employee-related costs, product and supply costs, third-party customer service, billing and collections and logistics costs, capital expenditures including patient equipment, acquisitions and debt service. Our future capital expenditure requirements will depend on many factors, including its patient volume and revenue growth rates. AdaptHealth’s capital expenditures are made in advance of patients beginning service. Certain operating costs are incurred at the beginning of the equipment service period and during initial patient set up. AdaptHealth may be required to seek additional equity or debt financing in connection with its business growth. In the event that additional financing is required from outside sources, AdaptHealth may not be able to raise it on acceptable terms or at all. If additional capital is unavailable when desired, AdaptHealth’s business, results of operations, and financial condition would be materially and adversely affected. AdaptHealth believes that its expected operating cash flows, together with its existing cash, cash equivalents, and amounts available under its credit facility, will continue to be sufficient to fund its operations and growth strategies for at least the next 12 months. As of December 31, 2019, AdaptHealth had $76.9 million of cash and cash equivalents and $160.5 million available under the Third Amended and Restated Credit and Guaranty Agreement (including $100.0 million available under the Delayed Draw Loan and $60.5 million available under its Revolving Credit Facility after consideration of stand-by letters of credit outstanding of $2.5 million). On March 20, 2019, AdaptHealth entered into the Third Amended and Restated Credit and Guaranty Agreement and restructured its debt borrowings with its bank group. The credit agreement consisted of $425 million in credit facilities, which included a $300 million Credit Facility Term Loan, a $50 million Delayed Draw Term Loan and a $75 million New Revolver, all with maturities in March 2024. The Credit Facility Term Loan may consist of Base Rate Loans or LIBOR Rate Loans (as defined in the agreement). Each LIBOR Rate Loan bears interest quarterly at variable rates based upon the sum of (a) the LIBOR Rate for such interest period, plus (b) an applicable margin based upon the AdaptHealth’s Consolidated Total Leverage Ratio. Each Base Rate Loan bears interest quarterly at variable rates based upon the sum of (a) the Base Rate (as defined in the agreement), plus (b) an applicable margin based upon the AdaptHealth’s Consolidated Total Leverage Ratio. The applicable margin was set at 3.50% and 2.50% for LIBOR Rate Loans and Base Rate Loans, respectively, following the closing of the transaction and are reset each quarter. As of December 31, 2019, AdaptHealth had $246.3 million outstanding under the Credit Facility Term Loan (4.55% interest rate at December 31, 2019). The Credit Facility Term Loan required quarterly principal repayments of $1.875 million beginning June 30, 2019 through March 31, 2021, quarterly principal repayments of $3.75 million beginning June 30, 2021 through December 31, 2023, and the unpaid principal amount of the Credit Facility Term Loan is due at maturity in March 2024. In November 2019, the Company repaid $50.0 million under the Credit Facility Term Loan using the proceeds received from the transactions completed as part of the Business Combination; such repayment was applied to the principal payments required to be paid through September 2023. In addition, in November 2019, the Company amended its credit facility primarily to (i) increase the amount available under the Delayed Draw Loan from $50 million to $100 million, and (ii) revise the Consolidated Total Leverage Ratio thresholds and lower the applicable margin to determine the variable quarterly interest rate under the credit facility. The Delayed Draw Loan allows up to $100 million to be drawn in order to fund permitted acquisitions and to pay fees and transaction costs associated with such acquisitions, and has an availability period from the first business day immediately following the closing date of the credit agreement (March 20, 2019) to the earliest of (a) the Credit Facility Term Loan maturity date (March 2024), (b) 24 months following the closing date, or (c) the date of the termination of the commitment. The Delayed Draw Loan may consist of Base Rate Loans or LIBOR Rate Loans. As of December 31, 2019, AdaptHealth did not have any borrowings outstanding under the Delayed Draw Loan. The New Revolver allows up to $75 million to be drawn in order to (1) finance working capital, make capital expenditures and for other general corporate purposes in an amount not to exceed $25 million, and (2) finance permitted acquisitions and to pay fees and transaction costs associated with such acquisitions in an amount not to exceed $50 million. As of December 31, 2019, AdaptHealth had $12 million outstanding under the New Revolver. Amounts outstanding under the New Revolver are due at maturity in March 2024. The interest rate under the New Revolver was 4.55% at December 31, 2019. Under the credit agreement, AdaptHealth is subject to various agreements that contain a number of restrictive covenants that, among other things, impose operating and financial restrictions on AdaptHealth. Financial covenants include a total leverage ratio and a fixed charges coverage ratio, as defined in the agreement. Additionally, under the terms of the credit agreement, AdaptHealth may be required to repay principal based on excess cash flow, as defined. AdaptHealth was in compliance with all debt covenants as of December 31, 2019. On March 20, 2019, AdaptHealth signed a Note and Unit Purchase Agreement with certain affiliates of BlueMountain Capital Management, LLC. In connection with the agreement, AdaptHealth entered into a promissory note agreement with a principal amount of $100 million (the “BM Note”). The outstanding principal amount under the BM Note was due on the tenth anniversary of the agreement and bore interest at the following rates (a) for the period starting on the closing date and ending on the seventh anniversary, a rate of 12% per annum, with 6% payable in cash and 6% payment in kind, and (b) for the period starting on the day after the seventh anniversary of the closing date and ending on the maturity date, a rate equal to the greater of (i) 15% per annum or (ii) the twelve-month LIBOR plus 12% per annum. In November 2019, in connection with the closing of the Business Combination, the BM Note was replaced with a new amended and restated promissory note with a principal amount of $100 million. In addition, certain affiliates of BlueMountain Capital Management, LLC converted certain of its members’ equity interests to a $43.5 million promissory note. The new $100 million promissory note, together with the $43.5 million promissory note, are collectively referred to herein as the New Promissory Note. The outstanding principal amount under the New Promissory Note is due on the tenth anniversary of the closing date of the Business Combination and bears interest at the following rates (a) for the period starting on the closing date and ending on the seventh anniversary, a rate of 12% per annum, with 6% payable in cash and 6% Payment in Kind, and (b) for the period starting on the day after the seventh anniversary of the closing date and ending on the maturity date, a rate equal to the greater of (i) 15% per annum or (ii) the twelve-month LIBOR plus 12% per annum. The Company has the option to pay the PIK interest in cash. At December 31, 2019, AdaptHealth’s working capital was $30.5 million, as compared to a working capital deficit of $44.9 million at December 31, 2018. A significant portion of AdaptHealth’s assets consists of accounts receivable from third-party payors that are responsible for payment for the equipment and the services that AdaptHealth provides. Cash Flow. The following table presents selected data from AdaptHealth’s consolidated statement of cash flows: Net cash provided by operating activities for the year ended December 31, 2019 was $60.4 million compared to $68.4 million for the year ended December 31, 2018, a decrease of $8.0 million. The decrease was primarily the result of a $37.2 million decrease in net income (loss) partially resulting from a $13.5 million increase in transaction costs and a $31.9 million increase in interest expense in 2019 compared to 2018, a net increase of $52.2 million in non-cash charges primarily from depreciation, provision for doubtful accounts, non-cash interest expense relating to the Company’s interest rate swaps, equity-based compensation expense and write-off of deferred financing costs, a change in deferred taxes of $3.1 million, and a $26.1 million increase in cash used resulting from the change in operating assets and liabilities, primarily resulting from the change in accounts receivable and accounts payable and accrued expenses for the period. Net cash used in investing activities for the year ended December 31, 2019 was $84.9 million compared to $96.3 million for the year ended December 31, 2018. The use of funds in the year ended December 31, 2019 consisted of $21.4 million for equipment and other fixed asset purchases and $63.5 million for acquisitions, including the Gould’s Acquisition, the SleepMed acquisition, and the acquisition of Choice Medical Healthcare, Inc. in the fourth quarter of 2019. The use of funds in the year ended December 31, 2018 consisted of $10.0 million for equipment and other fixed asset purchases and $86.3 million for acquisitions, including the Verus acquisition and the PPS acquisition. Net cash provided by financing activities for the year ended December 31, 2019 was $76.1 million compared to $48.8 million for the year ended December 31, 2018. Net cash provided by financing activities for the year ended December 31, 2019 was primarily related to the 2019 Recapitalization and the Business Combination, and consisted of $360.5 million of borrowings from long-term debt and lines of credit, $20.0 million of proceeds from the sale of members’ interests, net proceeds of $148.9 million from the transactions completed in connection with the Business Combination, and proceeds of $100.0 million from a preferred debt issuance, offset by total repayments of $274.9 million on long-term debt and capital lease obligations, payments of $9.0 million for financing costs, payments of $0.8 million for equity issuance costs, payment of $3.7 million for the redemption of members’ interests, payment of $13.0 million for earnout liabilities in connection with the Verus Acquisition and the HMEI Acquisition, distributions to members of $250.0 million, distributions to noncontrolling interests of $1.3 million, and net payments of $0.6 million relating to tax withholdings associated with equity-based compensation activity. For the year ended December 31, 2018, net cash provided by financing activities consisted of $164.8 million of borrowings from long-term debt and lines of credit, offset by total repayments of $112.0 million on long-term debt, lines of credit and capital lease obligations, and payments of $2.7 million for deferred financing costs, $1.0 million for debt prepayment penalties and distributions to noncontrolling interests of $0.3 million. Critical Accounting Policies and Significant Estimates The discussion and analysis of the Company’s financial condition and results of operations is based upon the Company’s consolidated financial statements, which have been prepared in accordance with U.S. GAAP. The preparation of the Company’s consolidated financial statements requires its management to make estimates and judgments that affect the reported amounts of assets, liabilities, revenue and expenses and related disclosures of contingent assets and liabilities. The Company’s management bases its estimates, assumptions and judgments on historical experience and various other factors that are believed to be reasonable under the circumstances, the results of which form the basis for making judgments about the carrying values of assets and liabilities that are not readily apparent from other sources. Different assumptions and judgments would change the estimates used in the preparation of the Company’s consolidated financial statements which, in turn, could change the results from those reported. In addition, actual results may differ from these estimates and such differences could be material to the Company’s financial position and results of operations. Critical accounting policies and significant estimates are those that the Company’s management considers the most important to the portrayal of the Company’s financial condition and results of operations because they require management’s most difficult, subjective or complex judgments, often as a result of the need to make estimates about the effect of matters that are inherently uncertain. The Company’s critical accounting policies and significant estimates in relation to its consolidated financial statements include those related to revenue recognition, accounts receivable, business combinations, and goodwill valuation. Revenue Recognition The Company generates revenues for services and related products that the Company provides to patients for home medical equipment, related supplies, and other items. The Company’s revenues are recognized in the period in which services and related products are provided to customers and are recorded either at a point in time for the sale of supplies and disposables, or over the fixed monthly service period for equipment. Revenues are recognized when control of the promised good or service is transferred to customers, in an amount that reflects the consideration to which the Company expects to receive from patients or under reimbursement arrangements with Medicare, Medicaid and third-party payors, in exchange for those goods and services. Performance obligations are determined based on the nature of the services provided. The majority of the Company’s services and related products represent a bundle of services that are not capable of being distinct and as such, are treated as a single performance obligation satisfied over time as services are rendered. The Company determines the transaction price based on contractually agreed-upon amounts or rates, adjusted for estimates of variable consideration, such as implicit price concessions. The Company utilizes the expected value method to determine the amount of variable consideration that should be included to arrive at the transaction price, using contractual agreements and historical reimbursement experience within each payor type. The Company applies constraint to the transaction price, such that net revenue is recorded only to the extent that it is probable that a significant reversal in the amount of the cumulative revenue recognized will not occur in the future. If actual amounts of consideration ultimately received differ from the Company’s estimates, the Company adjusts these estimates, which would affect net revenue in the period such adjustments become known. Sales revenue is recognized upon transfer of control of products or services to customers in an amount that reflects the consideration the Company expects to receive in exchange for those products or services. Revenues for the sale of durable medical equipment and related supplies, including oxygen equipment, ventilators, wheelchairs, hospital beds and infusion pumps, are recognized at the time of delivery. The Company provides certain equipment to patients which is reimbursed periodically in fixed monthly payments for as long as the patient is using the equipment and medical necessity continues (in certain cases, the fixed monthly payments are capped at a certain amount). The equipment provided to the patient is based upon medical necessity as documented by prescriptions and other documentation received from the patient’s physician. The patient generally does not negotiate or have input with respect to the manufacturer or model of the equipment prescribed by their physician and delivered by the Company. Once initial delivery of this equipment is made to the patient for initial setup, a monthly billing process is established based on the initial setup service date. The Company recognizes the fixed monthly revenue ratably over the service period as earned, less estimated adjustments, and defers revenue for the portion of the monthly bill that is unearned. No separate revenue is earned from the initial setup process. Included in fixed monthly revenue are unbilled amounts for which the revenue recognition criteria had been met as of period-end but were not yet billed to the payor. The estimate of net unbilled fixed monthly revenue recognized is based on historical trends and estimates of future collectability. The Company’s billing system contains payor-specific price tables that reflect the fee schedule amounts in effect or contractually agreed upon by various government and commercial payors for each item of equipment or supply provided to a customer. Revenues are recorded based on the applicable fee schedule. The Company has established a contractual allowance to account for adjustments that result from differences between the payment amount received and the expected realizable amount. If the payment amount received differs from the net realizable amount, an adjustment is recorded to revenues in the period that these payment differences are determined. The Company reports revenues in its consolidated financial statements net of such adjustments. The Company adopted Financial Accounting Standards Board (FASB) Accounting Standards Codification (ASC) Topic 606, Revenue from Contracts with Customers (ASC 606), effective January 1, 2019, using the modified retrospective transition method. The Company’s adoption of ASC 606 primarily impacts the presentation of revenues due to the inclusion of variable consideration in the form of implicit price concessions contained in certain of its contracts with customers. Under ASC 606, amounts estimated to be uncollectible are generally considered implicit price concessions that are a direct reduction to net revenue. Accounts Receivable Due to the continuing changes in the healthcare industry and third-party reimbursement environment, certain estimates are required to record accounts receivable at their net realizable values. Inherent in these estimates is the risk that they will have to be revised or updated as additional information becomes available. The complexity of third-party billing arrangements and laws and regulations governing Medicare and Medicaid may result in adjustments to amounts originally recorded. The Company performs a periodic analysis to review the valuation of accounts receivable and collectability of outstanding balances. Management’s evaluation takes into consideration such factors as historical bad debt experience, business and economic conditions, trends in healthcare coverage, other collection indicators and information about specific receivables. The Company’s evaluation also considers the age and composition of the outstanding amounts in determining their estimated net realizable value. Receivables are considered past due when not collected by established due dates. Specific patient balances are written off after collection efforts have been followed and the account has been determined to be uncollectible. Revisions in reserve estimates are recorded as an adjustment to net revenue or provision for doubtful accounts in the period of revision. Included in accounts receivable are earned but unbilled accounts receivables. Billing delays, ranging from several days to several weeks, can occur due to the Company’s policy of compiling required payor specific documentation prior to billing for its services rendered. In the event that a third-party payor does not accept the claim, the customer is ultimately responsible for payment for the products or services. Under ASC 606, the Company recognizes revenue in the statements of operations and contract assets on the consolidated balance sheets only when services have been provided. Since the Company has performed its obligation under the contract, it has unconditional rights to the consideration recorded as contract assets and therefore classifies those billed and unbilled contract assets as accounts receivable. Business Combinations The Company applies the acquisition method of accounting for business acquisitions. The results of operations of the businesses acquired by the Company are included as of the respective acquisition date. The acquisition-date fair value of the consideration transferred, including the fair value of any contingent consideration, is allocated to the underlying assets acquired and liabilities assumed based upon their estimated fair values at the date of acquisition. To the extent the acquisition-date fair value of the consideration transferred exceeds the fair value of the identifiable tangible and intangible assets acquired and liabilities assumed, such excess is allocated to goodwill. Patient relationships, medical records and patient lists are not reported as separate intangible assets due to the regulatory requirements and lack of contractual agreements but are part of goodwill. Customer related relationships are not reported as separate intangible assets but are part of goodwill as authorizing physicians are under no obligation to refer the Company’s services to their patients, who are free to change physicians and service providers at any time. The Company may adjust the preliminary purchase price allocation, as necessary, for up to one year after the acquisition closing date if it obtains more information regarding asset valuations and liabilities assumed that existed but were not available at the acquisition date. Acquisition related expenses are recognized separately from the business combination and are expensed as incurred. Valuation of Goodwill The Company has a significant amount of goodwill on its balance sheet that resulted from the business acquisitions the Company has made in recent years. Goodwill is not amortized and is tested for impairment annually and upon the occurrence of a triggering event or change in circumstance indicating a possible impairment. Such changes in circumstance can include, among others, changes in the legal environment, reimbursement environment, operating performance, and/or future prospects. The Company performs its annual impairment review of goodwill during the fourth quarter (December 31st) of each year. The impairment testing can be performed on either a quantitative or qualitative basis. During 2019 and 2018, the Company utilized a qualitative analysis for its annual impairment test and determined that there were no triggering events that would indicate that it is “more likely than not” that the carrying value of the Company’s reporting unit is higher than the respective fair value. As a result, the Company did not record any goodwill impairment charges. Recent Accounting Pronouncements Recently issued accounting pronouncements that may be relevant to the Company’s operations but have not yet been adopted are outlined in Note 2 (cc), Recently Issued Accounting Pronouncements, to its consolidated financial statements included elsewhere in this report. Related Party Transactions Executive Loan On December 31, 2014, an executive entered into a loan agreement to borrow approximately $1.0 million from the Company in order to acquire membership interests. Monthly, interest-only payments were due at a rate of 1.9% per annum, and the principal was due in full at maturity on December 31, 2021. The principal and accrued interest under the loan were forgiven by the Company in connection with the transactions completed as part of the Business Combination. Vendor Relationships The Company and two of its executive officers owned equity in SnapWorx, LLC, a vendor of the Company that provides workflow technology services. Each individual owned less than 1% of SnapWorx, LLC. The Company and each individual sold its ownership in Snap Worx, LLC in February 2020. The Company and two of its executive officers and shareholders own equity in Parachute Health, a vendor of the Company that provides automated order intake software. Each individual owns less than 1% of Parachute Health. The expense related to Snap Worx LLC and Parachute Health was approximately $6.5 million and $3.5 million for the years ended December 31, 2019 and 2018, respectively. Policies and Procedures for Related Party Transactions Our board of directors has adopted a written related party transaction policy that sets forth the following policies and procedures for the review and approval or ratification of related party transactions. A “Related Party Transaction” is a transaction, arrangement or relationship in which the post combination company or any of its subsidiaries was, is or will be a participant, the amount of which involved exceeds $120,000, and in which any Related Person had, has or will have a direct or indirect material interest. A “Related Person” means: · any person who is, or at any time during the applicable period was, one of the post combination company’s officers or one of the post combination company’s directors; · any person who is known by the post combination company to be the beneficial owner of more than 5% of our voting stock; · any immediate family member of any of the foregoing persons, which means any child, stepchild, parent, stepparent, spouse, sibling, mother in law, father in law, son in law, daughter in law, brother in law or sister in law of a director, an officer or a beneficial owner of more than 5% of our voting stock, and any person (other than a tenant or employee) sharing the household of such director, officer or beneficial owner of more than 5% of our voting stock; and · any firm, corporation or other entity in which any of the foregoing persons is a partner or principal or in a similar position or in which such person has a 10% or greater beneficial ownership interest. Off-Balance Sheet Arrangements As of December 31, 2019, the Company did not have any off-balance sheet arrangements, as defined in Item 303(a)(4)(ii) of Regulation S-K. Commitments and Contingencies In the normal course of business, the Company is subject to loss contingencies, such as legal proceedings and claims arising out of its business that cover a wide range of matters. In accordance with the Financial Accounting Standards Board Accounting Standards Codification Topic 450, Accounting for Contingencies, the Company records accruals for such loss contingencies when it is probable that a liability has been incurred and the amount of loss can be reasonably estimated. The Company’s management believes any liability that may ultimately result from its resolution will not have a material adverse effect on the Company’s financial conditions or results of operations. Other contingencies arising in the normal course of business relate to acquisitions and the related contingent purchase prices and deferred payments.

<s>[INST] AdaptHealth Corp. Overview AdaptHealth is a leading provider of home healthcare equipment, supplies and related services in the United States. The Company focuses primarily on providing (i) sleep therapy equipment, supplies and related services (including CPAP and bi PAP services) to individuals suffering from obstructive sleep apnea, (ii) home medical equipment to patients discharged from acute care and other facilities, (iii) oxygen and related chronic therapy services in the home and (iv) other HME medical devices and supplies on behalf of chronically ill patients with diabetes care, wound care, urological, ostomy and nutritional supply needs. The Company services beneficiaries of Medicare, Medicaid and commercial insurance payors. As of December 31, 2019, AdaptHealth serviced approximately 1.2 million patients annually in 49 states through its network of 173 locations in 35 states. Following its acquisition of PCS from McKesson Corporation in January 2020, AdaptHealth services over approximately 1.4 million patients annually in all 50 states through its network of 187 locations in 38 states. The Company’s principal executive offices are located at 220 West Germantown Pike, Suite 250, Plymouth Meeting, Pennsylvania 19462. Trends and Factors Affecting AdaptHealth’s Future Performance Significant trends and factors that AdaptHealth believes may affect its future performance include: · Home Medical Equipment Growth. According to CMS, the HME industry has grown from $40 billion in 2010 to $56 billion in 2018 (representing a 4.3% CAGR), of which AdaptHealth’s total addressable market for its sleep therapy, oxygen services, mobility products and hospice HME business lines comprised approximately $12 billion to $15 billion in 2018. During that time Medicaid data shows a continued shift of longterm services and supports (LTSS) spending into the home, with 57% of that spending going to home and communitybased services in 2016. According to CMS, the HME market is projected to continue to grow at a 6.1% CAGR over the next nine years. As a result of the acquisition of the diabetic, wound care, ostomy and urological supplies business of PCS in January 2020, the Company believes it has more than doubled its addressable market to more than $25 billion. · Aging U.S. Population. The population of adults aged 65 and older in the U.S., a significant group of end users of AdaptHealth’s products and services, is expected to continue to grow and thus grow AdaptHealth’s market opportunity. According to CMS, in the U.S., the population of adults between the ages of 65 and 84 is expected to grow at a 2.5% CAGR through 2030, while the population of adults over 85 is projected to grow at a 2.9% CAGR during that same time period. Not only is the elderly population expected to grow, but they are also expected to make up a larger percentage of the total U.S. population. According to the U.S. Census Bureau, the U.S. geriatric population was approximately 15% of the total population in 2014 and is expected to grow to approximately 24% of the total population by 2060. · Increasing Prevalence of Chronic Conditions. HME is necessary to help treat significant health issues affecting millions of Americans, such as chronic obstructive pulmonary disease, congestive heart failure, obstructive sleep apnea and diabetes. · Increasing Prevalence of and Preference for InHome Treatments. The number of conditions that can be treated in the home continues to grow, with recent additions including chronic wound care, sleep testing, dialysis and chemotherapy. In home care is also increasingly becoming the preferred method of treatment, particularly for the elderly population. According to the AARP Public Policy Institute, 90% of patients over age 55 have indicated a preference to receive care in the home rather than in [/INST] Negative. </s>

Surface Oncology, Inc.

2019-03-07

2018-12-31

Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations The following discussion and analysis of our financial condition and operating results should be read together with the section captioned “Selected Consolidated Financial Data” and our consolidated financial statements and the related notes included elsewhere in the Annual Report on Form 10-K. This discussion contains forward-looking statements that involve risks and uncertainties. As a result of many factors, such as those set forth in the section of the Annual Report on Form 10-K captioned “Risk Factors” and elsewhere in this Annual Report on Form 10-K, our actual results may differ materially from those anticipated in these forward-looking statements. Overview We are a clinical-stage immuno-oncology company focused on using our specialized knowledge of the biological pathways critical to the immunosuppressive tumor microenvironment, or the TME, for the development of next-generation cancer therapies. While first-generation immuno-oncology therapies, such as checkpoint inhibitors, are a remarkable therapeutic advancement, we believe most patients do not achieve durable clinical benefit primarily because these therapies focus on only one element of the complex and interconnected immunosuppressive TME. We believe there is a significant opportunity to more broadly engage both the innate and adaptive arms of the immune system in a multi-faceted, coordinated and patient-specific approach, to meaningfully improve cure rates for patients with a variety of cancers. We aim to identify key components within the TME to gain a deep understanding of its biology, leverage this understanding to define the optimal therapeutic targets and the patients most likely to benefit, and develop novel antibody therapeutics with differentiated biologic activity. By utilizing our expertise in immunology, oncology, assay development, antibody selection and characterization, and translational research, we are developing and advancing a broad pipeline of TME-focused programs that we believe are the next generation of immuno-oncology therapies. Our programs demonstrate our multi-faceted approach by targeting several critical components of the immunosuppressive TME, including metabolites, cytokines and macrophages. NZV930 (formerly SRF373) and SRF617 are antibodies inhibiting cluster of differentiation, or CD, 73 and CD39, respectively, and illustrate how our specialized knowledge of TME biology can be leveraged across programs. CD73 and CD39 are both critical enzymes involved in the production of extracellular adenosine, a key metabolite with strong immunosuppressive properties within the TME. In June 2018, a Phase 1 trial of NZV930 was initiated by our partner, Novartis Institutes for Biomedical Research, Inc., or Novartis, and we expect to file an investigational new drug application, or IND, for SRF617 in the fourth quarter of 2019. SRF388 is an antibody targeting interleukin 27, or IL-27, an immunosuppressive cytokine in the TME that is overexpressed in certain cancers. IL-27 is a cytokine secreted by macrophages and antigen presenting cells that plays an important physiologic role in suppressing the immune system. Due to its immunosuppressive nature, there is a rationale for inhibiting IL-27 to treat cancer as this approach will influence the activity of multiple types of immune cells that are necessary to recognize and attack a tumor. We expect to file an IND for SRF388 in the fourth quarter of 2019. SRF231 is an antibody targeting CD47, which is a protein expressed on many cells, but often overexpressed on tumor cells. By targeting CD47, we believe we can promote macrophage activation to attack such tumors. We initiated a Phase 1 clinical trial of SRF231 in February 2018. In December 2018, we announced the deprioritization of SRF231 as a result of toxicities seen during the dose escalation portion of the ongoing Phase 1 trial and the evolving competitive landscape. We are continuing dose exploration in the Phase 1 trial and expect to provide additional data regarding SRF231 in the second half of 2019. We also have several earlier stage programs that target other critical components of the TME, including regulatory T cells and natural killer, or NK, cells. We expect that the unique insights generated in any one of our product programs will accelerate the development of the other programs in a synergistic fashion due to the interconnections between these TME pathways. On April 23, 2018, we completed an initial public offering of our common stock by issuing 7,200,000 shares of our common stock, at $15.00 per share for net proceeds of $97.2 million. Concurrent with the initial public offering, we issued to Novartis Institutes for BioMedical Research, Inc., or Novartis, 766,666 shares of our common stock at $15.00 per share for proceeds of $11.5 million in a private placement. We were incorporated and commenced principal operations in 2014. We have devoted substantially all of our resources to developing our programs, including NZV930, SRF617, SRF388, and SRF231, building our intellectual property portfolio, business planning, raising capital and providing general and administrative support for these operations. To date, we have financed our operations with proceeds from the sales of preferred stock, payments received under the Collaboration Agreement, with Novartis, and proceeds from the Company’s initial public offering of common stock and concurrent private placement. Through December 31, 2018, we had received gross proceeds of $48.6 million from our sales of preferred stock and $150.0 million from the Collaboration Agreement. As of December 31, 2018, we had cash, cash equivalents and marketable securities of $158.8 million. Since our inception, we have incurred significant losses. Our ability to generate product revenue sufficient to achieve profitability will depend on the successful development and eventual commercialization of one or more of the product candidates we develop. Our net loss was $6.6 million and $45.4 million for the years ended December 31, 2018 and 2017, respectively. As of December 31, 2018, we had an accumulated deficit of $66.8 million. We expect to continue to incur significant expenses and increasing operating losses for at least the next several years. We anticipate that our expenses will increase substantially, particularly as we: • pursue the clinical development of product candidates; • leverage our programs to advance product candidates into preclinical and clinical development; • seek regulatory approvals for any product candidates that successfully complete clinical trials; • hire additional clinical, quality control, and scientific personnel; • expand our operational, financial, and management systems and increase personnel, including personnel to support our clinical development, manufacturing, and commercialization efforts, and our operations as a public company; • maintain, expand and protect our intellectual property portfolio; • establish a sales, marketing, medical affairs, and distribution infrastructure to commercialize any products for which we may obtain marketing approval and intend to commercialize on our own or jointly with a commercial partner; and • acquire or in-license other product candidates and technologies. As a result, we will need additional financing to support our continuing operations. Until such time as we can generate significant revenue from product sales, if ever, we expect to finance our operations through a combination of public or private equity or debt financings or other sources, which may include collaborations with third parties. We may be unable to raise additional funds or enter into other agreements or arrangements, when needed, on favorable terms, or at all. If we fail to raise capital or enter into such agreements as and when needed, we may have to significantly delay, scale back or discontinue the development or commercialization of one or more of our product candidates. Because of the numerous risks and uncertainties associated with product development, we are unable to predict the timing or amount of increased expenses or when or if we will be able to achieve or maintain profitability. Even if we are able to generate revenue from product sales, we may not become profitable. If we fail to become profitable or are unable to sustain profitability on a continuing basis, then we may be unable to continue our operations at planned levels and be forced to reduce or terminate our operations. We believe that our existing cash, cash equivalents and marketable securities, as of December 31, 2018 will enable us to fund our operating expenses and capital expenditure requirements into 2021, excluding milestone payments from Novartis. We have based this estimate on assumptions that may prove to be wrong, and we could exhaust our available capital resources sooner than we expect. Components of Our Results of Operations Revenue To date, we have not generated any revenue from product sales and do not expect to do so in the near future. All of our revenue to date has been derived from the Collaboration Agreement. If our development efforts for our programs are successful and result in regulatory approval or additional license or collaboration agreements with third parties, we may generate revenue in the future from a combination of product sales or payments from additional collaboration or license agreements that we may enter into with third parties. We expect that our revenue for the next several years will be derived primarily from the Collaboration Agreement as well as any additional collaborations that we may enter into in the future. Collaboration Agreement with Novartis In January 2016, we entered into the Collaboration Agreement to develop next-generation cancer therapies. Under the Collaboration Agreement, as amended, we are responsible for performing research on antibodies that bind to CD73 and four other specified targets. We are responsible for all costs and expenses incurred by, or on behalf of, us in connection with the research. Novartis also has the right, but not the obligation, to conduct research at its own cost on antibodies that bind to CD73 in accordance with the agreement. Pursuant to the Collaboration Agreement, we granted Novartis a worldwide exclusive license to research, develop, manufacture and commercialize antibodies that target CD73, along with the right to purchase exclusive option rights, each an Option, for up to four specified targets, each an Option Target, to obtain certain development, manufacturing and commercialization rights. If Novartis purchases an Option, following receipt of the IND acceptance for a candidate with respect to the applicable Option Target, Novartis will be entitled to exercise the Option for such Option Target. Pursuant to the Collaboration Agreement, Novartis initially had the right to exercise up to three purchased Options. In March 2018, Novartis notified us of its decision to not exercise its previously purchased Option for SRF231, our CD47 product candidate. In March 2018, we and Novartis also mutually agreed to cease development of one of the undisclosed programs subject to the Collaboration Agreement. As a result, as of December 31, 2018, Novartis had two Options remaining eligible for purchase, and potential exercise. At the time we entered into the Collaboration Agreement in January 2016, Novartis made an upfront payment to us of $70.0 million. Under the Collaboration Agreement, Novartis will also pay us a fee to purchase each Option for each Option Target and another fee to exercise an Option. As of December 31, 2018, we had received $5.0 million in option purchase payments and we were entitled to an aggregate of up to $67.5 million of potential option purchase and option exercise payments. We are also eligible to receive payments on a target-by-target basis upon the achievement of specified development and sales milestones, and tiered royalties on annual net sales by Novartis of licensed products ranging from high single-digit to mid-teens percentages upon successful commercialization of any products. Under the Collaboration Agreement, as of December 31, 2018, we were entitled to potential option purchase, option exercise, and milestone payments aggregating up to $1.17 billion, of which $80.0 million had been received as of December 31, 2018. Such amount of potential option purchase, option exercise, and milestone payments assumes that Novartis purchases, and exercises both of the remaining Options available to it pursuant to the Collaboration Agreement, as well as the successful clinical development of and achievement of all sales milestones for all targets covered by the Collaboration Agreement. In addition, we are required to pay Novartis tiered royalties on annual net sales by us of regional licensed products in the United States ranging from high single-digit to mid-teens percentages. The royalty payments are subject to reduction under specified conditions set forth in the Collaboration Agreement. In January 2016, Novartis also purchased $13.5 million of our Series A-1 preferred stock. The equity investment was made at fair value, and we determined it to be distinct from the Collaboration Agreement. Under ASC 606 we account for (i) the license conveyed with respect to CD73 and (ii) our obligations to perform research on CD73 and other specified targets as a single performance obligation under the Collaboration Agreement. We recognize revenue using the cost-to-cost method, which we believe best depicts the transfer of control to the customer. Under the cost-to-cost method, the extent of progress towards completion is measured based on the ratio of actual costs incurred to the total estimated costs expected upon satisfying the identified performance obligation. Under this method, revenue is recorded as a percentage of the estimated transaction price based on the extent of progress towards completion. In February 2018, we received an additional milestone payment of $45.0 million from Novartis upon Novartis’ receipt and acceptance of the first final audited GLP toxicology study report for NZV930. Upon achieving the milestone, we concluded this variable consideration was no longer constrained and included this amount in the transaction price. We recognized $27.9 million as collaboration revenue - related party in the year ended December 31, 2018, based on the ratio of our actual costs incurred as of the milestone achievement date to our total estimated costs with respect to performing research on antibodies that bind to CD73 and other specified targets under the Collaboration Agreement. The remaining unrecognized amount was initially recorded as deferred revenue and will subsequently be recognized as revenue over the performance period in proportion to the costs incurred by us under the Collaboration Agreement. In March 2018, Novartis notified us of its decision not to exercise its option related to CD47. We recognized the $5.0 million exclusive option right payment as collaboration revenue - related party in the first quarter of 2018 because we no longer had any remaining performance obligations related to CD47. Through December 31, 2018, we had received an aggregate of $150.0 million from Novartis in upfront payments, milestone payments, and option purchase payments. During the year ended December 31, 2018, 2017, and 2016 we recognized revenue of $59.4 million, $12.8 million and $6.6 million, respectively, related to the Collaboration Agreement. In February 2019, Novartis notified us of its decision not to purchase its Option related to IL-27 (See Note 19 “Subsequent Events” for further discussion). Accordingly, as of February 4, 2019, Novartis had one Option remaining eligible for purchase and potential exercise. As a result, the maximum aggregate amount of potential option purchase, option exercise and milestone payments that we are entitled to receive under the Collaboration Agreement was reduced from $1.17 billion to $750 million. The decision by Novartis to terminate the IL-27 target under the Collaboration Agreement will result in our removing all future costs associated with IL-27 from the estimated total costs in the cost-to-cost model in the first quarter of 2019. This change in the total estimated costs in the cost-to-cost model will result in our recognizing revenue of approximately $13.0 million in the first quarter of 2019. Operating Expenses Research and Development Expenses Research and development expenses are expensed as incurred and consist of costs incurred for our research activities, including our discovery efforts, and the development of our programs. These expenses include: • salaries, benefits and other related costs, including stock-based compensation, for personnel engaged in research and development functions; • expenses incurred in connection with the preclinical development of our programs and clinical trials of our product candidates, including under agreements with third parties, such as consultants, contractors, and contract research organizations, or CROs; • the cost of manufacturing drug products for use in our preclinical studies and clinical trials, including under agreements with third parties, such as consultants, contractors, and contract manufacturing organizations, or CMOs; • laboratory supplies; • facilities, depreciation and other expenses, which include direct and allocated expenses for depreciation and amortization, rent and maintenance of facilities, insurance and supplies; and • third-party license fees. We do not track our internal research and development expenses on a program-by-program basis as they primarily relate to personnel, early research and consumable costs, which are deployed across multiple projects under development. These costs are included in unallocated research and development expenses in the table below. A portion of our research and development costs are external costs, which we do track on a program-by-program basis. The following table summarizes our research and development expenses by program: Product candidates in later stages of clinical development generally have higher development costs than those in earlier stages of clinical development, primarily due to the increased size and duration of later-stage clinical trials. As a result, we expect our research and development expenses to increase over the next several years as we initiate clinical trials and pursue later stages of development of SRF617 and SRF388, initiate clinical trials for the product candidates we develop and continue to discover and develop additional product candidates. At this time, we cannot reasonably estimate or know the nature, timing, and estimated costs of the efforts that will be necessary to complete the development of any of our product candidates that we develop from our programs. We are also unable to predict when, if ever, net cash inflows will commence from sales of product candidates we develop. This is due to the numerous risks and uncertainties associated with developing product candidates, including the uncertainty of: • successful completion of clinical trials and preclinical studies; • sufficiency of our financial and other resources to complete the necessary clinical trials and preclinical studies; • acceptance of INDs for our planned clinical trials or future clinical trials; • successful enrollment and completion of clinical trials; • successful data from our clinical program that supports an acceptable risk-benefit profile of our product candidates in the intended populations; • receipt of regulatory and marketing approvals from applicable regulatory authorities; • receipt and maintenance of marketing approvals from applicable regulatory authorities; • establishing agreements with third-party manufacturers for clinical supply for our clinical trials and commercial manufacturing, if any of our product candidates are approved; • entry into collaborations to further the development of our product candidates; • obtaining and maintaining patent and trade secret protection or regulatory exclusivity for our product candidates; • successfully launching commercial sales of our product candidates, if and when approved; • acceptance of our product candidates’ benefits and uses, if and when approved, by patients, the medical community and third-party payors; • maintaining a continued acceptable safety profile of the product candidates following approval; • effectively competing with other therapies; and • obtaining and maintaining healthcare coverage and adequate reimbursement from third-party payors. A change in the outcome of any of these variables with respect to the development of any of our programs or any product candidate we develop would significantly change the costs, timing, and viability associated with the development of such program or product candidate. General and Administrative Expenses General and administrative expenses consist primarily of salaries and personnel-related costs, including stock-based compensation, for our personnel in executive, legal, finance and accounting, human resources, and other administrative functions. General and administrative expenses also include legal fees relating to patent and corporate matters; professional fees paid for accounting, auditing, consulting and tax services; insurance costs; travel expenses; and facility costs not otherwise included in research and development expenses. We anticipate that our general and administrative expenses will increase in the future as we increase our headcount to support research activities and development of our programs. We also anticipate that we will incur increased accounting, audit, legal, regulatory, compliance, and director and officer insurance costs as well as investor and public relations expenses associated with operating as a public company. Interest and Other Income (Expense), Net Interest and other income consists primarily of interest earned on our cash, cash equivalents, and marketable securities. Income Taxes We have not recorded any income tax benefits for the net losses we incurred or for the research and development tax credits we generated during the years ended December 31, 2018 and 2017 as we believed, based upon the weight of available evidence, that it was more likely than not that all of the net operating loss carryforwards and tax credits will not be realized. As of December 31, 2018, we had federal and state net operating loss carryforwards of $19.1 million and $19.4 million, respectively, which may be available to offset future income tax liabilities and begin to expire in 2034. As of December 31, 2018, we also had federal and state research and development tax credit carryforwards of $1.4 million and $0.7 million, respectively, which begin to expire in 2034 and 2030, respectively. Through December 31, 2018, we had recorded a full valuation allowance against our net deferred tax assets at each balance sheet date. Results of Operations Comparison of Years Ended December 31, 2018, 2017, and 2016 The following table summarizes our results of operations for the years ended December 31, 2018, 2017, and 2016, along with the changes in those items: Collaboration Revenue - Related Party Collaboration revenue - related party was $59.4 million, $12.8 million, and $6.6 million for the years ended December 31, 2018, 2017, and 2016, respectively, all of which was derived from the Collaboration Agreement. The increase in collaboration revenue during the year ended December 31, 2017 was primarily due to the partial recognition of revenue related to a milestone payment of $30.0 million that we received in May 2017 from Novartis upon initiation of the first GLP toxicology study for NZV930 (formerly SRF373). The increase in collaboration revenue - related party during the year ended December 31, 2018 was primarily due to the partial recognition of $27.9 million in revenue related to a milestone payment of $45.0 million that we received in February 2018 from Novartis upon Novartis’ receipt and acceptance of the first final audited GLP toxicology study report for NZV930. Additionally, we recognized $5.0 million of revenue upon Novartis’ decision not to exercise its Option relating to CD47 in March 2018. The remaining unrecognized amount will subsequently be recognized as revenue over the performance period in proportion to the costs incurred by us under the Collaboration Agreement. Research and Development Expenses Research and development expenses were $52.5 million for the year ended December 31, 2018, compared to $47.8 million for the year ended December 31, 2017. The increase of $4.7 million was primarily due to increases of $1.2 million in external costs for our SRF388 program, $4.8 million in external costs for our SRF617 program, and $3.5 million for research and discovery and unallocated costs, partially offset by decreases of $2.3 million in external costs for our SRF231 program, $1.3 million in external costs for our SRF373 program, and $1.1 million in external costs for our other early-stage programs. The increase in research and development expenses for our SRF388 program was primarily due to a payment made for an exclusive license to the antibodies related to this program as well as increased contract manufacturing work. The increase in research and development expenses for our SRF617 program was primarily due to the commencement of contract manufacturing work. The increase in research and discovery and unallocated expenses was primarily due to the increase of $3.4 million in personnel-related costs due to increased headcount. The decrease in research and development expenses for our NZV930 program was primarily due to initiation of the Phase 1 clinical trial by Novartis in June 2018. Novartis has worldwide exclusive rights to this program, and as a result of the initiation of the Phase 1 clinical by Novartis, we are no longer incurring expenses for this program. The decrease in research and development expenses for our other early-stage programs was primarily a result of costs related to SRF617, which were not tracked as a separate program until 2018. This decrease was offset by increases relating to the advancement and initiation of new early discovery programs. Research and development expenses were $47.8 million for the year ended December 31, 2017, compared to $20.5 million for the year ended December 31, 2016. The increase of $27.3 million was primarily due to increases of $14.3 million in external costs for our SRF231 program, $1.0 million in external costs for our NZV930 program, $1.7 million in external costs for our SRF388 program, $2.9 million in external costs for our other early-stage programs and $7.3 million for research and discovery and unallocated costs. The increase in research and development expenses for our SRF231 program was primarily related to advancing the program through IND-enabling activities and clinical material production costs. The increases in research and development expenses for our NZV930 and SRF388 programs were primarily due to commencement of IND-enabling activities for each program. The increase in research and development expenses for our other early-stage programs was primarily due to advancement and initiation of new early discovery programs. The increase in research and discovery and unallocated expenses was primarily due to increases of $4.9 million in personnel-related costs (including an increase in stock-based compensation expense of $1.1 million) due to increased headcount and $2.5 million in increased facility and laboratory costs related to our new corporate headquarters. General and Administrative Expenses General and administrative expenses were $16.1 million for the year ended December 31, 2018, compared to $11.0 million for the year ended December 31, 2017. The increase of $5.1 million was primarily due to an increase of $2.6 million in personnel-related costs as a result of an increase in headcount; an increase of $1.0 million for professional fees related to legal and audit services, and an increase of $1.1 million in facility costs. General and administrative expenses were $11.0 million for the year ended December 31, 2017, compared to $4.1 million for the year ended December 31, 2016. The increase of $6.9 million was primarily due to an increase of $5.5 million in personnel-related costs as a result of both an increase in headcount as well as a one-time charge of $2.3 million related to separation costs for our former chief executive officer, an increase of $0.9 million for professional fees related to legal and audit services, and an increase of $0.5 million in facility costs related to our new corporate headquarters. Interest and Other Income (Expense), Net Interest and other income was approximately $2.6 million, $0.6 million, and $0.6 million during the years ended December 31, 2018, 2017, and 2016, respectively, due primarily to interest income on invested balances of our cash, cash equivalents and marketable securities. The increase in interest income was due to investing of the initial public offering proceeds in April 2018. Liquidity and Capital Resources Since our inception, we have incurred significant operating losses. We have generated limited revenue to date from the Collaboration Agreement. We have not yet commercialized any product and we do not expect to generate revenue from sales of any products for several years, if at all. To date, we have financed our operations with proceeds from the sales of preferred stock, payments received under the Collaboration Agreement, and proceeds from our initial public offering of common stock and concurrent private placement. Through December 31, 2018, we had received gross proceeds of $48.6 million from our sales of preferred stock and $150.0 million from the Collaboration Agreement. On April 23, 2018, we completed an initial public offering of our common stock by issuing 7,200,000 shares of common stock, at $15.00 per share for gross proceeds of $108.0 million, or net proceeds of $97.2 million. Concurrent with the initial public offering, we issued Novartis 766,666 shares of our common stock at $15.00 per share for proceeds of $11.5 million, in a private placement. As of December 31, 2018, we had cash, cash equivalents and marketable securities of $158.8 million. Future Funding Requirements We expect our expenses to increase substantially in connection with our ongoing activities, in particular as we continue to advance our product candidates and our discovery programs and conduct research under the Collaboration Agreement. In addition, we expect to continue to incur additional costs associated with operating as a public company. We believe that our existing cash, cash equivalents, and marketable securities, as of March 7, 2019, will enable us to fund our operating expenses and capital expenditure requirements into 2021, excluding milestone payments from Novartis. We have based this estimate on assumptions that may prove to be wrong, and we could exhaust our capital resources sooner than we expect. Because of the numerous risks and uncertainties associated with research, development and commercialization of pharmaceutical product candidates, we are unable to estimate the exact amount of our working capital requirements. Our future funding requirements will depend on and could increase significantly as a result of many factors, including: • completing clinical development of existing product candidates and programs, identifying new product candidates, and completing pre-clinical and clinical development of such product candidates; • seeking and obtaining marketing approvals for any of product candidates that we develop; • launching and commercializing product candidates for which we obtain marketing approval by establishing a sales force, marketing, medical affairs and distribution infrastructure or, alternatively, collaborating with a commercialization partner; • achieving adequate coverage and reimbursement by hospitals, government and third-party payors for product candidates that we develop; • establishing and maintaining supply and manufacturing relationships with third parties that can provide adequate, in both amount and quality, products and services to support clinical development and the market demand for product candidates that we develop, if approved; • obtaining market acceptance of product candidates that we develop as viable treatment options; • addressing any competing technological and market developments; • negotiating favorable terms in any collaboration, licensing or other arrangements into which we may enter and performing our obligations in such collaborations; • maintaining, protecting and expanding our portfolio of intellectual property rights, including patents, trade secrets and know-how; • defending against third-party interference or infringement claims, if any; and • attracting, hiring and retaining qualified personnel. A change in the outcome of any of these or other variables with respect to the development of any of our product candidates could significantly change the costs and timing associated with the development of that product candidate. Further, our operating plans may change in the future, and we may need additional funds to meet operational needs and capital requirements associated with such operating plans. In addition to the variables described above, if and when any product candidate we develop successfully completes development, we will incur substantial additional costs associated with regulatory filings, marketing approval, post-marketing requirements, maintaining our intellectual property rights, and regulatory protection, in addition to other costs. We cannot reasonably estimate these costs at this time. Until such time, if ever, that we can generate substantial product revenue, we expect to finance our cash needs through a combination of equity or debt financings and collaboration arrangements, including the Collaboration Agreement. We currently have no credit facility or committed sources of capital. To the extent that we raise additional capital through the future sale of equity or debt, the ownership interests of our stockholders will be diluted, and the terms of these securities may include liquidation or other preferences that adversely affect the rights of our existing common stockholders. If we raise additional funds through the issuance of debt securities, these securities could contain covenants that would restrict our operations. We may require additional capital beyond our currently anticipated amounts. Additional capital may not be available on reasonable terms, or at all. If we raise additional funds through collaboration arrangements in the future, we may have to relinquish valuable rights to our technologies, future revenue streams or product candidates, or grant licenses on terms that may not be favorable to us. If we are unable to raise additional funds when needed, we may be required to delay, limit, reduce or terminate development or future commercialization efforts. Cash Flows The following table summarizes information regarding our cash flows for each of the periods presented: Operating Activities During the year ended December 31, 2018, net cash used in operating activities was $13.2 million, primarily due to net cash used in our operating assets and liabilities of $12.8 million and our net loss of $6.6 million, partially offset by non-cash charges of $6.2 million. Net cash used in changes in our operating assets and liabilities for the year ended December 31, 2018 consisted primarily of a $14.4 million decrease in deferred revenue, a $0.5 million decrease in accrued expenses and other current liabilities, and a $2.2 million decrease in prepaid expenses and other current assets. The decrease in deferred revenue was due to the cumulative effect adjustment upon the adoption of ASC 606 in January 2018. The decrease in accrued expenses and other current liabilities was primarily due to the payment of $3.4 million of manufacturing costs to Novartis in the current year offset increased manufacturing costs incurred to support ongoing clinical trial activities and payroll related accruals. The decrease in prepaid expenses and other current assets was primarily due to a reduction in prepaid taxes, offset by an increase in other assets resulting from an insurance claim that had not been received as of December 31, 2018. During the year ended December 31, 2017, net cash used in operating activities was $12.4 million, primarily due to our net loss of $45.4 million partially offset by net cash provided by changes in our operating assets and liabilities of $26.7 million and non-cash charges of $6.2 million. Net cash provided by changes in our operating assets and liabilities for the year ended December 31, 2017 consisted primarily of a $17.2 million increase in deferred revenue, a $5.0 million decrease in amounts due from Novartis, a related party, a $2.9 million increase in accrued expenses and other current liabilities, and a $1.1 million decrease in prepaid expenses and other current assets. The increase in deferred revenue was due to the $35.0 million of aggregate milestone and option purchase payments received from Novartis during the year ended December 31, 2017, which were not fully recognized as revenue at that time. The increase in accrued expenses and other current liabilities was primarily due to increased manufacturing costs incurred to support ongoing clinical trial activities and payroll related accruals. The decrease in prepaid expenses and other current assets was primarily due to a reduction in prepaid taxes. During the year ended December 31, 2016, net cash provided by operating activities was $41.4 million, primarily resulting from net cash provided by changes in our operating assets and liabilities of $58.6 million and net non-cash charges of $0.3 million, partially offset by our net loss of $17.5 million. Net cash provided by changes in our operating assets and liabilities for the year ended December 31, 2016 consisted primarily of a $64.9 million increase in deferred revenue, a $5.4 million increase in accrued expenses and other current liabilities and a $1.8 million increase in accounts payable, partially offset by an $8.5 million increase in prepaid expenses and other current assets and a $5.0 million increase in amounts due from Novartis, a related party. The increase in deferred revenue was due to the $70.0 million upfront payment received from Novartis during the year ended December 31, 2016, which was not fully recognized as revenue at that time. The increase in accrued expenses and other current liabilities was due to accruals related to manufacturing costs. The increase in accounts payable was due to timing of invoices for clinical manufacturing costs. The increase in prepaid expenses and other current assets was due to prepayments for estimated taxes. The increase in amounts due from Novartis was the result of our achievement in December 2016 of a specified milestone under the Collaboration Agreement. Investing Activities During the year ended December 31, 2018, net cash used in investing activities was $36.6 million, primarily due to purchases of marketable securities of $107.3 million and $2.0 million of purchases of property and equipment, primarily related to leasehold improvements in our corporate headquarters facility. This was partially offset by $72.7 million in proceeds from sales or maturities of marketable securities. During the year ended December 31, 2017, net cash provided by investing activities was $25.9 million, consisting primarily of $27.9 million of proceeds from sales or maturities of marketable securities, partially offset by $2.0 million of purchases of property and equipment, primarily related to leasehold improvements in our corporate headquarters facility. During the year ended December 31, 2016, net cash used in investing activities was $69.0 million, consisting primarily of $97.0 million for purchases of marketable securities, an increase in restricted cash of $1.0 million and $0.8 million of purchases of property and equipment, all partially offset by $28.9 million of proceeds from sales or maturities of marketable securities. Financing Activities During the year ended December 31, 2018, net cash provided by financing activities was $110.4 million, consisting primarily of $100.4 million of net proceeds received upon the completion of the initial public offering in April 2018, $11.5 million from a private placement of common stock with Novartis, a related party, and $0.5 million of proceeds received from the exercise of stock options, partially offset by $2.0 million paid for initial public offering costs. During the year ended December 31, 2017, net cash used in financing activities was $1.0 million, consisting primarily of payments of initial public offering costs of $1.2 million, partially offset by $0.1 million of proceeds received from the exercise of stock options. During the year ended December 31, 2016, net cash provided by financing activities was $25.9 million, consisting primarily of net proceeds from the sales of our Series A and Series A-1 preferred stock. Contractual Obligations and Commitments The following table summarizes our contractual obligations as of December 31, 2018 and the effects that such obligations are expected to have on our liquidity and cash flow in future periods: (1) Reflects payments due for leases of office and laboratory space that expire in May 2030. (2) Reflects commitments for costs associated with external CMOs and CROs engaged to manufacture clinical trial materials as well as to conduct discovery research and preclinical development activities. Under various license and collaboration agreements to which we are a party, we may be required to make milestone payments and pay royalties and other amounts to third parties. We have not included any such contingent payment obligations in the table above as the amount, timing and likelihood of such payments are not known. Under our Collaboration Agreement, if Novartis obtains a regional license from us for a product under the agreement, we will be required to pay to Novartis tiered royalties of a high single-digit to mid-teens percentage on annual net sales in the United States by us or our sublicensees of regional licensed products under the agreement. Under our license agreement with Harbour Antibodies H2L2 BV, or H2L2, we are obligated to pay to H2L2 a low five-digit upfront license fee for each antibody program that we initiate using the H2L2 mice. In addition, we may be obligated to pay up to an aggregate of $1.04 million in milestone payments to H2L2 for each antibody product we develop through Phase 3 clinical trials and regulatory approval. We are required to pay H2L2 a one-time sales performance payment of a low seven-digit dollar amount for each antibody product that is commercialized and achieves worldwide gross sales in excess of a low eight-digit dollar amount. If we enter into an agreement with a third party to further research or commercialize an antibody product developed under the H2L2 agreement, then we are obligated to pay H2L2 a one-time payment of the lesser of (i) a low double-digit percentage of the upfront fee paid to us by the third party or (ii) a low six-digit dollar amount. Under our license agreement with Harbour Antibodies B.V., or Harbour, we are required to pay a nominal annual maintenance fee during the term of the agreement. In addition, we are obligated to pay up to an aggregate of $4.75 million upon the achievement of specified development and commercial milestones for each product licensed under the agreement. We are also obligated to pay Harbour royalties of a low single-digit percentage on the worldwide net sales of any licensed product on a country-by-country basis. Under our development and option agreement with Adimab LLC, or Adimab, we are obligated to make milestone payments and to pay specified fees upon the exercise of the research or commercialization options under the agreement. During the discovery term, we may be obligated to pay Adimab up to $250,000 for technical milestones achieved against each biological target. Upon exercise of a research option, we are obligated to pay a nominal research maintenance fee on each of the next four anniversaries of the exercise. Upon the exercise of each commercialization option, we will be required to pay an option exercise fee of a low seven-digit dollar amount, and we may be responsible for milestone payments of up to an aggregate of $13.0 million for each licensed product that receives marketing approval. For any licensed product that is commercialized, we are obligated to pay Adimab tiered royalties of a low to mid single-digit percentage on worldwide net sales of such product. We may also partially exercise a commercialization option with respect to ten antibodies against a biological target by paying 65% of the option fee and later either (i) paying the balance and choosing up to 20 antibodies for commercialization or (ii) foregoing the commercialization option entirely. Critical Accounting Policies and Significant Judgments and Estimates Our management’s discussion and analysis of our financial condition and results of operations is based on our consolidated financial statements, which we have prepared in accordance with the rules and regulations of the SEC, and generally accepted accounting principles in the United States, or GAAP. The preparation of these consolidated financial statements requires us to make estimates and assumptions that affect the reported amounts of assets, liabilities, and the disclosure of contingent assets and liabilities at the date of the financial statements, as well as revenue and expenses during the reporting period. 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 the carrying value of assets and liabilities that are not readily apparent from other sources. Our actual results may differ from these estimates under different assumptions or conditions. While our significant accounting policies are described in more detail in Note 2 to our consolidated financial statements, we believe that the accounting policies discussed below are critical to understanding our historical and future performance, as these policies relate to the more significant areas involving management’s judgments and estimates. Revenue Recognition Effective January 1, 2018, we adopted Accounting Standards Codification (“ASC”) Topic 606, Revenue from Contracts with Customers, using the modified retrospective transition method. Under this method, we recognized the cumulative effect of initially adopting ASC Topic 606, as an adjustment to the opening balance of accumulated deficit. Additionally, under this method of adoption, we apply the guidance to all incomplete contracts in scope as of the date of initial application. This standard applies to all contracts with customers, except for contracts that are within the scope of other standards, such as leases, insurance, collaboration arrangements and financial instruments. In accordance with ASC Topic 606, we recognize revenue when our customer obtains control of promised goods or services, in an amount that reflects the consideration which the entity expects to receive in exchange for those goods or services. To determine revenue recognition for arrangements that we determine are within the scope of ASC Topic 606, we perform the following five steps: i. identify the contract(s) with a customer; ii. identify the performance obligations in the contract; iii. determine the transaction price iv. allocate the transaction price to the performance obligations within the contract; and v. recognize revenue when (or as) the entity satisfies a performance obligation. We only apply the five-step model to contracts when we determine that it is probable we will collect the consideration we are entitled to in exchange for the goods or services we transfer to the customer. At contract inception, once the contract is determined to be within the scope of ASC 606, we assess the goods or services promised within the contract to determine whether each promised good or service is a performance obligation. The promised goods or services in our arrangements typically consist of a license to our intellectual property and/or research and development services. We may provide options to additional items in such arrangements, which are accounted for as separate contracts when the customer elects to exercise such options, unless the option provides a material right to the customer. Performance obligations are promises in a contract to transfer a distinct good or service to the customer that (i) the customer can benefit from on its own or together with other readily available resources, and (ii) is separately identifiable from other promises in the contract. Goods or services that are not individually distinct performance obligations are combined with other promised goods or services until such combined group of promises meet the requirements of a performance obligation. We determine transaction price based on the amount of consideration we expect to receive for transferring the promised goods or services in the contract. Consideration may be fixed, variable, or a combination of both. At contract inception for arrangements that include variable consideration, we estimate the probability and extent of consideration we expect to receive under the contract utilizing either the most likely amount method or expected amount method, whichever best estimates the amount expected to be received. We then consider any constraints on the variable consideration and includes in the transaction price variable consideration to the extent it is deemed probable that a significant reversal in the amount of cumulative revenue recognized will not occur when the uncertainty associated with the variable consideration is subsequently resolved. We then allocate the transaction price to each performance obligation based on the relative standalone selling price and recognizes as revenue the amount of the transaction price that is allocated to the respective performance obligation when (or as) control is transferred to the customer and the performance obligation is satisfied. For performance obligations which consist of licenses and other promises, we utilize judgment to assess the nature of the combined performance obligation to determine whether the combined performance obligation is satisfied over time or at a point in time and, if over time, the appropriate method of measuring progress. We evaluate the measure of progress each reporting period and, if necessary, adjust the measure of performance and related revenue recognition. We record amounts as accounts receivable when the right to consideration is deemed unconditional. When consideration is received, or such consideration is unconditionally due, from a customer prior to transferring goods or services to the customer under the terms of a contract, a contract liability is recorded for deferred revenue. Amounts received prior to satisfying the revenue recognition criteria are recognized as deferred revenue in our balance sheet. Amounts expected to be recognized as revenue within the 12 months following the balance sheet date are classified as current portion of deferred revenue. Amounts not expected to be recognized as revenue within the 12 months following the balance sheet date are classified as deferred revenue, non-current. Our revenue arrangement includes the following: Up-front License Fees: If a license is determined to be distinct from the other performance obligations identified in the arrangement, we recognize revenues from nonrefundable, up-front fees allocated to the license when the license is transferred to the licensee and the licensee is able to use and benefit from the license. For licenses that are bundled with other promises, we utilize judgment to assess the nature of the combined performance obligation to determine whether the combined performance obligation is satisfied over time or at a point in time and, if over time, the appropriate method of measuring progress for purposes of recognizing revenue from non-refundable, up-front fees. We evaluate the measure of progress each reporting period and, if necessary, adjust the measure of performance and related revenue recognition. Milestone Payments: At the inception of an agreement that includes research and development milestone payments, we evaluate each milestone to determine when and how much of the milestone to include in the transaction price. We first estimate the amount of the milestone payment that we could receive using either the expected value or the most likely amount approach. We primarily use the most likely amount approach as that approach is generally most predictive for milestone payments with a binary outcome. Then, we consider whether any portion of that estimated amount is subject to the variable consideration constraint (that is, whether it is probable that a significant reversal of cumulative revenue would not occur upon resolution of the uncertainty.) We update the estimate of variable consideration included in the transaction price at each reporting date which includes updating the assessment of the likely amount of consideration and the application of the constraint to reflect current facts and circumstances. Royalties: For arrangements that include sales-based royalties, including milestone payments based on the level of sales, and the license is deemed to be the predominant item to which the royalties relate, we will recognize revenue at the later of (i) when the related sales occur, or (ii) when the performance obligation to which some or all of the royalty has been allocated has been satisfied (or partially satisfied). To date, we have not recognized any revenue related to sales-based royalties or milestone payments based on the level of sales. All of our revenues to date have been generated through the Collaboration Agreement with Novartis See Note 8, “Collaboration Agreement with Novartis” for additional details regarding the Company’s collaboration arrangement. Accrued Research and Development Expenses As part of the process of preparing our financial statements, we are required to estimate our accrued expenses. This process involves reviewing open contracts and purchase orders, communicating with our personnel to identify services that have been performed on our behalf, and estimating the level of service performed and the associated cost incurred for the service when we have not yet been invoiced or otherwise notified of the actual cost. The majority of our service providers invoice us monthly in arrears for services performed, or when contractual milestones are met; however, some require advanced payments. We make estimates of our accrued expenses as of each balance sheet date based on facts and circumstances known to us at that time. We periodically confirm the accuracy of our estimates with the service providers and make adjustments if necessary. The significant estimates in our accrued research and development expenses include the costs incurred for services performed by our vendors in connection with research and development activities for which we have not yet been invoiced. There may be instances in which payments made to our vendors will exceed the level of services provided and result in a prepayment of the expense. In accruing service fees, we estimate the time period over which services will be performed and the level of effort to be expended in each period. If the actual timing of the performance of services or the level of effort varies from the estimate, we adjust the accrual or the amount of prepaid expenses accordingly. Although we do not expect our estimates to be materially different from amounts actually incurred, if our estimates of the status and timing of services performed differ from the actual status and timing of services performed, it could result in us reporting amounts that are too high or too low in any particular period. To date, there have been no material differences between our estimates of such expenses and the amounts actually incurred. Income Taxes We account for income taxes using the asset and liability method, which requires the recognition of deferred tax assets and liabilities for the expected future tax consequences of events that have been recognized in the financial statements or in our tax returns. Deferred taxes are determined based on the difference between the financial statement and tax basis of assets and liabilities using enacted tax rates in effect in the years in which the differences are expected to reverse. Changes in deferred tax assets and liabilities are recorded in the provision for income taxes. We assess the likelihood that our deferred tax assets will be recovered from future taxable income and, to the extent we believe, based upon the weight of available evidence, that it is more likely than not that all or a portion of the deferred tax assets will not be realized, a valuation allowance is established through a charge to income tax expense. We evaluate the potential recovery of deferred tax assets by analyzing carryback capacity in periods with taxable income, reversal of existing taxable temporary differences and estimating the future taxable profits expected and considering prudent and feasible tax planning strategies. We account for uncertainty in income taxes recognized in the financial statements by applying a two-step process to determine the amount of tax benefit to be recognized. First, the tax position must be evaluated to determine the likelihood that it will be sustained upon external examination by the taxing authorities. If the tax position is deemed more-likely-than-not to be sustained, the tax position is then assessed to determine the amount of benefit to recognize in the financial statements. The amount of the benefit that may be recognized is the largest amount that has a greater than 50% likelihood of being realized upon ultimate settlement. The provision for income taxes includes the effects of any resulting tax reserves, or unrecognized tax benefits, that are considered appropriate as well as the related net interest and penalties. Stock-Based Compensation We measure stock options and other stock-based awards granted to employees and directors based on the fair value on the date of the grant and recognize the corresponding compensation expense of those awards over the requisite service period, which is generally the vesting period of the respective award. Generally, we issue stock options and restricted stock awards with only service-based vesting conditions and record the expense for these awards using the straight-line method. For stock-based awards granted to non-employee consultants, we recognize compensation expense over the period during which services are rendered by such non-employees until completed. At the end of each financial reporting period prior to completion of the service, the fair value of these awards is remeasured using the then-current fair value of our common stock and updated assumption inputs in the Black-Scholes option-pricing model referenced below. We estimate the fair value of our stock-based awards to employees and non-employees using the Black-Scholes option pricing model, which requires the input of subjective assumptions, including (i) the expected volatility of our stock, (ii) the expected term of the award, (iii) the risk-free interest rate, and (iv) expected dividends. Due to the lack of company specific historical and implied volatility data, we based our estimate of expected volatility on the estimate and expected volatilities of a representative group of publicly traded companies. For these analyses, we select companies with comparable characteristics to ours including enterprise value, risk profiles, position within the industry, and with historical share price information sufficient to meet the expected life of the stock-based awards. We compute the historical volatility data using the daily closing prices for the selected companies’ shares during the equivalent period of the calculated expected term of our stock-based awards. We will continue to apply this process until a sufficient amount of historical information regarding the volatility of our own stock price becomes available. For awards that qualify as “plain-vanilla” options, we estimate the expected life of our employee stock options using the “simplified” method, whereby, the expected life equals the average of the vesting term and the original contractual term of the option. The expected term of stock options granted to non-employees is equal to the contractual term of the option award. The risk-free interest rate is determined by reference to the U.S. Treasury yield curve in effect at the time of grant of the award for time periods approximately equal to the expected term of the award. Expected dividend yield is based on the fact that the Company has never paid cash dividends and does not expect to pay any cash dividends in the foreseeable future. We elect to account for forfeitures as they occur rather than apply an estimated forfeiture rate to share based payment expense. Off-Balance Sheet Arrangements We did not have, during the periods presented, and we do not currently have, any off-balance sheet arrangements, as defined under applicable Securities and Exchange Commission rules. Recently Issued Accounting Pronouncements A description of recently issued accounting pronouncements that may potentially impact our financial position and results of operations is disclosed in Note 2 to our consolidated financial statements.

<s>[INST] Overview We are a clinicalstage immunooncology company focused on using our specialized knowledge of the biological pathways critical to the immunosuppressive tumor microenvironment, or the TME, for the development of nextgeneration cancer therapies. While firstgeneration immunooncology therapies, such as checkpoint inhibitors, are a remarkable therapeutic advancement, we believe most patients do not achieve durable clinical benefit primarily because these therapies focus on only one element of the complex and interconnected immunosuppressive TME. We believe there is a significant opportunity to more broadly engage both the innate and adaptive arms of the immune system in a multifaceted, coordinated and patientspecific approach, to meaningfully improve cure rates for patients with a variety of cancers. We aim to identify key components within the TME to gain a deep understanding of its biology, leverage this understanding to define the optimal therapeutic targets and the patients most likely to benefit, and develop novel antibody therapeutics with differentiated biologic activity. By utilizing our expertise in immunology, oncology, assay development, antibody selection and characterization, and translational research, we are developing and advancing a broad pipeline of TMEfocused programs that we believe are the next generation of immunooncology therapies. Our programs demonstrate our multifaceted approach by targeting several critical components of the immunosuppressive TME, including metabolites, cytokines and macrophages. NZV930 (formerly SRF373) and SRF617 are antibodies inhibiting cluster of differentiation, or CD, 73 and CD39, respectively, and illustrate how our specialized knowledge of TME biology can be leveraged across programs. CD73 and CD39 are both critical enzymes involved in the production of extracellular adenosine, a key metabolite with strong immunosuppressive properties within the TME. In June 2018, a Phase 1 trial of NZV930 was initiated by our partner, Novartis Institutes for Biomedical Research, Inc., or Novartis, and we expect to file an investigational new drug application, or IND, for SRF617 in the fourth quarter of 2019. SRF388 is an antibody targeting interleukin 27, or IL27, an immunosuppressive cytokine in the TME that is overexpressed in certain cancers. IL27 is a cytokine secreted by macrophages and antigen presenting cells that plays an important physiologic role in suppressing the immune system. Due to its immunosuppressive nature, there is a rationale for inhibiting IL27 to treat cancer as this approach will influence the activity of multiple types of immune cells that are necessary to recognize and attack a tumor. We expect to file an IND for SRF388 in the fourth quarter of 2019. SRF231 is an antibody targeting CD47, which is a protein expressed on many cells, but often overexpressed on tumor cells. By targeting CD47, we believe we can promote macrophage activation to attack such tumors. We initiated a Phase 1 clinical trial of SRF231 in February 2018. In December 2018, we announced the deprioritization of SRF231 as a result of toxicities seen during the dose escalation portion of the ongoing Phase 1 trial and the evolving competitive landscape. We are continuing dose exploration in the Phase 1 trial and expect to provide additional data regarding SRF231 in the second half of 2019. We also have several earlier stage programs that target other critical components of the TME, including regulatory T cells and natural killer, or NK, cells. We expect that the unique insights generated in any one of our product programs will accelerate the development of the other programs in a synergistic fashion due to the interconnections between these TME pathways. On April 23, 2018, we completed an initial public offering of our common stock by issuing 7,200,000 shares of our common stock, at $15.00 per share for net proceeds of $ [/INST] Positive. </s>

Surface Oncology, Inc.

2020-03-10

2019-12-31

Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations The following discussion and analysis of our financial condition and operating results should be read together with the section captioned “Selected Consolidated Financial Data” and our consolidated financial statements and the related notes included elsewhere in the Annual Report on Form 10-K. This discussion contains forward-looking statements that involve risks and uncertainties. As a result of many factors, such as those set forth in the section of the Annual Report on Form 10-K captioned “Risk Factors” and elsewhere in this Annual Report on Form 10-K, our actual results may differ materially from those anticipated in these forward-looking statements. Overview We are a clinical-stage immuno-oncology company focused on using our specialized knowledge of the biological pathways critical to the immunosuppressive tumor microenvironment, or the TME, for the development of next-generation cancer therapies. While first-generation immuno-oncology therapies, such as checkpoint inhibitors, represent a remarkable therapeutic advancement, we believe most patients do not achieve durable clinical benefit primarily because these therapies focus on only one element of the complex and interconnected immunosuppressive TME. We believe there is a significant opportunity to more broadly engage both the innate and adaptive arms of the immune system in a multi-faceted, coordinated and patient-specific approach, to meaningfully improve cure rates for patients with a variety of cancers. We aim to identify key components within the TME to gain a deep understanding of its biology, leverage this understanding to define the optimal therapeutic targets and the patients most likely to benefit, and develop novel antibody therapeutics with differentiated biologic activity. By utilizing our expertise in immunology, oncology, assay development, antibody selection and characterization, and translational research, we are developing and advancing a broad pipeline of TME-focused programs that we believe are the next generation of immuno-oncology therapies. Our programs demonstrate our multi-faceted approach by targeting several critical components of the immunosuppressive TME. NZV930 (formerly SRF373) and SRF617 are antibodies inhibiting CD73 and CD39, respectively, and illustrate how our specialized knowledge of TME biology can be leveraged across programs. CD73 and CD39 are both critical enzymes involved in the production of extracellular adenosine, a key metabolite with strong immunosuppressive properties within the TME. In addition, inhibition of CD39 results in an increase in the pro-inflammatory metabolite adenosine triphosphate, or ATP, within the TME. In June 2018, a Phase 1 trial of NZV930 was initiated by our partner, Novartis Institutes for Biomedical Research, Inc., or Novartis, and we filed an investigational new drug application, or IND, for SRF617 in November 2019 and received permission to proceed from the FDA on December 12, 2019. SRF388 is an antibody targeting interleukin 27, or IL-27, an immunosuppressive cytokine, or protein secreted by cells, in the TME that is overexpressed in certain cancers, including hepatocellular and renal cell carcinoma. IL-27 is a cytokine secreted by macrophages and antigen presenting cells that plays an important physiologic role in suppressing the immune system. Due to its immunosuppressive nature, there is a rationale for inhibiting IL-27 to treat cancer as this approach will influence the activity of multiple types of immune cells that are necessary to recognize and attack a tumor. We filed an IND for SRF388 in December 2019 and received permission to proceed from the FDA on January 17, 2020. SRF813 is an antibody targeting CD112R, an inhibitory protein expressed on natural killer, or NK, and T cells. SRF813 binds a distinct epitope on CD112R and blocks the interaction of CD112R with CD112, its binding partner that is expressed on tumor cells. SRF813 can promote the activation of both NK and T cells, with potential to elicit a strong anti-tumor response and promote immunological memory. In October 2019, we formally declared SRF813 as a development candidate resulting in the initiation of IND-enabling activities. SRF231 is an antibody targeting CD47, a protein expressed on many cells that is often overexpressed on tumor cells. By targeting CD47, we believe we can promote macrophage activation to attack such tumors. We initiated a Phase 1 clinical trial of SRF231 in February 2018. In December 2018, we announced the deprioritization of SRF231 as a result of toxicities seen during the dose escalation portion of the ongoing Phase 1 trial and the evolving competitive landscape. We expect to conclude the Phase 1 trial in 2020, and do not plan to further develop SRF231. We also have an earlier stage program targeting regulatory T cells, another critical component of the TME. We expect that the unique insights generated in any one of our product programs will accelerate the development of the other programs in a synergistic fashion due to the interconnections between these TME pathways. On April 23, 2018, we completed an initial public offering of our common stock by issuing 7,200,000 shares of our common stock, at $15.00 per share for net proceeds of $97.2 million. Concurrent with the initial public offering, we issued 766,666 shares of our common stock to Novartis at $15.00 per share for proceeds of $11.5 million in a private placement. We were incorporated and commenced principal operations in 2014. We have devoted substantially all of our resources to developing our programs, including NZV930, SRF617, SRF388, SRF813, and SRF231, building our intellectual property portfolio, business planning, raising capital and providing general and administrative support for these operations. To date, we have financed our operations with proceeds from the sales of preferred stock, payments received under the Collaboration Agreement with Novartis, a debt financing, and proceeds from our initial public offering of common stock and concurrent private placement. As of December 31, 2019, we had cash, cash equivalents and marketable securities of $105.2 million. Since our inception, we have incurred significant losses. Our ability to generate product revenue sufficient to achieve profitability will depend on the successful development and eventual commercialization of one or more of the product candidates we develop. Our net loss was $54.8 million, $6.6 million, and $45.4 million for the years ended December 31, 2019, 2018, and 2017, respectively. As of December 31, 2019 and 2018 we had an accumulated deficit of $121.6 million and $66.8 million, respectively. We expect to continue to incur significant expenses and operating losses for at least the next several years, particularly as we: • pursue the clinical development of product candidates; • leverage our programs to advance product candidates into preclinical and clinical development; • seek regulatory approvals for any product candidates that successfully complete clinical trials; • hire additional clinical, quality control, and scientific personnel; • expand our operational, financial, and management systems and increase personnel, including personnel to support our clinical development, manufacturing, and commercialization efforts, and our operations as a public company; • maintain, expand and protect our intellectual property portfolio; • establish a sales, marketing, medical affairs, and distribution infrastructure to commercialize any products for which we may obtain marketing approval and intend to commercialize on our own or jointly with a commercial partner; and • acquire or in-license other product candidates and technologies. As a result, we will need additional financing to support our continuing operations. Until such time as we can generate significant revenue from product sales, if ever, we expect to finance our operations through a combination of public or private equity or debt financings or other sources, which may include collaborations with third parties. We may be unable to raise additional funds or enter into other agreements or arrangements, when needed, on favorable terms, or at all. If we fail to raise capital or enter into such agreements as and when needed, we may have to significantly delay, scale back or discontinue the development or commercialization of one or more of our product candidates. Because of the numerous risks and uncertainties associated with product development, we are unable to predict the timing or amount of increased expenses or when or if we will be able to achieve or maintain profitability. Even if we are able to generate revenue from product sales, we may not become profitable. If we fail to become profitable or are unable to sustain profitability on a continuing basis, then we may be unable to continue our operations at planned levels and be forced to reduce or terminate our operations. We believe that our existing cash, cash equivalents and marketable securities, as of December 31, 2019 will enable us to fund our operating expenses, debt service obligations and capital expenditure requirements into 2022, excluding any future milestone payments from Novartis. We have based this estimate on assumptions that may prove to be wrong, and we could exhaust our available capital resources sooner than we expect. Components of Our Results of Operations Revenue To date, we have not generated any revenue from product sales and do not expect to do so in the near future. All of our revenue to date has been derived from the Collaboration Agreement. If our development efforts for our programs are successful and result in regulatory approval or additional license or collaboration agreements with third parties, we may generate revenue in the future from a combination of product sales or payments from additional collaboration or license agreements that we may enter into with third parties. We expect that our revenue for the next several years will be derived primarily from the Collaboration Agreement as well as any additional collaborations that we may enter into in the future. Collaboration Agreement with Novartis In January 2016, we entered into the Collaboration Agreement to develop next-generation cancer therapies. Under the Collaboration Agreement, as amended, we were responsible for performing research on antibodies that bind to CD73 and four other specified targets. We were responsible for all costs and expenses incurred by, or on behalf of, us in connection with the research. Upon entering into the agreement, we received an upfront payment of $70.0 million from Novartis and granted Novartis a worldwide exclusive license to research, develop, manufacture and commercialize antibodies that target CD73. In addition, we initially granted Novartis the right to purchase exclusive option rights, each an Option, to up to four specified targets, including certain research, development, manufacturing and commercialization rights. Pursuant to the Collaboration Agreement, Novartis initially had the right to exercise up to three purchased Options. In March 2018, Novartis notified us of its decision to not exercise its previously purchased Option for SRF231, our CD47 product candidate. In March 2018, we and Novartis also mutually agreed to cease development of one of the undisclosed programs subject to the Collaboration Agreement. In February 2019, Novartis notified us of its decision not to purchase its Option related to IL-27. As of December 31, 2019, Novartis had one Option remaining eligible for purchase and potential exercise. In January 2020, Novartis did not purchase and exercise its single remaining Option under the Collaboration Agreement and, as a result, the option purchase period expired. Accordingly, there are no Options remaining eligible for purchase and exercise by Novartis, and our performance obligations under the Collaboration Arrangement have ended. We are currently entitled to potential milestones of $525.0 million, as well as tiered royalties on annual net sales of NZV930 by Novartis ranging from high single-digit to mid-teens percentages. Such amount of potential milestone payments assumes the successful clinical development and achievement of all sales milestones for NZV930. Under ASC 606 we account for (i) the license conveyed with respect to CD73 and (ii) our obligations to perform research on CD73 and other specified targets as a single performance obligation under the Collaboration Agreement. We recognize revenue using the cost-to-cost method, which we believe best depicts the transfer of control to the customer. Under the cost-to-cost method, the extent of progress towards completion is measured based on the ratio of actual costs incurred to the total estimated costs expected upon satisfying the identified performance obligation. Under this method, revenue is recorded as a percentage of the estimated transaction price based on the extent of progress towards completion. Through December 31, 2019, we had received an aggregate of $150.0 million from Novartis in upfront payments, milestone payments, and option purchase payments. During the year ended December 31, 2019, 2018, and 2017, we recognized revenue of $15.4 million, $59.4 million and $12.8 million, respectively, related to the Collaboration Agreement. As of January 2020, we no longer have any performance obligations under the Collaboration Agreement. We will remove all costs associated with the remaining performance obligation for the single remaining Option from the cost-to-cost model in the first quarter of 2020. This will result in our recognizing the remaining deferred revenue of $38.6 million to collaboration revenue - related party in the first quarter of 2020. Operating Expenses Research and Development Expenses Research and development expenses are expensed as incurred and consist of costs incurred for our research activities, including our discovery efforts, and the development of our programs. These expenses include: • salaries, benefits and other related costs, including stock-based compensation, for personnel engaged in research and development functions; • expenses incurred in connection with the preclinical development of our programs and clinical trials of our product candidates, including under agreements with third parties, such as consultants, contractors, and contract research organizations, or CROs; • the cost of manufacturing drug products for use in our preclinical studies and clinical trials, including under agreements with third parties, such as consultants, contractors, and contract manufacturing organizations, or CMOs; • laboratory supplies; • facilities, depreciation and other expenses, which include direct and allocated expenses for depreciation and amortization, rent and maintenance of facilities, insurance and supplies; and • third-party license fees. We do not track our internal research and development expenses on a program-by-program basis as they primarily relate to personnel, early research and consumable costs, which are deployed across multiple projects under development. These costs are included in unallocated research and development expenses in the table below. A portion of our research and development costs are external costs, which we do track on a program-by-program basis. The following table summarizes our research and development expenses by program: Product candidates in later stages of clinical development generally have higher development costs than those in earlier stages of clinical development, primarily due to the increased size and duration of later-stage clinical trials. We anticipate that our research and development expenses will decrease in the future as a result of the strategic restructuring and the reduction in force announced in January 2020, however, we still anticipate incurring increased clinical development costs as we advance our SRF617 and SRF388 clinical trials. At this time, we cannot reasonably estimate or know the nature, timing, and estimated costs of the efforts that will be necessary to complete the development of any of our product candidates that we develop from our programs. We are also unable to predict when, if ever, net cash inflows will commence from sales of product candidates we develop. This is due to the numerous risks and uncertainties associated with developing product candidates, including the uncertainty of: • successful completion of clinical trials and preclinical studies; • sufficiency of our financial and other resources to complete the necessary clinical trials and preclinical studies; • acceptance of INDs for our planned clinical trials or future clinical trials; • successful enrollment and completion of clinical trials; • successful data from our clinical program that supports an acceptable risk-benefit profile of our product candidates in the intended populations; • receipt of regulatory and marketing approvals from applicable regulatory authorities; • receipt and maintenance of marketing approvals from applicable regulatory authorities; • establishing agreements with third-party manufacturers for clinical supply for our clinical trials and commercial manufacturing, if any of our product candidates are approved; • entry into collaborations to further the development of our product candidates; • obtaining and maintaining patent and trade secret protection or regulatory exclusivity for our product candidates; • successfully launching commercial sales of our product candidates, if and when approved; • acceptance of our product candidates’ benefits and uses, if and when approved, by patients, the medical community and third-party payors; • maintaining a continued acceptable safety profile of the product candidates following approval; • effectively competing with other therapies; and • obtaining and maintaining healthcare coverage and adequate reimbursement from third-party payors. A change in the outcome of any of these variables with respect to the development of any of our programs or any product candidate we develop would significantly change the costs, timing, and viability associated with the development of such program or product candidate. General and Administrative Expenses General and administrative expenses consist primarily of salaries and personnel-related costs, including stock-based compensation, for our personnel in executive, legal, finance and accounting, human resources, and other administrative functions. General and administrative expenses also include legal fees relating to patent and corporate matters; professional fees paid for accounting, auditing, consulting and tax services; insurance costs; travel expenses; and facility costs not otherwise included in research and development expenses. We anticipate that our general and administrative expenses will decrease in the future as a result of the strategic restructuring and the reduction in force announced in January 2020, however, we still anticipate incurring increased accounting, audit, legal, regulatory, compliance, and director and officer insurance costs as well as investor and public relations expenses associated with operating as a public company. Interest and Other Income (Expense), Net Interest and other income consist primarily of interest earned on our cash, cash equivalents, and marketable securities. Income Taxes We have not recorded any income tax benefits for the net losses we incurred or for the research and development tax credits we generated during the years ended December 31, 2019 and 2018 as we believed, based upon the weight of available evidence, that it was more likely than not that all of the net operating loss carryforwards and tax credits will not be realized. As of December 31, 2019, we had federal and state net operating loss carryforwards of $71.5 million and $73.0 million, respectively, which may be available to offset future income tax liabilities and begin to expire in 2034. As of December 31, 2019, we also had federal and state research and development tax credit carryforwards of $4.5 million and $2.0 million, respectively, which begin to expire in 2034 and 2030, respectively. Through December 31, 2019, we had recorded a full valuation allowance against our net deferred tax assets at each balance sheet date. Results of Operations Comparison of Years Ended December 31, 2019, 2018, and 2017 The following table summarizes our results of operations for the years ended December 31, 2019, 2018, and 2017, along with the changes in those items: Collaboration Revenue - Related Party Collaboration revenue - related party was $15.4 million, $59.4 million, and $12.8 million for the years ended December 31, 2019, 2018, and 2017, respectively, all of which was derived from the Collaboration Agreement. The decrease in collaboration revenue - related party during the year ended December 31, 2019 was primarily due to a reduction in costs incurred in the current year resulting from Novartis’ decision not to purchase its Option related to IL-27 in February 2019. This decision reduced the number of remaining specified targets in our Collaboration Agreement from two in the year ended December 31, 2018, to one in the year ended December 31, 2019. The increase in collaboration revenue - related party during the year ended December 31, 2018 was primarily due to the partial recognition of $27.9 million in revenue related to a milestone payment of $45.0 million that we received in February 2018 from Novartis upon Novartis’ receipt and acceptance of the first final audited GLP toxicology study report for NZV930. Additionally, we recognized $5.0 million of revenue upon Novartis’ decision not to exercise its Option relating to CD47 in March 2018. In January 2020, Novartis did not purchase and exercise its single remaining Option under the Collaboration Agreement and, as a result, the option purchase period expired. Accordingly, there are no Options remaining eligible for purchase and exercise, and our performance obligations under the Collaboration Arrangement have ended. As such, the remaining deferred revenue will be recognized as collaboration revenue - related party in the first quarter of 2020. Research and Development Expenses Research and development expenses were $52.1 million for the year ended December 31, 2019, compared to $52.5 million for the year ended December 31, 2018. The decrease of $0.4 million was primarily due to decreases of $13.6 million in external costs for our SRF231 program, $1.0 million in external costs for our NZV930 program, and $2.4 million in external costs for our other early-stage programs, which were partially offset by increases of $3.3 million in external costs for our SRF388 program, $8.5 million in external costs for our SRF617 program, and $3.3 million for research and discovery and unallocated costs. The decrease in research and development expenses for our SRF231 program was primarily due to a reduction in contract manufacturing work completed in 2019 compared to 2018, as well as the deprioritization of SRF231, which we announced in December 2018. The decrease in research and development expenses for our NZV930 program was primarily due to initiation of the Phase 1 clinical trial by Novartis in June 2018. Novartis has worldwide exclusive rights to this program, and as a result of the initiation of the Phase 1 clinical by Novartis, we are no longer incurring expenses for this program. The decrease in research and development expenses for our other early-stage programs was primarily a result of costs related to SRF813, which were not tracked as a separate program until 2019, as well as our strategic focus on filing INDs for SRF617 and SRF388 in the fourth quarter of 2019. The increase in research and development expenses for our SRF388 program was primarily due to increased contract manufacturing work and additional costs incurred in advancing the program, which led to the successful filing of an IND in the December 2019. The increase in research and development expenses for our SRF617 program was primarily due to increased contract manufacturing work and additional costs incurred in advancing the program, which led to the successful filing of an IND in the fourth quarter of 2019. The increase in research and discovery and unallocated expenses was primarily due to the increase of $2.3 million in personnel-related costs due to increased headcount, and an increase of $0.9 million in facility related costs. Research and development expenses were $52.5 million for the year ended December 31, 2018, compared to $47.8 million for the year ended December 31, 2017. The increase of $4.7 million was primarily due to increases of $1.2 million in external costs for our SRF388 program, $4.8 million in external costs for our SRF617 program, and $3.5 million for research and discovery and unallocated costs, partially offset by decreases of $2.3 million in external costs for our SRF231 program, $1.3 million in external costs for our SRF373 program, and $1.1 million in external costs for our other early-stage programs. The increase in research and development expenses for our SRF388 program was primarily due to a payment made for an exclusive license to the antibodies related to this program as well as increased contract manufacturing work. The increase in research and development expenses for our SRF617 program was primarily due to the commencement of contract manufacturing work. The increase in research and discovery and unallocated expenses was primarily due to the increase of $3.4 million in personnel-related costs due to increased headcount. The decrease in research and development expenses for our NZV930 program was primarily due to initiation of the Phase 1 clinical trial by Novartis in June 2018. Novartis has worldwide exclusive rights to this program, and as a result of the initiation of the Phase 1 clinical by Novartis, we are no longer incurring expenses for this program. The decrease in research and development expenses for our other early-stage programs was primarily a result of costs related to SRF617, which were not tracked as a separate program until 2018. This decrease was offset by increases relating to the advancement and initiation of new early discovery programs. General and Administrative Expenses General and administrative expenses were $20.6 million for the year ended December 31, 2019, compared to $16.1 million for the year ended December 31, 2018. The increase of $4.5 million was primarily due to an increase of $2.4 million in personnel-related costs as a result of an increase in headcount; an increase of $ 0.4 million for professional fees related to legal and audit services, and an increase of $1.3 million in facility costs. General and administrative expenses were $16.1 million for the year ended December 31, 2018, compared to $11.0 million for the year ended December 31, 2017. The increase of $5.1 million was primarily due to an increase of $2.6 million in personnel-related costs as a result of an increase in headcount; an increase of $1.0 million for professional fees related to legal and audit services, and an increase of $1.1 million in facility costs. Interest and Other Income (Expense), Net Interest and other income was approximately $2.6 million, $2.6 million, and $0.6 million during the years ended December 31, 2019, 2018, and 2017, respectively, due primarily to interest income on invested balances of our cash, cash equivalents and marketable securities. Liquidity and Capital Resources Since our inception, we have incurred significant operating losses. We have generated limited revenue to date from the Collaboration Agreement. We have not yet commercialized any product and we do not expect to generate revenue from sales of any products for several years, if at all. To date, we have financed our operations with proceeds from the sales of preferred stock, payments received under the Collaboration Agreement, debt financing and proceeds from our initial public offering of common stock and concurrent private placement. Through December 31, 2019, we had received gross proceeds of $48.6 million from our sales of preferred stock, $7.5 million from our loan and security agreement with K2 HealthVentures (see Note 12 to our consolidated financial statements), and $150.0 million from the Collaboration Agreement. On April 23, 2018, we completed an initial public offering of our common stock by issuing 7,200,000 shares of common stock, at $15.00 per share for gross proceeds of $108.0 million, or net proceeds of $97.2 million. Concurrent with the initial public offering, we issued Novartis 766,666 shares of our common stock at $15.00 per share for proceeds of $11.5 million, in a private placement. In May 2019, we entered into a Capital on DemandTM Sales Agreement, or the Sales Agreement, with JonesTrading Institutional Services to issue and sell up to $30.0 million in shares of our common stock, from time to time. In 2019, we sold 10,581 shares under the ATM Facility for net proceeds of less than $0.1 million. As of December 31, 2019, we had cash, cash equivalents and marketable securities of $105.2 million. Future Funding Requirements We expect our expenses to decrease in connection with our strategic restructuring, in particular as we shift focus to initiating and advancing Phase 1 clinical trials for SRF617 and SRF388, as well as the reduction in our workforce. However, we expect to continue to incur additional costs associated with operating as a public company. We believe that our existing cash, cash equivalents, and marketable securities, as of March 10, 2020, will enable us to fund our operating expenses, debt service obligations and capital expenditure requirements into 2022, excluding any future milestone payments from Novartis. We have based this estimate on assumptions that may prove to be wrong, and we could exhaust our capital resources sooner than we expect. Because of the numerous risks and uncertainties associated with research, development and commercialization of pharmaceutical product candidates, we are unable to estimate the exact amount of our working capital requirements. Our future funding requirements will depend on and could increase significantly as a result of many factors, including: • completing clinical development of existing product candidates and programs, identifying new product candidates, and completing pre-clinical and clinical development of such product candidates; • seeking and obtaining marketing approvals for any of product candidates that we develop; • launching and commercializing product candidates for which we obtain marketing approval by establishing a sales force, marketing, medical affairs and distribution infrastructure or, alternatively, collaborating with a commercialization partner; • achieving adequate coverage and reimbursement by hospitals, government and third-party payors for product candidates that we develop; • establishing and maintaining supply and manufacturing relationships with third parties that can provide adequate, in both amount and quality, products and services to support clinical development and the market demand for product candidates that we develop, if approved; • obtaining market acceptance of product candidates that we develop as viable treatment options; • addressing any competing technological and market developments; • negotiating favorable terms in any collaboration, licensing or other arrangements into which we may enter and performing our obligations in such collaborations; • maintaining, protecting and expanding our portfolio of intellectual property rights, including patents, trade secrets and know-how; • defending against third-party interference or infringement claims, if any; and • attracting, hiring and retaining qualified personnel. A change in the outcome of any of these or other variables with respect to the development of any of our product candidates could significantly change the costs and timing associated with the development of that product candidate. Further, our operating plans may change in the future, and we may need additional funds to meet operational needs and capital requirements associated with such operating plans. In addition to the variables described above, if and when any product candidate we develop successfully completes development, we will incur substantial additional costs associated with regulatory filings, marketing approval, post-marketing requirements, maintaining our intellectual property rights, and regulatory protection, in addition to other costs. We cannot reasonably estimate these costs at this time. Until such time, if ever, that we can generate substantial product revenue, we expect to finance our cash needs through a combination of equity or debt financings and collaboration arrangements, including the Collaboration Agreement. To the extent that we raise additional capital through the future sale of equity or debt, the ownership interests of our stockholders will be diluted, and the terms of these securities may include liquidation or other preferences that adversely affect the rights of our existing common stockholders. If we raise additional funds through the issuance of debt securities, these securities could contain covenants that would restrict our operations. We may require additional capital beyond our currently anticipated amounts. Additional capital may not be available on reasonable terms, or at all. If we raise additional funds through collaboration arrangements in the future, we may have to relinquish valuable rights to our technologies, future revenue streams or product candidates, or grant licenses on terms that may not be favorable to us. If we are unable to raise additional funds when needed, we may be required to delay, limit, reduce or terminate development or future commercialization efforts. Cash Flows The following table summarizes information regarding our cash flows for each of the periods presented: Operating Activities During the year ended December 31, 2019, net cash used in operating activities was $60.1 million, primarily due to our net loss of $54.8 million and net cash used in our operating assets and liabilities of $14.3 million, partially offset by non-cash charges of $8.9 million. Net cash used in changes in our operating assets and liabilities for the year ended December 31, 2019 consisted primarily of a $15.4 million decrease in deferred revenue, a $0.7 million decrease in accrued expenses and other current liabilities, a decrease of $1.8 million in our lease liability and a $3.0 million decrease in prepaid expenses and other current assets. The decrease in deferred revenue was due to recognition of revenue under the Collaboration Agreement in 2019. The decrease in accrued expenses and other current liabilities was primarily due to the reduction of manufacturing costs incurred in the current year offset increased payroll related accruals. The decrease in our lease liability is a result of rent payments made on our corporate lease in 2019. The decrease in prepaid expenses and other current assets was primarily due to the collection of the insurance claim in 2019. During the year ended December 31, 2018, net cash used in operating activities was $13.2 million, primarily due to changes in our operating assets and liabilities of $12.8 million and our net loss of $6.6 million, partially offset by non-cash charges of $6.2 million. Net cash used in changes in our operating assets and liabilities for the year ended December 31, 2018 consisted primarily of a $14.4 million decrease in deferred revenue, a $0.5 million decrease in accrued expenses and other current liabilities, and a $2.2 million decrease in prepaid expenses and other current assets. The decrease in deferred revenue was due to the cumulative effect adjustment upon the adoption of ASC 606 in January 2018. The decrease in accrued expenses and other current liabilities was primarily due to the payment of $3.4 million of manufacturing costs to Novartis in the current year offset increased manufacturing costs incurred to support ongoing clinical trial activities and payroll related accruals. The decrease in prepaid expenses and other current assets was primarily due to a reduction in prepaid taxes, offset by an increase in other assets resulting from an insurance claim that had not been received as of December 31, 2018. During the year ended December 31, 2017, net cash used in operating activities was $12.4 million, primarily due to our net loss of $45.4 million partially offset by changes in our operating assets and liabilities of $26.7 million and non-cash charges of $6.2 million. Net cash provided by changes in our operating assets and liabilities for the year ended December 31, 2017 consisted primarily of a $17.2 million increase in deferred revenue, a $5.0 million decrease in amounts due from Novartis, a related party, a $2.9 million increase in accrued expenses and other current liabilities, and a $1.1 million decrease in prepaid expenses and other current assets. The increase in deferred revenue was due to the $35.0 million of aggregate milestone and option purchase payments received from Novartis during the year ended December 31, 2017, which were not fully recognized as revenue at that time. The increase in accrued expenses and other current liabilities was primarily due to increased manufacturing costs incurred to support ongoing clinical trial activities and payroll related accruals. The decrease in prepaid expenses and other current assets was primarily due to a reduction in prepaid taxes. Investing Activities During the year ended December 31, 2019, net cash provided by investing activities was $17.0 million, primarily due to $136.9 million in proceeds from sales or maturities of marketable securities. This was partially offset by purchases of marketable securities of $118.3 million and $1.5 million of purchases of property and equipment, primarily related to leasehold improvements in our corporate headquarters facility. During the year ended December 31, 2018, net cash used in investing activities was $36.6 million, primarily due to purchases of marketable securities of $107.3 million and $ 2.0 million of purchases of property and equipment, primarily related to leasehold improvements in our corporate headquarters facility. This was partially offset by $72.7 million in proceeds from sales or maturities of marketable securities. During the year ended December 31, 2017, net cash provided by investing activities was $25.9 million, consisting primarily of $27.9 million of proceeds from sales or maturities of marketable securities, partially offset by $2.0 million of purchases of property and equipment, primarily related to leasehold improvements in our corporate headquarters facility. Financing Activities During the year ended December 31, 2019, net cash provided by financing activities was $7.4 million, consisting of $7.2 million of net proceeds received from the debt facility with K2 Health Ventures and $0.3 million proceeds received from the exercise of stock options. During the year ended December 31, 2018, net cash provided by financing activities was $110.4 million, consisting primarily of $100.4 million of net proceeds received upon the completion of the initial public offering in April 2018, $11.5 million from a private placement of common stock with Novartis, a related party, and $0.5 million of proceeds received from the exercise of stock options, partially offset by $2.0 million paid for initial public offering costs. During the year ended December 31, 2017, net cash used in financing activities was $1.0 million, consisting primarily of payments of initial public offering costs of $1.2 million, partially offset by $0.1 million of proceeds received from the exercise of stock options. Contractual Obligations and Commitments The following table summarizes our contractual obligations as of December 31, 2019 and the effects that such obligations are expected to have on our liquidity and cash flow in future periods: (1) Reflects payments due for leases of office and laboratory space that expire in December 2029. (2) Reflects payments due under our debt facility with K2 Health Ventures. (3) Reflects commitments for costs associated with external CMOs and CROs engaged to manufacture clinical trial materials as well as to conduct our clinical trials and discovery research and preclinical development activities. Under various license and collaboration agreements to which we are a party, we may be required to make milestone payments and pay royalties and other amounts to third parties. We have not included any such contingent payment obligations in the table above as the amount, timing and likelihood of such payments are not known. Under our license agreement with Harbour Antibodies B.V., or Harbour, we are required to pay a nominal annual maintenance fee during the term of the agreement. In addition, we are obligated to pay up to an aggregate of $4.75 million upon the achievement of specified development and commercial milestones for each product licensed under the agreement. We are also obligated to pay Harbour royalties of a low single-digit percentage on the worldwide net sales of any licensed product on a country-by-country basis. Under our development and option agreement with Adimab LLC, or Adimab, we are obligated to make milestone payments and to pay specified fees upon the exercise of the research or commercialization options under the agreement. During the discovery term, we may be obligated to pay Adimab up to $250,000 for technical milestones achieved against each biological target. Upon exercise of a research option, we are obligated to pay a nominal research maintenance fee on each of the next four anniversaries of the exercise. Upon the exercise of each commercialization option, we will be required to pay an option exercise fee of a low seven-digit dollar amount, and we may be responsible for milestone payments of up to an aggregate of $13.0 million for each licensed product that receives marketing approval. For any licensed product that is commercialized, we are obligated to pay Adimab tiered royalties of a low to mid single-digit percentage on worldwide net sales of such product. We may also partially exercise a commercialization option with respect to ten antibodies against a biological target by paying 65% of the option fee and later either (i) paying the balance and choosing up to 20 antibodies for commercialization or (ii) foregoing the commercialization option entirely. Critical Accounting Policies and Significant Judgments and Estimates Our management’s discussion and analysis of our financial condition and results of operations is based on our consolidated financial statements, which we have prepared in accordance with the rules and regulations of the SEC, and generally accepted accounting principles in the United States, or GAAP. The preparation of these consolidated financial statements requires us to make estimates and assumptions that affect the reported amounts of assets, liabilities, and the disclosure of contingent assets and liabilities at the date of the financial statements, as well as revenue and expenses during the reporting period. 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 the carrying value of assets and liabilities that are not readily apparent from other sources. Our actual results may differ from these estimates under different assumptions or conditions. While our significant accounting policies are described in more detail in Note 2 to our consolidated financial statements, we believe that the accounting policies discussed below are critical to understanding our historical and future performance, as these policies relate to the more significant areas involving management’s judgments and estimates. Revenue Recognition Effective January 1, 2018, we adopted Accounting Standards Codification (“ASC”) Topic 606, Revenue from Contracts with Customers, using the modified retrospective transition method. Under this method, we recognized the cumulative effect of initially adopting ASC Topic 606, as an adjustment to the opening balance of accumulated deficit. Additionally, under this method of adoption, we apply the guidance to all incomplete contracts in scope as of the date of initial application. This standard applies to all contracts with customers, except for contracts that are within the scope of other standards, such as leases, insurance, collaboration arrangements and financial instruments. In accordance with ASC Topic 606, we recognize revenue when our customer obtains control of promised goods or services, in an amount that reflects the consideration which the entity expects to receive in exchange for those goods or services. To determine revenue recognition for arrangements that we determine are within the scope of ASC Topic 606, we perform the following five steps: i. identify the contract(s) with a customer; ii. identify the performance obligations in the contract; iii. determine the transaction price iv. allocate the transaction price to the performance obligations within the contract; and v. recognize revenue when (or as) the entity satisfies a performance obligation. We only apply the five-step model to contracts when we determine that it is probable that we will collect the consideration we are entitled to in exchange for the goods or services we transfer to the customer. At contract inception, once the contract is determined to be within the scope of ASC 606, we assess the goods or services promised within the contract to determine whether each promised good or service is a performance obligation. The promised goods or services in our arrangements typically consist of a license to our intellectual property and/or research and development services. We may provide options to additional items in such arrangements, which are accounted for as separate contracts when the customer elects to exercise such options, unless the option provides a material right to the customer. Performance obligations are promises in a contract to transfer a distinct good or service to the customer that (i) the customer can benefit from on its own or together with other readily available resources, and (ii) is separately identifiable from other promises in the contract. Goods or services that are not individually distinct performance obligations are combined with other promised goods or services until such combined group of promises meet the requirements of a performance obligation. We determine transaction price based on the amount of consideration we expect to receive for transferring the promised goods or services in the contract. Consideration may be fixed, variable, or a combination of both. At contract inception for arrangements that include variable consideration, we estimate the probability and extent of consideration we expect to receive under the contract utilizing either the most likely amount method or expected amount method, whichever best estimates the amount expected to be received. We then consider any constraints on the variable consideration and includes in the transaction price variable consideration to the extent it is deemed probable that a significant reversal in the amount of cumulative revenue recognized will not occur when the uncertainty associated with the variable consideration is subsequently resolved. We then allocate the transaction price to each performance obligation based on the relative standalone selling price and recognizes as revenue the amount of the transaction price that is allocated to the respective performance obligation when (or as) control is transferred to the customer and the performance obligation is satisfied. For performance obligations which consist of licenses and other promises, we utilize judgment to assess the nature of the combined performance obligation to determine whether the combined performance obligation is satisfied over time or at a point in time and, if over time, the appropriate method of measuring progress. We evaluate the measure of progress each reporting period and, if necessary, adjust the measure of performance and related revenue recognition. We record amounts as accounts receivable when the right to consideration is deemed unconditional. When consideration is received, or such consideration is unconditionally due, from a customer prior to transferring goods or services to the customer under the terms of a contract, a contract liability is recorded for deferred revenue. Amounts received prior to satisfying the revenue recognition criteria are recognized as deferred revenue in our balance sheet. Amounts expected to be recognized as revenue within the 12 months following the balance sheet date are classified as current portion of deferred revenue. Amounts not expected to be recognized as revenue within the 12 months following the balance sheet date are classified as deferred revenue, non-current. Our revenue arrangement includes the following: Up-front License Fees: If a license is determined to be distinct from the other performance obligations identified in the arrangement, we recognize revenues from nonrefundable, up-front fees allocated to the license when the license is transferred to the licensee and the licensee is able to use and benefit from the license. For licenses that are bundled with other promises, we utilize judgment to assess the nature of the combined performance obligation to determine whether the combined performance obligation is satisfied over time or at a point in time and, if over time, the appropriate method of measuring progress for purposes of recognizing revenue from non-refundable, up-front fees. We evaluate the measure of progress each reporting period and, if necessary, adjust the measure of performance and related revenue recognition. Milestone Payments: At the inception of an agreement that includes research and development milestone payments, we evaluate each milestone to determine when and how much of the milestone to include in the transaction price. We first estimate the amount of the milestone payment that we could receive using either the expected value or the most likely amount approach. We primarily use the most likely amount approach as that approach is generally most predictive for milestone payments with a binary outcome. Then, we consider whether any portion of that estimated amount is subject to the variable consideration constraint (that is, whether it is probable that a significant reversal of cumulative revenue would not occur upon resolution of the uncertainty.) We update the estimate of variable consideration included in the transaction price at each reporting date which includes updating the assessment of the likely amount of consideration and the application of the constraint to reflect current facts and circumstances. Royalties: For arrangements that include sales-based royalties, including milestone payments based on the level of sales, and the license is deemed to be the predominant item to which the royalties relate, we will recognize revenue at the later of (i) when the related sales occur, or (ii) when the performance obligation to which some or all of the royalty has been allocated has been satisfied (or partially satisfied). To date, we have not recognized any revenue related to sales-based royalties or milestone payments based on the level of sales. All of our revenues to date have been generated through the Collaboration Agreement with Novartis See Note 8, “Collaboration Agreement with Novartis” for additional details regarding our Collaboration Agreement. Accrued Research and Development Expenses As part of the process of preparing our financial statements, we are required to estimate our accrued expenses. This process involves reviewing open contracts and purchase orders, communicating with our personnel to identify services that have been performed on our behalf, and estimating the level of service performed and the associated cost incurred for the service when we have not yet been invoiced or otherwise notified of the actual cost. The majority of our service providers invoice us monthly in arrears for services performed, or when contractual milestones are met; however, some require advanced payments. We make estimates of our accrued expenses as of each balance sheet date based on facts and circumstances known to us at that time. We periodically confirm the accuracy of our estimates with the service providers and make adjustments if necessary. The significant estimates in our accrued research and development expenses include the costs incurred for services performed by our vendors in connection with research and development activities for which we have not yet been invoiced. There may be instances in which payments made to our vendors will exceed the level of services provided and result in a prepayment of the expense. In accruing service fees, we estimate the time period over which services will be performed and the level of effort to be expended in each period. If the actual timing of the performance of services or the level of effort varies from the estimate, we adjust the accrual or the amount of prepaid expenses accordingly. Although we do not expect our estimates to be materially different from amounts actually incurred, if our estimates of the status and timing of services performed differ from the actual status and timing of services performed, it could result in us reporting amounts that are too high or too low in any particular period. To date, there have been no material differences between our estimates of such expenses and the amounts actually incurred. Off-Balance Sheet Arrangements We did not have, during the periods presented, and we do not currently have, any off-balance sheet arrangements, as defined under applicable Securities and Exchange Commission rules. Recently Issued Accounting Pronouncements A description of recently issued accounting pronouncements that may potentially impact our financial position and results of operations is disclosed in Note 2 to our consolidated financial statements.

<s>[INST] Overview We are a clinicalstage immunooncology company focused on using our specialized knowledge of the biological pathways critical to the immunosuppressive tumor microenvironment, or the TME, for the development of nextgeneration cancer therapies. While firstgeneration immunooncology therapies, such as checkpoint inhibitors, represent a remarkable therapeutic advancement, we believe most patients do not achieve durable clinical benefit primarily because these therapies focus on only one element of the complex and interconnected immunosuppressive TME. We believe there is a significant opportunity to more broadly engage both the innate and adaptive arms of the immune system in a multifaceted, coordinated and patientspecific approach, to meaningfully improve cure rates for patients with a variety of cancers. We aim to identify key components within the TME to gain a deep understanding of its biology, leverage this understanding to define the optimal therapeutic targets and the patients most likely to benefit, and develop novel antibody therapeutics with differentiated biologic activity. By utilizing our expertise in immunology, oncology, assay development, antibody selection and characterization, and translational research, we are developing and advancing a broad pipeline of TMEfocused programs that we believe are the next generation of immunooncology therapies. Our programs demonstrate our multifaceted approach by targeting several critical components of the immunosuppressive TME. NZV930 (formerly SRF373) and SRF617 are antibodies inhibiting CD73 and CD39, respectively, and illustrate how our specialized knowledge of TME biology can be leveraged across programs. CD73 and CD39 are both critical enzymes involved in the production of extracellular adenosine, a key metabolite with strong immunosuppressive properties within the TME. In addition, inhibition of CD39 results in an increase in the proinflammatory metabolite adenosine triphosphate, or ATP, within the TME. In June 2018, a Phase 1 trial of NZV930 was initiated by our partner, Novartis Institutes for Biomedical Research, Inc., or Novartis, and we filed an investigational new drug application, or IND, for SRF617 in November 2019 and received permission to proceed from the FDA on December 12, 2019. SRF388 is an antibody targeting interleukin 27, or IL27, an immunosuppressive cytokine, or protein secreted by cells, in the TME that is overexpressed in certain cancers, including hepatocellular and renal cell carcinoma. IL27 is a cytokine secreted by macrophages and antigen presenting cells that plays an important physiologic role in suppressing the immune system. Due to its immunosuppressive nature, there is a rationale for inhibiting IL27 to treat cancer as this approach will influence the activity of multiple types of immune cells that are necessary to recognize and attack a tumor. We filed an IND for SRF388 in December 2019 and received permission to proceed from the FDA on January 17, 2020. SRF813 is an antibody targeting CD112R, an inhibitory protein expressed on natural killer, or NK, and T cells. SRF813 binds a distinct epitope on CD112R and blocks the interaction of CD112R with CD112, its binding partner that is expressed on tumor cells. SRF813 can promote the activation of both NK and T cells, with potential to elicit a strong antitumor response and promote immunological memory. In October 2019, we formally declared SRF813 as a development candidate resulting in the initiation of INDenabling activities. SRF231 is an antibody targeting CD47, a protein expressed on many cells that is often overexpressed on tumor cells. By targeting CD47, we believe we can promote macrophage activation to attack such tumors. We initiated a Phase 1 clinical trial of SRF231 in February 2018. In December 2 [/INST] Positive. </s>

EVO Payments, Inc.

2019-03-25

2018-12-31

ITEM 7. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS Introduction This “Management’s Discussion and Analysis of Financial Condition and Results of Operations” (“MD&A”) is intended to provide an understanding of our financial condition, changes in financial condition, cash flow, liquidity and results of operations. This MD&A should be read in conjunction with our consolidated financial statements and the notes to the accompanying consolidated financial statements appearing elsewhere in this Form 10-K and the Risk Factors included in Part I, Item 1A of this Form 10-K, as well as other cautionary statements and risks described elsewhere in this Form 10-K. The following discussion and analysis reflects the historical results of operations and financial position of EVO, LLC and its consolidated subsidiaries prior to the Reorganization Transactions and that of EVO, Inc. and its consolidated subsidiaries (including EVO, LLC) following the completion of the Reorganization Transactions. The historical results of operations and financial condition of EVO, LLC prior to the completion of the Reorganization Transactions, including the IPO, do not reflect certain items that affected our results of operations and financial condition after giving effect to the Reorganization Transactions and the use of proceeds from the IPO. Overview We are a leading payments technology and services provider offering an array of payment solutions to merchants ranging from small and mid-size enterprises to multinational companies and organizations across North America and Europe. As a fully integrated merchant acquirer and payment processor in over 50 markets and 150 currencies worldwide, we provide competitive solutions that promote business growth, increase customer loyalty and enhance data security in the markets we serve. Executive overview · Revenue for the year ended December 31, 2018 increased 11.9% to $564.8 million from $504.8 million in 2017, driven by an 18.7% increase in Europe segment revenue and a 7.2% increase in North America segment revenue. · North America segment profit for the year ended December 31, 2018 was $85.4 million, 3.2% higher than the year ended December 31, 2017. · Europe segment profit for the year ended December 31, 2018 was $61.2 million, 11.6% higher than the year ended December 31, 2017. Recent acquisitions See Note 4, “Acquisitions” in the notes to the accompanying consolidated financial statements for further information about recent acquisitions. Our segments We classify our business into two segments: North America and Europe. The alignment of our segments is designed to establish lines of business that support the geographical markets in which we operate and allow us to further globalize our solutions while working seamlessly with our teams across these markets. Both segments provide businesses with merchant acquiring solutions, including integrated solutions for retail transactions at physical business locations, as well as eCommerce and mobile transactions. The business segment measurements provided to and evaluated by the segment leaders are computed in accordance with the principles listed below: · The accounting policies of the operating segments are the same as those described in the summary of the significant accounting policies. · Segment profit, which is the measure used by our chief operating decision maker to evaluate the performance of and to allocate resources to our segments, is calculated as segment revenue less (1) segment expenses, plus (2) segment income from unconsolidated investees, plus (3) segment other income, net, less (4) segment non-controlling interests. Certain corporate-wide governance functions, as well as depreciation and amortization, are not allocated to our segments. North America Our North America segment is comprised of the United States, Canada and Mexico. We distribute our products and services through a combination of bank referrals, a direct sales force, specialized integrated solution companies, sales agents and ISOs. Europe Our Europe segment is comprised of Western Europe (Spain, United Kingdom, Ireland, Germany and Malta) and Eastern Europe (Poland and the Czech Republic). We distribute our products and services through a combination of bank referrals, a direct sales force, specialized integrated solution companies and ISOs. We also provide ATM processing services to a financial institution and third-party ATM providers. Key financial definitions Revenue consists primarily of fees derived from the monetary value of and number of transactions processed for our merchants, as defined through contractual agreements with the merchants. We also receive revenues related to other fees for certain services and products. We follow guidance provided in Accounting Standards Codification (“ASC”) 605-45, Principal Agent Considerations, which establishes guidance for whether revenue is recognized based on the gross amount billed to a customer or the net amount retained. Through the evaluation of ASC 605-45, certain revenues are presented net of interchange fees paid to issuers, certain fees and assessments paid to the card networks (e.g., Visa, Mastercard, American Express and Discover), as these costs are controlled by the networks in which we effectively act as a clearing house collecting and remitting fees, and commissions paid to our distribution partners. Revenues earned from processing merchant transactions are recognized at the time merchant transactions are processed. These revenues include a rate charged to the merchant based on the percentage of the value of the transaction processed, a rate per transaction or some combination thereof. Cost of services and products, exclusive of depreciation and amortization shown separately below consists primarily of fees paid to card networks, front- and back-end fees paid to third-party network service providers and hardware vendors (such as vendors selling terminals or mobile devices) and payments to third parties for other product offerings. These fees are presented on a gross basis as we contract directly with the end customer, assume the risk of loss and have pricing flexibility. These expenses exclude any depreciation or amortization, which is described below. Selling, general and administrative consists primarily of sales, customer support, advertising and other administrative costs. Sales expenses are comprised of salaries, commissions for internal sales personnel, payroll-related benefits and office infrastructure expenses. General and administrative expenses are comprised of compensation, benefits and other expenses associated with corporate management, finance, human resources, shared services, information technology and other activities. Depreciation and amortization consists of depreciation and amortization expenses related to card processing, office equipment, computer software, leasehold improvements, furniture and fixtures, merchant contract portfolios, marketing alliance agreements, finite-lived trademarks, internally developed software, and non-competition agreements. Interest income consists of interest earned by investing excess cash balances. Interest expense consists of interest cost incurred from our borrowings and the amortization of financing costs. Income from investment in unconsolidated investees consists of income earned from the investment in businesses in which we have a minority ownership stake and under which our share in the investees’ financial results are not consolidated for reporting purposes. Other income consists primarily of other income items not considered part of the normal course of business operations. Income tax (expense) benefit represents federal, state, local and foreign taxes based on income in multiple domestic and foreign jurisdictions. Net income attributable to non-controlling interests arises from net income from the non-owned portion of businesses where we have a controlling interest but less than 100% ownership. This represents both the non-controlling interests that are consolidating entities of EVO, LLC and EVO, LLC non-controlling interests, which is comprised of the income allocated to Continuing LLC Owners as a result of their proportional ownership of LLC Interests. Factors impacting our business and results of operations In general, our revenue is impacted by factors such as global consumer spending trends, foreign exchange rates, the pace of adoption of commerce-enablement and payment solutions, acquisitions and dispositions, types and quantities of products and services provided to enterprises, timing and length of contract renewals, new enterprise wins, retention rates, mix of payment solution types employed by consumers, changes in card network fees including interchange rates and size of enterprises served. In addition, we may pursue acquisitions from time to time. These acquisitions could result in redundant costs, such as increased interest expense resulting from any indebtedness incurred to finance any acquisitions, or could require us to incur losses as we restructure or reorganize our operations following these acquisitions. Seasonality We have experienced in the past, and expect to continue to experience, seasonality in our revenue as a result of consumer spending patterns. In North America, our revenue has been strongest in our fourth quarter and weakest in our first quarter as many of our merchant categories experience a seasonal lift during the traditional vacation and holiday months. In Europe, our revenue has been strongest in our third quarter and weakest in our first quarter. Operating expenses do not typically fluctuate seasonally. Foreign currency translation impact on our operations Our consolidated revenues and expenses are subject to variations caused by the net effect of foreign currency translation on revenues recognized and expenses incurred by our non-U.S. operations. It is difficult to predict the future fluctuations of foreign currency exchange rates and how those fluctuations will impact our consolidated statements of operations and comprehensive loss in the future. As a result of the relative size of our international operations, these fluctuations may be material on individual balances. Our revenues and expenses from our international operations are generally denominated in the local currency of the country in which they are derived or incurred. Therefore, the impact of currency fluctuations on our operating results and margins is partially mitigated. Key performance indicators “Transactions processed” refers to the number of transactions we processed during any given period of time and is a meaningful indicator of our business and financial performance, as a significant portion of our revenue is driven by the number of transactions we process. In addition, transactions processed provides a valuable measure of the level of economic activity across our merchant base. In our North America segment, transactions include acquired Visa and Mastercard credit and signature debit, American Express, Discover, UnionPay, PIN-debit, electronic benefit transactions and gift card transactions. In our Europe segment, transactions include acquired Visa and Mastercard credit and signature debit, other card network merchant acquiring transactions, and ATM transactions. For the year ended December 31, 2018, we processed more than 950 million transactions in North America and approximately 2.1 billion transactions in Europe, an aggregate increase of 17.0% December 31, 2017, driven by organic growth and the impact of acquisitions. Transactions processed in North America accounted for 31% of the total transactions we processed in 2018. For the year ended December 31, 2017, we processed more than 900 million transactions in North America and approximately 1.7 billion transactions in Europe, an aggregate increase of 22.3% compared to the year ended December 31, 2016, driven by organic growth and the impact of acquisitions. Excluding the impact of acquisitions, transactions processed grew 15.5% from 2016 to 2017. Transactions processed in North America accounted for 35% of the total transactions we processed in 2017. For the year ended December 31, 2016, we processed more than 760 million transactions in North America and approximately 1.4 billion transactions in Europe, an aggregate increase of 36.8% compared to the year ended December 31, 2015, driven by organic growth and the impact of acquisitions. Excluding the impact of acquisitions, transactions processed grew 17.2% from 2015 to 2016. Transactions processed in North America accounted for 35% of the total transactions we processed in 2016. Comparison of results for the years ended December 31, 2018 and 2017 The following table sets forth the consolidated statements of operations in dollars and as a percentage of revenue for the period presented. Revenue Revenue was $564.8 million for the year ended December 31, 2018, an increase of $60.0 million, or 11.9%, compared to revenue of $504.8 million for the year ended December 31, 2017. This increase was driven primarily by organic growth in our European segment, Mexico and the U.S. Tech-enabled division. North America segment revenue was $320.5 million for the year ended December 31, 2018, an increase of $21.4 million, or 7.2%, compared to the year ended December 31, 2017. The increase was driven by organic growth in our U.S. Tech-enabled division and Mexico. North America transactions increased 4.6% for the year ended December 31, 2018, compared to the year ended December 31, 2017, primarily driven by organic growth in Mexico, revenue from the acquisition of Federated Payment Systems, LLC and Federated Payment Canada Corporation (“Federated”) and our U.S. Tech-enabled division, partially offset by declines in transactions in the U.S. Direct and Traditional divisions. Changes in foreign currency exchange rates decreased reported revenue by $2.3 million for the year ended December 31, 2018. Europe segment revenue was $244.3 million for the year ended December 31, 2018, an increase of $38.6 million, or 18.7%, compared to the year ended December 31, 2017, driven by strong growth in Europe transactions. Europe transactions increased 23.6%, as compared to the year ended December 31, 2017. Changes in foreign currency exchange rates increased reported revenue by $9.1 million for the year ended December 31, 2018. Operating expenses Cost of services and products, exclusive of depreciation and amortization Cost of services and products, exclusive of depreciation and amortization, was $189.4 million for the year ended December 31, 2018, an increase of $24.9 million, or 15.1%, compared to the year ended December 31, 2017. This increase was due primarily to the increase in transactions processed and increases in card network fees. Our cost of services and products includes both fixed and variable components, with variable components dependent upon transactions processed, among other secondary measures. The increase in cost was due to the variable component from the increase in transactions processed. Selling, general and administrative expenses Selling, general and administrative expenses were $311.4 million for the year ended December 31, 2018, an increase of $90.4 million, or 40.9%, compared to the year ended December 31, 2017. The increase was due primarily to share-based compensation expense incurred in the current period and other transition, acquisition and integration costs. At the consummation of the IPO and through the year ended December 31, 2018, the Company recognized one-time, non-cash compensation expenses of approximately $51.4 million in connection with (i) the Company waiving all time-based and performance-based vesting requirements applicable to EVO, LLC’s outstanding unvested Class D units that were reclassified as LLC interests and issuing Class C common stock or Class D common stock and (ii) the Company waiving all performance-based vesting and performance-based forfeiture requirements and issuing of shares of Class A common stock to members of our management and certain of our current and former employees upon conversion of the outstanding unit appreciation awards held by these individuals. We also incurred $4.1 million of compensation expense representing the amount recognized in connection with the grant of stock options and restricted stock units to our directors, officers and certain employees in connection with the IPO. We had no such expense for the year ended December 31, 2017. Depreciation and amortization Depreciation and amortization was $87.2 million for the year ended December 31, 2018, an increase of $13.0 million, or 17.6%, compared to the year ended December 31, 2017. This increase was due primarily to purchases of POS terminals to support growth in certain of our international markets and other hardware and software purchases as well as the amortization of intangible assets acquired during the year ended December 31, 2018. Impairment of intangible assets For the year ended December 31, 2018, we recognized a non-cash impairment charge of $14.6 million relating to trademarks, indefinite-lived, primarily related to the accelerated integration of the Sterling tradename into the EVO portfolio in November 2018. Interest expense Interest expense was $59.8 million for the year ended December 31, 2018, compared to $62.9 million for the year ended December 31, 2017. The decrease was due to reductions in borrowings from the use of IPO proceeds raised in the second quarter of 2018, partially offset by debt extinguishment costs and a prepayment penalty associated with the paydown of the second lien term loan. Gain on acquisition of unconsolidated investee Gain on acquisition of unconsolidated investee was $8.4 million for the year ended December 31, 2018, related to the fair value mark-up on the acquisition of a previously minority owned subsidiary. Income tax expense Historically, as a limited liability company treated as a partnership for U.S. federal income tax purposes, EVO, LLC’s income was not subject to corporate tax in the U.S., but only on income earned in foreign jurisdictions. In the U.S., our members were taxed on their proportionate share of income of EVO, LLC. However, following the Reorganization Transactions, we incur corporate tax at the U.S. federal income tax rate on our share of taxable income of EVO, LLC. Our income tax expense reflects such U.S. federal, state and local income tax as well as taxes payable in foreign jurisdictions by certain of our subsidiaries. Our income tax expense was $10.4 million for the year ended December 31, 2018, compared to income tax expense of $16.6 million for the year ended December 31, 2017. Net loss Net loss was $98.9 million for the year ended December 31, 2018, an increase of $66.5 million, compared to net loss of $32.3 million for the year ended December 31, 2017. This increase was due to higher selling, general and administrative expenses, primarily due to the impact of share-based compensation, higher professional fees related to integration and acquisition activities in the current period, and the $14.6 million impairment of the Sterling trademark in the current period. These drivers in net loss were partially offset by the $8.4 million gain on the acquisition of an unconsolidated investee. Net loss attributable to non-controlling interests of EVO Investco, LLC Net loss attributable to non-controlling interests of EVO Investco, LLC was $90.8 million for the year ended December 31, 2018. There was no net loss attributable to non-controlling interests of EVO Investco, LLC for the year ended December 31, 2017 as it was prior to the IPO and reorganization activities. Segment performance North America segment profit for the year ended December 31, 2018 was $85.4 million, 3.2% higher than the year ended December 31, 2017. The increase is primarily due to organic growth in Mexico and the U.S. Tech-enabled division and the impact of cost reduction programs in the United States. North America segment profit margin was 26.6% for the year ended December 31, 2018, compared to 27.7% for the year ended December 31, 2017. Europe segment profit was $61.2 million for the year ended December 31, 2018, compared to $54.8 million for the year ended December 31, 2017. The increase is primarily due to organic growth and the impact of acquisitions. Europe segment profit margin was 25.1% for the year ended December 31, 2018, compared to 26.7% for the year ended December 31, 2017. Corporate expenses not allocated to a segment were $41.4 million for the year ended December 31, 2018, compared to $25.7 million for the year ended December 31, 2017. The increase in expense is due to additional public company costs related to insurance, board of directors fees, certain related party transactions as described in Note 9 “Related Party Transactions” and an increase in consulting and advisor fees, including legal fees. Comparison of results for the years ended December 31, 2017 and 2016 The following table sets forth the consolidated statements of operations in dollars and as a percentage of revenue for the period presented. Revenue Revenue was $504.8 million for the year ended December 31, 2017, an increase of $85.5 million, or 20.4%, compared to revenue of $419.2 million for the year ended December 31, 2016. This increase was driven primarily by the inclusion of revenue from the Sterling acquisition and organic growth in our Mexico market and European segment. North America segment revenue was $299.0 million for the year ended December 31, 2017, an increase of $58.0 million, or 24.0%, compared to the year ended December 31, 2016. The acquisition of the Sterling business on January 4, 2017 contributed $50.5 million, while organic growth in our North America sales channels contributed $7.4 million. North America transactions increased 17.8% for the year ended December 31, 2017, compared to the year ended December 31, 2016, primarily driven by the Sterling acquisition and organic growth in Mexico. Changes in foreign currency exchange rates decreased revenue by $1.2 million. Europe segment revenue was $205.7 million for the year ended December 31, 2017, an increase of $27.6 million, or 15.5%, compared to the year ended December 31, 2016. Europe transactions increased 24.7% from double digit growth across all countries. The number of transactions processed increased faster than revenue due to certain one-time incentive payments received in the year ended December 31, 2016. Changes in foreign currency exchange rates increased revenue by $6.7 million for the year ended December 31, 2017. Operating expenses Cost of services and products, exclusive of depreciation and amortization Cost of services and products, exclusive of depreciation and amortization was $164.5 million for the year ended December 31, 2017, an increase of $23.8 million, or 16.9%, compared to the year ended December 31, 2016. This increase was due to the increase in transactions processed and the inclusion of costs from Sterling. Our cost of services and products includes both fixed and variable components, with variable components dependent upon transactions processed, among other secondary measures. The increase in cost was due to the variable component from the increase in transactions processed and the inclusion of costs from Sterling. Selling, general and administrative expenses Selling, general and administrative expenses was $221.0 million for the year ended December 31, 2017, an increase of $46.8 million, or 26.9%, compared to the year ended December 31, 2016. The increase was due primarily to the inclusion of expenses from Sterling, severance charges incurred and other strategic investments to support continued growth. Depreciation and amortization Depreciation and amortization was $74.1 million for the year ended December 31, 2017, an increase of $10.1 million, or 15.8%, compared to the year ended December 31, 2016. This increase was due primarily to the inclusion of expenses from Sterling. Interest expense Interest expense was $62.9 million for the year ended December 31, 2017, an increase of $22.2 million compared to interest expense of $40.7 million for the year ended December 31, 2016. This increase was due primarily to higher debt balances related to the Sterling acquisition and higher interest rates applicable to the Senior Secured Credit Facilities. Income tax expense Income tax expense was $16.6 million for the year ended December 31, 2017, a decrease of $0.4 million, compared to an income tax expense of $17.0 million for the year ended December 31, 2016. This decrease was due primarily to higher income before income tax for the prior year period resulting from the one-time gain on the sale of the company’s membership interest in Visa Europe. The taxation of this gain was limited due to German tax exemption on a significant majority of the gain on sale. Net loss Net loss was $32.3 million for the year ended December 31, 2017, a decrease of $89.8 million compared to net income of $57.5 million for the year ended December 31, 2016. This decrease was due primarily to the one-time gain on the sale of the company’s membership interest in Visa Europe in the prior year period, the increase in operating expenses related to strategic investments and the increase in interest expense from higher debt balances related to the Sterling acquisition. Net income attributable to non-controlling interests of EVO Investco, LLC Net loss attributable to the Members of EVO Investco, LLC was $40.2 million for the year ended December 31, 2017, compared to net income of $47.7 million for the year ended December 31, 2016. The decrease was due primarily to the one-time gain on the sale of the company’s membership interest in Visa Europe in the prior year period, the increase in operating expenses related to strategic investments and the increase in interest expense from higher debt balances related to the Sterling acquisition. Segment performance North America segment profit for the year ended December 31, 2017 was $82.8 million, 25.3% higher than the year ended December 31, 2016, primarily due to the inclusion of Sterling results in the current period, organic growth in the Mexico market and the impact of cost reduction programs in the United States. North America segment profit margin was 27.7% in the year ended December 31, 2017, compared to 27.4% for the year ended December 31, 2016. Europe segment profit was $54.8 million for the year ended December 31, 2017, a decrease of $73.1 million compared to the year ended December 31, 2016. This decrease was driven by the one-time gain on the sale of our Visa Europe membership interest in the prior year period. Europe segment profit margin was 26.7% for the year ended December 31, 2017, compared to 71.8% for the year ended December 31, 2016. The prior year segment profit margin includes the impact of the one-time gain on sale of our membership interest in Visa Europe and one-time incentive payments received in 2016. The current year segment profit margin includes the impact of strategic investments, including additional gateway capabilities acquired with the purchase of Intelligent Payments Gateway (“IPG”) in December 2016. Corporate expenses not allocated to a segment was $25.7 million for the years ended December 31, 2017, and 2016, respectively. Liquidity and capital resources Overview We have historically funded our operations primarily with cash flow from operations and, when needed, with borrowings, including under our Senior Secured Credit Facilities. Our principal uses for liquidity have been debt service, capital expenditures, working capital and funds required to finance acquisitions. We expect to continue to use capital to innovate and advance our products as new technologies emerge. We expect these strategies to be funded primarily through cash flow from operations and borrowings from our Senior Secured Credit Facilities, as needed. Short-term liquidity needs will primarily be funded through the revolving credit facility portion of our Senior Secured Credit Facilities. As of December 31, 2018, our capacity under the revolving credit facility portion of our Senior Secured Credit Facilities was $200.0 million, with availability of $157.7 million for additional borrowings. To the extent that additional funds are necessary to finance future acquisitions, and to meet our long-term liquidity needs as we continue to execute on our strategy, we anticipate that they will be obtained through additional indebtedness, equity or debt issuances, or both. We have structured our operations in a manner to allow for cash to be repatriated through tax-efficient methods using dividends from foreign jurisdictions as our main source of repatriation. We follow local government regulations and contractual restrictions which regulate the nature of cash as well as how much and when dividends can be repatriated. As of December 31, 2018, cash and cash equivalents of $350.7 million includes cash in the United States of $143.7 million and $207.0 million in foreign jurisdictions. Of the foreign cash balances, $31.9 million is available for general purposes. The remaining $175.1 million is considered settlement and merchant reserves related cash and is therefore unable to be repatriated. We do not intend to pay cash dividends on our Class A common stock in the foreseeable future. EVO, Inc. is a holding company that does not conduct any business operations of its own. As a result, EVO, Inc.’s ability to pay cash dividends on its common stock, if any, is dependent upon cash dividends and distributions and other transfers from EVO, LLC. The amounts available to EVO, Inc. to pay cash dividends are subject to the covenants and distribution restrictions in its subsidiaries’ loan agreements. In connection with our IPO, we entered into the Exchange Agreement with certain of the Continuing LLC Owners, under which these Continuing LLC Owners have the right, from time to time, to exchange their units in EVO, LLC and related shares of EVO, Inc. for shares of our Class A common stock or, at our option, cash. If we choose to satisfy the exchange in cash, we anticipate that we will fund such exchange through cash from operations, funds available under the revolving portion of our Senior Secured Credit Facilities, equity or debt issuances or a combination thereof. In addition, in connection with the IPO, we entered into a TRA with the Continuing LLC Owners. Although the actual timing and amount of any payments that may be made under the TRA will vary, we expect that the payments that we will be required to make to the Continuing LLC Owners will be significant. Any payments made by us to non-controlling LLC owners under the TRA will generally reduce the amount of overall cash flow that might have otherwise been available to us and, to the extent that we are unable to make payments under the TRA for any reason, the unpaid amounts generally will be deferred and will accrue interest until paid by us. The following table sets forth summary cash flow information for the years ended December 31, 2018 and 2017: Operating activities Net cash provided by operating activities was $202.0 million for the year ended December 31, 2018, an increase of $193.8 million compared to cash provided by operating activities of $8.2 million for the year ended December 31, 2017. This increase was due primarily to changes in working capital, including the timing of settlement-related assets and liabilities. Net cash provided by operating activities was $8.2 million for the year ended December 31, 2017, a decrease of $24.5 million compared to operating activities of $32.8 million for the year ended December 31, 2016. This decrease was due to changes in working capital, including the timing of settlement-related assets and liabilities and deferred taxes. Investing activities Net cash used in investing activities was $125.6 million for the year ended December 31, 2018, an increase of $67.4 million compared to net cash used in investing activities of $58.1 million or the year ended December 31, 2017. The increase was primarily due to POS terminal purchases and acquisition-related investments during 2018. During 2017, restricted cash in escrow was used to fund the January 2017 acquisition of Sterling in the amount of $125.0 million. We purchased $48.8 million in equipment and improvements for the year ended December 31, 2018, an increase of $6.8 million compared to $42.0 million for the year ended December 31, 2017. The increase was due primarily to terminals purchased to support Poland’s cashless program, growth in Mexico terminal placements, internally developed software initiatives and the Liberbank acquisition accounted for as an acquisition of assets under ASC 805. Capital expenditures of $31.1 million primarily relate to the purchase of POS terminals that are installed at merchant locations outside of the United States. As is customary in those markets, we provide the POS terminal hardware to merchants and charge associated fees related to this hardware. Additionally, our capital expenditures include hardware and software necessary for our data centers, processing platforms, and information security initiatives. During the year ended December 31, 2018, we spent $56.2 million on assets associated with our business combinations, inclusive of terminals, office equipment, computer software, merchant contract portfolios, trademarks, internally developed software and non-competition agreements. Net cash used in investing activities was $58.1 million for the year ended December 31, 2017, a decrease of $59.1 million compared to net cash used in investing activities of $117.2 million for the year ended December 31, 2016. This decrease was due primarily to the gain on the sale of the company’s interest in Visa Europe in the prior year period. During 2016, restricted cash was held in escrow in the amount of $125.0 million in order to fund the January 2017 Sterling acquisition. Cash proceeds received related to our sale of Visa Europe equity reduced the net cash used in investing activities in the prior year period. Capital expenditures were $42.0 million for the year ended December 31, 2017, an increase of $10.3 million compared to capital expenditures of $31.7 million for the year ended December 31, 2016. The increase was due primarily to terminals purchased to support Poland’s terminalization initiative, as well as additional hardware and software investments. Capital expenditures primarily relate to the purchase of POS terminals that are installed at merchant locations outside of the United States. As is customary in those markets, we provide the POS terminal hardware to merchants and charge associated fees related to this hardware. POS terminal purchases totaled $23.1 million for the year ended December 31, 2017, an increase of $5.1 million over the year ended December 31, 2016. Additionally, our capital expenditures include hardware and software necessary for our data centers, processing platforms, and information security initiatives. Financing activities Net cash provided by financing activities was $80.6 million for the year ended December 31, 2018, an increase of $42.2 million, compared to net cash provided by financing activities of $38.5 million for the year ended December 31, 2017. This increase was primarily due to the net proceeds from the IPO and the Secondary Offering, partially offset by debt repayments and the early repayment of deferred purchase price under the Sterling acquisition. Net cash provided by financing activities was $38.5 million for the year ended December 31, 2017, a decrease of $3.7 million, compared to net cash provided by financing activities of $42.2 million for the year ended December 31, 2016. This decrease was due primarily to contributions by members and lower 2017 net borrowings. Senior Secured Credit Facilities On December 22, 2016, we (through our subsidiary EPI) entered into a new borrowing arrangement, referred to as our Senior Secured Credit Facilities, which includes the following: · A first lien senior secured credit facility, comprised of a $100.0 million revolving credit facility maturing on December 22, 2021, and a $570.0 million term loan maturing on December 22, 2023, with SunTrust Bank, as administrative agent, swingline lender and issuing bank; and · A second lien senior secured credit facility, comprised of a $175.0 million term loan maturing on December 22, 2024, with SunTrust Bank, as administrative agent. In addition, our Senior Secured Credit Facilities also provide us with the option to access incremental credit facilities, refinance the loans with debt incurred outside our Senior Secured Credit Facilities and extend the maturity date of the revolving loans and term loans, subject to certain limitations and terms. On October 24, 2017, we entered into an incremental amendment agreement to the first lien credit facility, pursuant to which we increased the existing multicurrency revolving credit facility to $135.0 million. On April 3, 2018, we entered into a second incremental amendment agreement to the first lien credit facility, pursuant to which we increased the existing loan credit facility to $665.0 million. We used the proceeds from the increase to complete acquisitions and provide liquidity. On May 25, 2018, we repaid all outstanding amounts under the second lien credit facility using a portion of the proceeds from the IPO. On June 14, 2018, we entered into a restatement agreement which extended the maturity of the first lien senior secured credit facility to June 2023, increased the revolving commitment by $65.0 million to $200.0 million and decreased the interest rate margins for loans under the Senior Secured Credit Facilities as described below. Borrowings under the first lien senior secured credit facility bear interest at an annual rate equal to, at EPI’s option, (a) a base rate, plus an applicable margin or (b) LIBOR, plus an applicable margin. The applicable margin for base rate revolving loans ranges from 0.75% to 2.00% per annum and for LIBOR revolving loans ranges from 1.75% to 3.00% per annum, in each case based upon achievement of certain consolidated leverage ratios. The applicable margin for base rate term loans is 3.25% and for LIBOR term loans is 2.25%, subject to a 25 basis point reduction upon an upgrade to the Company’s credit rating. In addition to paying interest on outstanding principal, EPI is required to pay a commitment fee to the lenders in respect of the unutilized revolving commitments thereunder ranging from 0.25% to 0.5% per annum based upon achievement of certain consolidated leverage ratios. The first lien senior secured credit facility requires prepayment of outstanding loans with: (1) 100% of the net cash proceeds of non-ordinary course asset sales or other dispositions of assets (including casualty events) by EPI and its restricted subsidiaries, subject to reinvestment rights and certain other exceptions, and (2) 50% of the excess cash flow (subject to step-downs to 25% and 0% based on achievement of certain first lien leverage ratios). Upon a change of control, EPI is required to offer to prepay the loans at par. EPI may voluntarily repay outstanding loans under the first lien senior secured credit facility at any time, without premium, subject to a 1% premium in the event of a repricing event within the six-month anniversary of the date of the Restatement Agreement. All obligations under the first lien senior secured credit facility are unconditionally guaranteed by most of EPI’s direct and indirect, wholly-owned material domestic subsidiaries, subject to certain exceptions. All obligations under the first lien senior secured credit facility, and the guarantees of such obligations, are secured, subject to permitted liens and other exceptions, by: · a first-priority lien on the capital stock owned by EPI or by any guarantor in each of EPI’s or their respective subsidiaries (limited, in the case of capital stock of foreign subsidiaries, to 65% of the voting stock and 100% of the non-voting stock of first tier foreign subsidiaries); and · a first-priority lien on substantially all of EPI’s and each guarantor’s present and future intangible and tangible assets (subject to customary exceptions). The first lien senior secured credit facility contains a number of significant negative covenants. These covenants, among other things, restrict, subject to certain exceptions, EPI’s and its restricted subsidiaries’ ability to incur indebtedness; create liens; engage in mergers or consolidations; make investments, loans and advances; pay dividends and distributions and repurchase capital stock; sell assets; engage in certain transactions with affiliates; enter into sale and leaseback transactions; make certain accounting changes; and make prepayments on junior indebtedness. The first lien senior secured credit facility also contains a springing financial covenant that requires EPI to remain under a maximum consolidated leverage ratio determined on a quarterly basis. In addition, the first lien senior secured credit facility contains certain customary representations and warranties, affirmative covenants and events of default. If an event of default occurs, the lenders under the first lien senior secured credit facility will be entitled to take various actions, including the acceleration of amounts due thereunder and the exercise of the remedies on the collateral. Refer to Note 11, “Long-Term Debt and Lines of Credit” in the notes to the accompanying consolidated financial statements for additional information on our long-term debt and settlement lines of credit. Sterling acquisition deferred purchase price In connection with the acquisition of Sterling on January 4, 2017, we agreed to a deferred purchase price of $70.0 million, which we refer to as the deferred purchase price. The deferred purchase price accrued interest at a rate of 5% per annum, and was payable in quarterly installments of $5.0 million, plus accrued and unpaid interest, beginning September 30, 2017. In May 2018, the Company paid in full the outstanding balance of the Sterling deferred purchase price, utilizing proceeds from the IPO and funds drawn from the revolving credit facility portion of our Senior Secured Credit Facilities. Settlement lines of credit We have specialized lines of credit which are restricted for use in funding settlement. The settlement lines of credit generally have variable interest rates and are subject to annual review. As of December 31, 2018, we had $41.8 million outstanding under these lines of credit with additional capacity of $57.9 million as of December 31, 2018 to fund settlement. The weighted average interest rate on these borrowings was 4.5% at December 31, 2018. Contractual obligations The following table summarizes our contractual obligations as of December 31, 2018. (1) Interest on long-term debt is based on rates effective and amounts borrowed as of December 31, 2018. Since the contractual rates for our long-term debt and settlements are variable, actual cash payments may differ from the estimates provided. (2) As of December 31, 2018, we are obligated under non-cancelable operating leases for our premises, which expire through 2036. Rent expense, inclusive of real estate taxes, utilities and maintenance incurred under operating leases, which totaled $15.4 million during the year ended December 31, 2018, is included in selling, general and administrative in our consolidated statements of operations and comprehensive loss. (3) Deferred consideration related to acquisitions. Note: Due to the fact that the timing of certain amounts to be paid cannot be determined or for other reasons discussed below, the following contractual commitments have not been presented in the table above. (4) As noted previously, we have entered into a tax receivable agreement with our Continuing LLC Owners which requires us to pay to our Continuing LLC Owners 85% of any tax savings received by us from our step-up in tax basis. The tax savings achieved may not ensure that we have sufficient cash available to pay this liability and we might be required to incur additional debt to satisfy this liability. Off-balance sheet transactions During 2018, 2017, and 2016, we did not engage in any off-balance sheet financing activities other than operating leases included in the “Contractual Obligations” discussion above and those reflected in Note 16, “Commitments and Contingencies” in our consolidated financial statements in Part II, Item 8 of this Form 10-K. Critical accounting policies Our discussion and analysis of our historical financial condition and results of operations for the periods described is based on our audited consolidated financial statements and our unaudited interim condensed consolidated financial statements, each of which have been prepared in accordance with U.S. GAAP. The preparation of these historical financial statements in conformity with U.S. GAAP requires management to make estimates, assumptions and judgments in certain circumstances that affect the reported amounts of assets, liabilities and contingencies as of the date of the consolidated financial statements and the reported amounts of revenue and expenses during the reporting periods. We evaluate our assumptions and estimates on an ongoing basis. We base our estimates on historical experience and on various other assumptions that we believe to be reasonable under the circumstances, the results of which form the basis for making judgments about the carrying values of assets and liabilities that are not readily apparent from other sources. Actual results may differ from these estimates under different assumptions or conditions. We have provided a summary of our significant accounting policies, as well as a discussion of our evaluation of the impact of recent accounting pronouncements regarding goodwill, cash flows, revenue recognition and leases, in Note 1, “Description of Business and Summary of Significant Accounting Policies” in the notes to the accompanying consolidated financial statements. The following critical accounting discussion pertains to accounting policies management believes are most critical to the portrayal of our historical financial condition and results of operations and that require significant, difficult, subjective or complex judgments. Other companies in similar businesses may use different estimation policies and methodologies, which may impact the comparability of our financial condition, results of operations and cash flows to those of other companies. Revenue recognition Our primary revenue sources consist of fees for payment processing services. Payment processing service revenue is primarily based on a percentage of transaction value or on a specified amount per transaction or related services. Our arrangements are considered multiple element arrangements. We follow the guidance in ASC 605-25, Revenue Recognition - Multiple-Element Arrangements. However, because the elements are primarily accounted for as services or rentals with a similar delivery pattern, the elements have the same revenue recognition timing. We recognize revenue when the following criteria are met: (1) persuasive evidence of an arrangement exists; (2) delivery has occurred or services have been rendered; (3) the sales price is fixed or determinable; and (4) collectability is reasonably assured. We follow the guidance in ASC 605-45, Principal Agent Consideration. ASC 605-45 states that the determination of whether a company should recognize revenue based on the gross amount billed to a customer or the net amount retained is a matter of judgment that depends on the facts and circumstances of the arrangement and that certain factors should be considered in the evaluation. Revenue is generally reported net of interchange and card network fees, commissions and network processing costs and other fees. In May 2014, the FASB issued Accounting Standards Update (“ASU”) 2014-09, Revenue from Contracts with Customers, with amendments in 2015, 2016 and 2017, which creates new ASC Topic 606 (“Topic 606”) that will replace most existing revenue recognition guidance in GAAP when it becomes effective. Topic 606 requires an entity to recognize the amount of revenue to which it expects to be entitled for the transfer of promised goods or services to customers. The new standard will be adopted in our first quarter of fiscal year 2019 with the cumulative effect recognized as of the date of initial application (modified retrospective transition method). The Company currently expects the most significant ongoing impact of adopting the new revenue standard in 2019 to be driven by changes in principal versus agent considerations, with the majority of the change overall in total net revenue attributable to the Company reflecting network processing fees on a net basis prospectively, as opposed to our gross presentation of $91.6 million in 2018. The Company does not expect the adoption of the new revenue standard to have a material impact on net income. The Company will include additional disclosures of the amount by which each financial statement line item is affected during 2019, as compared to the guidance that was in effect before the change, and an explanation of the reasons for significant changes. Refer to Note 1, “Description of Business and Summary of Significant Accounting Policies” in the notes to the accompanying consolidated financial statements for additional information on our revenue recognition policy and Topic 606. Goodwill and intangible assets We regularly evaluate whether events and circumstances have occurred that indicate the carrying amounts of goodwill, acquired merchant portfolios and other intangible assets may not be recoverable. Goodwill represents the excess of the consideration transferred over fair value of identifiable tangible net assets and intangible assets acquired through acquisitions. We evaluate our goodwill and indefinite-lived intangible assets, consisting of certain unamortized trade names, for impairment annually as of October 1, or more frequently as circumstances warrant. For 2018, in assessing whether our goodwill and indefinite-lived intangibles were impaired in connection with its annual impairment test performed during the fourth quarter of 2018 using October 1, 2018 carrying values, we performed a qualitative assessment to determine whether it would be necessary to perform a quantitative analysis, as prescribed by ASC 350, Intangibles - Goodwill and Other, to assess our goodwill and indefinite-lived intangible assets for indicators of impairment. A qualitative assessment includes consideration of macroeconomic conditions, industry and market considerations, changes in certain costs, overall financial performance and other relevant entity specific events. In performing the qualitative assessment, we considered the results of the step-one test performed in 2017 and the financial performance of the North America and Europe reporting units during 2018. Based upon such assessment, we also determined that it was more likely than not that the fair values of these reporting units exceeded their carrying amounts for 2018. As of December 31, 2018, there were no significant events since the timing of our annual impairment test that would have triggered the need for a further assessment for indicators of impairment. For 2017, we utilized the two-step approach to determine whether events or circumstances have occurred giving rise to the need for further quantitative testing. In the first step, the fair value for the reporting unit is compared to its carrying value, including goodwill. In the event that the fair value of the reporting unit was determined to be less than the carrying value, a second step is performed which compares the implied fair value of the reporting unit’s goodwill to the carrying value of the goodwill. The implied fair value for the goodwill is determined based on the difference between the fair value of the reporting unit and the fair value of the net identifiable assets. If the implied fair value of the goodwill is less than its carrying value, the difference is recognized as an impairment. As a result of the annual impairment testing for 2017, we did not recognize any impairment. As of the date of the 2017 impairment test, the fair values of the North America and Europe reporting units exceeded their carrying values by approximately $500 million and $300 million, respectively. Finite-lived assets include merchant contract portfolios, marketing alliance agreements, trademarks and internally developed software stated net of accumulated amortization or impairment charges and foreign currency translation adjustments. Finite-lived assets are reviewed for impairment whenever events or changes in circumstances indicate that the carrying amount of an asset may not be recoverable. Recoverability is measured by a comparison of the carrying amount of an asset to estimated undiscounted future cash flows expected to be generated by the respective asset. Estimated future cash flows for merchant contract portfolios, represented by merchant contracts acquired from third parties that will generate revenue for us, marketing alliance agreements and trademarks are based on estimates of revenue, expenses and merchant attrition associated with the underlying portfolio of merchant accounts or expected merchant referrals from our referral partners. Estimating merchant attrition involves analysis of historical attrition rates adjusted for management’s assumptions about future business closures, transfers of merchants’ accounts to our competitors, unsuccessful contract renewal and changes in our relationships with referral partners. For internally developed software, assigning estimated useful lives involves significant judgment and includes an analysis of potential obsolescence due to new technology, competition and other economic factors. Indefinite-life intangible assets include other trademarks and are evaluated for impairment annually comparing the estimated fair value with its carrying value. When factors indicate that long-lived assets should be evaluated for possible impairment, we assess our recoverability by determining whether the carrying value will be recovered through its future undiscounted cash flows and its eventual disposition. When the carrying value exceeds its fair value, an impairment loss is recognized in an amount equal to the difference. The determination of fair values requires significant judgment and is subject to changes in underlying assumptions. For the year ended December 31, 2018, the Company recognized a non-cash impairment charge of $14.6 million relating to indefinite-lived trademarks, primarily related to the accelerated integration of the Sterling tradename into the EVO portfolio in November 2018. No goodwill impairment was recognized in the year ended December 31, 2018. Refer to Note 1, “Description of Business and Summary of Significant Accounting Policies” and Note 6, “Goodwill and Intangible Assets” in the notes to the accompanying consolidated financial statements for further discussion of the Company's goodwill and intangible assets. Income taxes EVO, LLC is considered a pass-through entity for U.S. federal and most applicable state and local income tax purposes. As a pass-through entity, taxable income or loss is passed through to and included in the taxable income of its members. EVO, Inc. is subject to U.S. federal, state, and local income taxes with respect to our allocable share of taxable income of EVO, LLC and is taxed at the prevailing corporate tax rates. In addition to tax expenses, we also make payments under the TRA, which we expect to be significant. We account for the income tax effects and corresponding TRA’s effects resulting from future taxable purchases or redemptions of LLC Interests of the Continuing LLC Owners by recognizing an increase in our deferred tax assets based on enacted tax rates at the date of the purchase or redemption. Further, we evaluate the likelihood that we will realize the benefit represented by the deferred tax asset and, to the extent that we estimate that it is more likely than not that we will not realize the benefit, we will reduce the carrying amount of the deferred tax asset with a valuation allowance. The amounts to be recorded for both the deferred tax assets and the liability for our obligations under the TRA are estimated at the time of any purchase or redemption as a reduction to shareholders’ equity, and the effects of changes in any of our estimates after this date are included in net income. Similarly, the effect of subsequent changes in the enacted tax rates are included in net income. We currently believe our deferred tax assets will be recovered based upon the projected profitability of our operations, with the exception of our deferred tax assets in certain European jurisdictions. Judgement is required in assessing the future tax consequences of events that will be recognized in EVO, Inc.’s consolidated financial statements. A change in the assessment of such consequences (e.g., realization of deferred tax assets, changes in tax laws or interpretations thereof) could materially impact our results. Redeemable non-controlling interests Redeemable non-controlling interests (“RNCI”) relate to the portion of equity in a consolidated subsidiary not attributable, directly or indirectly, to us, which is realizable upon the occurrence of an event that is not solely within our control. Such interests are reported in the mezzanine section between total liabilities and permanent shareholders’ equity in our consolidated balance sheets, as temporary equity. We adjust the RNCI to reflect our estimate of the maximum redemption amount against our shareholders’ equity (deficit). Such estimate is based on the conditions that exist as of a balance sheet date, including the current fair value. Depending on the underlying non-controlling interest, fair value estimate may be based on projected operating performance and satisfying other conditions specified in the related agreements, or our stock value, and may not be what we will eventually pay for the business. Refer to Note 13, “Redeemable Non-controlling Interests” in the notes to the accompanying consolidated financial statements for additional information on RNCI. Stock compensation plans and share-based compensation awards For our stock options, we utilize the Black-Scholes option-pricing model to compute the estimated fair value. The Black-Scholes model includes assumptions regarding dividend yields, expected volatility, expected lives and risk-free interest rates. These assumptions reflect our best estimates but these items involve uncertainties based on market and other conditions outside of our control. As a result, if other assumptions had been used, stock-based compensation expense could have been materially affected. Furthermore, if different assumptions are used in future periods, share-based compensation expense could be materially affected in future years. Refer to Note 19, “Stock Compensation Plans and Share-Based Compensation Plans” in the notes to the accompanying consolidated financial statements for further discussion of stock compensation plans and share-based compensation awards. New accounting pronouncements For information regarding new accounting pronouncements, and the impact of these pronouncements on our consolidated financial statements, if any, refer to Note 1, “Description of Business and Summary of Significant Accounting Policies” in the notes to the accompanying consolidated financial statements. Inflation While inflation may impact our revenue and expenses, we believe the effects of inflation, if any, on our results of operations and financial condition have not been significant. However, there can be no assurance that our results of operations and financial condition will not be materially impacted by inflation in the future. JOBS Act We qualify as an “emerging growth company” under the JOBS Act, which enables us to postpone complying with certain reporting and other obligations under securities laws. In addition, Section 102 of the JOBS Act provides that an emerging growth company can take advantage of the extended transition period provided in Section 7(a)(2)(B) of the Securities Act for complying with new or revised accounting standards. We are electing to delay the adoption of new or revised accounting standards, and as a result, we may not comply with new or revised accounting standards on the relevant dates on which adoption of such standards is required for non-emerging growth companies. As a result, our financial statements may not be comparable to companies that comply with new or revised accounting pronouncements as of public company effective dates.

<s>[INST] This “Management’s Discussion and Analysis of Financial Condition and Results of Operations” (“MD&A”) is intended to provide an understanding of our financial condition, changes in financial condition, cash flow, liquidity and results of operations. This MD&A should be read in conjunction with our consolidated financial statements and the notes to the accompanying consolidated financial statements appearing elsewhere in this Form 10K and the Risk Factors included in Part I, Item 1A of this Form 10K, as well as other cautionary statements and risks described elsewhere in this Form 10K. The following discussion and analysis reflects the historical results of operations and financial position of EVO, LLC and its consolidated subsidiaries prior to the Reorganization Transactions and that of EVO, Inc. and its consolidated subsidiaries (including EVO, LLC) following the completion of the Reorganization Transactions. The historical results of operations and financial condition of EVO, LLC prior to the completion of the Reorganization Transactions, including the IPO, do not reflect certain items that affected our results of operations and financial condition after giving effect to the Reorganization Transactions and the use of proceeds from the IPO. Overview We are a leading payments technology and services provider offering an array of payment solutions to merchants ranging from small and midsize enterprises to multinational companies and organizations across North America and Europe. As a fully integrated merchant acquirer and payment processor in over 50 markets and 150 currencies worldwide, we provide competitive solutions that promote business growth, increase customer loyalty and enhance data security in the markets we serve. Executive overview · Revenue for the year ended December 31, 2018 increased 11.9% to $564.8 million from $504.8 million in 2017, driven by an 18.7% increase in Europe segment revenue and a 7.2% increase in North America segment revenue. · North America segment profit for the year ended December 31, 2018 was $85.4 million, 3.2% higher than the year ended December 31, 2017. · Europe segment profit for the year ended December 31, 2018 was $61.2 million, 11.6% higher than the year ended December 31, 2017. Recent acquisitions See Note 4, “Acquisitions” in the notes to the accompanying consolidated financial statements for further information about recent acquisitions. Our segments We classify our business into two segments: North America and Europe. The alignment of our segments is designed to establish lines of business that support the geographical markets in which we operate and allow us to further globalize our solutions while working seamlessly with our teams across these markets. Both segments provide businesses with merchant acquiring solutions, including integrated solutions for retail transactions at physical business locations, as well as eCommerce and mobile transactions. The business segment measurements provided to and evaluated by the segment leaders are computed in accordance with the principles listed below: · The accounting policies of the operating segments are the same as those described in the summary of the significant accounting policies. · Segment profit, which is the measure used by our chief operating decision maker to evaluate the performance of and to allocate resources to our segments, is calculated as segment revenue less (1) segment expenses, plus (2) segment income from unconsolidated investees, plus (3) segment other income, net, less (4) segment noncontrolling interests. Certain corporatewide governance functions, as well as depreciation and amortization, are not allocated to our segments. North America Our North America segment is comprised of the United States, Canada and Mexico. We distribute our products and services through a combination of bank referrals, a direct sales force, specialized integrated solution companies, sales agents and ISOs. Europe Our Europe segment is comprised of Western Europe (Spain, United Kingdom, Ireland, Germany and Malta) and Eastern Europe (Poland and the Czech Republic). We distribute our products and services through a combination of bank referrals, a direct sales force, specialized integrated solution companies and ISOs. We also provide ATM processing services to a financial institution and thirdparty ATM providers. Key financial definitions Revenue [/INST] Positive. </s>

EVO Payments, Inc.

2020-02-27

2019-12-31

ITEM 7. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS Introduction This “Management’s Discussion and Analysis of Financial Condition and Results of Operations” (“MD&A”) is intended to provide an understanding of our financial condition, changes in financial condition, cash flow, liquidity and results of operations. This MD&A should be read in conjunction with our consolidated financial statements and the notes to the accompanying consolidated financial statements appearing elsewhere in this Form 10-K and the Risk Factors included in Part I, Item 1A of this Form 10-K, as well as other cautionary statements and risks described elsewhere in this Form 10-K. The following discussion and analysis reflects the historical results of operations and financial position of EVO, LLC and its consolidated subsidiaries prior to the Reorganization Transactions and that of EVO, Inc. and its consolidated subsidiaries (including EVO, LLC) following the completion of the Reorganization Transactions. The historical results of operations and financial condition of EVO, LLC prior to the completion of the Reorganization Transactions, including the IPO, do not reflect certain items that affected our results of operations and financial condition after giving effect to the Reorganization Transactions and the use of proceeds from the IPO. Company background We are a leading payments technology and services provider offering an array of payment solutions to merchants ranging from small and mid-size enterprises to multinational companies and organizations across the Americas and Europe. As a fully integrated merchant acquirer and payment processor across more than 50 markets and 150 currencies worldwide, we provide competitive solutions that promote business growth, increase customer loyalty and enhance data security in the markets we serve. Founded in 1989 as an individually owned, independent sales organization in the United States, by 2012, we had transformed into an international payment processor and merchant acquirer. Today, the Company derives more than 60% of its revenues from markets outside of the United States. Our business operations are located across two segments: the Americas and Europe; and are comprised of three sales distribution channels: the Tech-enabled division, the Direct division, and the Traditional division. Our European segment is comprised of Western Europe (Spain, United Kingdom, Ireland, Germany and Malta) and Eastern Europe (Poland and the Czech Republic). Our Americas segment is comprised of the United States, Canada, and Mexico. In both Europe and the Americas, our payment technology solutions enable our customers to accept all forms of digital payments, including credit and debit card, gift card, and ACH, among other forms of electronic payments, such as market-specific payment solutions. In both segments, we distribute our products and services through a combination of bank referrals, a direct sales force, and specialized integrated solution companies. Our distribution in the Americas segment also leverages sales agents in the United States (“Traditional”); in our European segment, we also provide ATM processing services to financial institutions and third-party ATM providers. These segments are evaluated based on their segment profits. For a full discussion on how we calculate segment profit, please refer to Note 19, “Segment Information.” Our Tech-enabled division includes our integrated business, our B2B business, and our eCommerce business. Our Direct division includes long-term, exclusive referral relationships with leading financial institutions as well as our direct sales force, such as our direct salespersons and call center representatives. In markets where we do not have an active bank referral network, such as the United States, our direct sales force represents the entirety of this division. Our Traditional Division, unlike our Direct and Tech-enabled divisions, represents a merchant portfolio which is not actively managed by the Company. This division only exists in the United States, as it represents our heritage ISO relationships, and its profits are used to invest in our growth opportunities, such as tech-enabled capabilities and M&A. The majority of our revenue is generated from transaction-based fees, calculated as a percentage of transaction value or as a standard fee per transaction. We plan to continue to grow our business and improve our operations by expanding market share in our existing markets and entering new markets. In our current markets, we seek to grow our business through broadening our distribution network, leveraging our innovative payment and technology solutions, and acquiring additional merchant portfolios and tech-enabled businesses. We seek to enter new markets through acquisitions and partnerships in Latin America, Europe, and certain other markets. Executive overview On January 1, 2019, the Company adopted ASC 606, and as the result, we changed our revenue recognition from the gross amount billed to a customer to the net amount retained. The new revenue accounting standard impacted our reported revenues and operating expenses during the year ended December 31, 2019 by the same amount. This change in presentation therefore had no impact on the Company’s earnings (loss) or recorded profits. For a full description of ASC 606 and its impact on the Company’s financial statements, please refer to Notes 1(t), “Recently Adopted Accounting Pronouncements.” The Company delivered strong financial performance in the year ended December 31, 2019, as demonstrated by the following highlights: · Revenue for the year ended December 31, 2019 was $485.8 million, a decrease of 14.0% compared to the $564.8 million recognized for the twelve months ended December 31, 2018. The decrease was primarily due to $112.3 million impact of the reclassification of network and processing fees in connection with the Company’s adoption of ASC 606, partially offset by an increase of $33.3 million driven primarily by organic growth in our international markets and the Federated acquisition in the United States. Excluding the $112.3 million impact of the reclassification of network and processing fees following the changes in revenue recognition, revenue for the year ended December 31, 2019 increased 5.9% to $598.0 million1. · Americas segment profit for the year ended December 31, 2019 was $96.6 million, 13.1% higher than the year ended December 31, 2018. · Europe segment profit for the year ended December 31, 2019 was $55.3 million, 9.6% lower than the year ended December 31, 2018. · The Company processed approximately 3.6 billion transactions across the Americas and Europe in the year ended December 31, 2019, an increase of 16.8% from the year ended December 31, 2018. Factors impacting our business and results of operations In general, our revenue is impacted by factors such as global consumer spending trends, foreign exchange rates, the pace of adoption of commerce-enablement and payment solutions, acquisitions and dispositions, types and quantities of products and services provided to enterprises, timing and length of contract renewals, new enterprise wins, retention rates, mix of payment solution types employed by consumers, changes in card network fees including interchange rates and size of enterprises served. In addition, we may pursue acquisitions from time to time. These acquisitions could result in redundant costs, such as increased interest expense resulting from any indebtedness incurred to finance any acquisitions, or could require us to incur losses as we restructure or reorganize our operations following these acquisitions. Seasonality We have experienced in the past, and expect to continue to experience, seasonality in our revenues as a result of consumer spending patterns. In both the Americas and Europe, our revenue has been strongest in our fourth quarter and weakest in our first quarter as many of our merchants experience a seasonal lift during the traditional vacation and holiday months. Operating expenses do not typically fluctuate seasonally. 1 The Company adopted ASC 606 using the modified retrospective method as of January 1, 2019, and did not restate the comparative prior periods. Therefore, management’s discussion and analysis includes discussion of the results of operations excluding the impact of adoption of the standard to provide comparability across the periods presented in the financial statements. Foreign currency translation impact on our operations Our consolidated revenues and expenses are subject to variations caused by the net effect of foreign currency translation on revenues recognized and expenses incurred by our non-U.S. operations. It is difficult to predict the future fluctuations of foreign currency exchange rates and how those fluctuations will impact our consolidated statements of operations and comprehensive (loss) income in the future. As a result of the relative size of our international operations, these fluctuations may be material on individual balances. Our revenues and expenses from our international operations are generally denominated in the local currency of the country in which they are derived or incurred. Therefore, the impact of currency fluctuations on our operating results and margins is partially mitigated. Increased Regulations and Compliance We and our merchants are subject to laws and regulations that affect the electronic payments industry in the many countries in which our services are used. Our merchants are subject to numerous laws and regulations applicable to banks, financial institutions, and card issuers in the United States and abroad, and, consequently, we are at times affected by these foreign, federal, state, and local laws and regulations. A number of our subsidiaries in our European segment hold a PI license, allowing them to operate in the EU member states in which such subsidiaries do business. As a PI, we are subject to regulation and oversight in the applicable EU member states, which includes, among other obligations, a requirement to maintain specific regulatory capital and adhere to certain rules regarding the conduct of our business, including PSD2. PSD2 contains a number of additional regulatory provisions and deadlines, such as provisions relating to SCA, which requires industry wide systems upgrades. In the second half of 2019, we began updating our systems in preparation for the new SCA compliance requirements, which will go into effect on December 31, 2020. From an operations perspective, we also increased our focus on coordinating updates and implementations with our merchants and third party providers such as hardware vendors, card issuers, card networks, and among others. The EU has also enacted certain legislation relating to the offering of DCC services, which will come into effect in April 2020 and require additional disclosures to consumers in connection with our DCC product offerings. Compliance with current and upcoming regulations and compliance deadlines remains a focus for the remainder of 2020 and beyond. Key performance indicators Transactions Processed “Transactions processed” refers to the number of transactions we processed during any given period of time and is a meaningful indicator of our business and financial performance, as a significant portion of our revenue is driven by the number of transactions we process. In addition, transactions processed provides a valuable measure of the level of economic activity across our merchant base. In our Americas segment, transactions include acquired Visa and Mastercard credit and signature debit, American Express, Discover, UnionPay, PIN-debit, electronic benefit transactions and gift card transactions. In our Europe segment, transactions include acquired Visa and Mastercard credit and signature debit, other card network merchant acquiring transactions, and ATM transactions. For the year ended December 31, 2019, we processed approximately 3.6 billion transactions, which included more than 1.0 billion transactions in the Americas and approximately 2.5 billion transactions in Europe. This represents an increase of 12.4% in the Americas and an increase of 18.8% in Europe for an aggregate increase of 16.8% compared to the year ended December 31, 2018, driven by organic growth and the impact of acquisitions. Transactions processed in the Americas and Europe accounted for 30% and 70%, respectively, of the total transactions we processed in 2019. For the year ended December 31, 2018, we processed approximately 3.0 billion transactions, which included more than 950 million transactions in the Americas and approximately 2.1 billion transactions in Europe, an aggregate increase of 17.0% compared to the year ended December 31, 2017, driven by organic growth and the impact of acquisitions. Transactions processed in the Americas accounted for 31% of the total transactions we processed in 2018. Comparison of results for the years ended December 31, 2019 and 2018 The following table sets forth the consolidated statements of operations in dollars and as a percentage of revenue for the period presented. Revenue Revenue was $485.8 million for the year ended December 31, 2019, a decrease of $79.0 million, or 14.0%, compared to revenue of $564.8 million for the year ended December 31, 2018, primarily due to the $112.3 million impact of the reclassification of network and processing fees in connection with the Company’s adoption of ASC 606, partially offset by an increase of $33.3 million, driven primarily by organic growth in our international markets and inclusion of our recent acquisitions. Excluding the $112.3 million impact of the reclassification of network and processing fees following the changes in revenue recognition, revenue for the year ended December 31, 2019 increased 5.9% to $598.0 million. Americas segment revenue was $303.8 million for the year ended December 31, 2019, a decrease of $16.6 million, or 5.2%, compared to the year ended December 31, 2018, primarily due to the $36.9 million impact of the reclassification of network and processing fees in connection with the Company’s adoption of ASC 606, partially offset by an increase of $20.3 million driven primarily by organic growth in Mexico and the Federated acquisition in the United States. Europe segment revenue was $181.9 million for the year ended December 31, 2019, a decrease of $ 62.3 million, or 25.5%, compared to the year ended December 31, 2018, primarily due to the $75.3 million impact of the reclassification of network and processing fees in connection with the Company’s adoption of ASC 606, partially offset by an increase of $13.0 million driven primarily by organic growth in Poland, Germany, Ireland, and the United Kingdom. Operating expenses Cost of services and products Cost of services and products was $96.4 million for the year ended December 31, 2019, a decrease of $93.0 million, or 49.1%, compared to the year ended December 31, 2018, primarily due to the Company’s adoption of ASC 606. Excluding the impact of the reclassification of network and processing fees following the adoption of ASC 606, costs of services and products increased by $19.2 million, or 10.2%, for the year ended December 31, 2019, primarily due to an increase in transactions processed and an increase in equipment sold. Our cost of services and products includes both fixed and variable components, with variable components dependent upon transactions processed and the number merchants added. The increase in cost was due to the variable component from the increase in transactions and merchants during the year. Selling, general and administrative expenses Selling, general and administrative expenses were $267.9 million for the year ended December 31, 2019, a decrease of $43.4 million, or 13.9%, compared to the year ended December 31, 2018. The decrease was due primarily to the vesting of share-based compensation awards upon the Company’s IPO during the year ended December 31, 2018, which did not occur in the year ended December 31, 2019. Depreciation and amortization Depreciation and amortization was $92.1 million for the year ended December 31, 2019, an increase of $4.9 million, or 5.6%, compared to the year ended December 31, 2018. This increase was due primarily to purchases of POS terminals to support growth in certain of our international markets and other hardware and software purchases as well as the amortization of intangible assets acquired during the second half of 2018. Impairment of intangible assets For the year ended December 31, 2019, we recognized non-cash impairment charges of $13.1 million, primarily related to the termination of the Raiffeisen Bank Polska marketing alliance agreement and the retirement of certain trademarks driven by an internal reorganization and the Santander branch consolidation in Spain. For the year ended December 31, 2018, we recognized a non-cash impairment charge of $14.6 million primarily related to the accelerated integration of the Sterling tradename into the EVO portfolio. Interest expense Interest expense was $44.0 million for the year ended December 31, 2019, compared to $59.8 million for the year ended December 31, 2018. The decrease was due to lower average variable interest rates, partially offset by the use of debt for acquisitions. Gain on acquisition of unconsolidated investee Gain on acquisition of unconsolidated investee was $8.4 million for the year ended December 31, 2018 related to the fair value mark-up on the acquisition of a previously minority owned subsidiary. Income tax expense Income tax expense represents federal, state, local and foreign taxes based on income in multiple domestic and foreign jurisdictions. Historically, as a limited liability company treated as a partnership for U.S. federal income tax purposes, EVO, LLC’s income was not subject to corporate tax in the United States, but only on income earned in foreign jurisdictions. In the United States, our members were taxed on their proportionate share of income of EVO, LLC. However, following the Reorganization Transactions, we incur corporate tax at the U.S. federal income tax rate on our share of taxable income of EVO, LLC. Our income tax expense reflects such U.S. federal, state and local income tax as well as taxes payable in foreign jurisdictions by certain of our subsidiaries. Our income tax expense was $4.5 million for the year ended December 31, 2019, compared to income tax expense of $10.4 million for the year ended December 31, 2018. Net loss Net loss was $23.4 million for the year ended December 31, 2019, a decrease of $75.5 million, compared to net loss of $98.9 million for the year ended December 31, 2018. This improvement was due to growth in revenue and lower share-based compensation and interest expense for the year ended December 31, 2019, compared to the year ended December 31, 2018. Net loss attributable to non-controlling interests of EVO Investco, LLC Net income (loss) attributable to non-controlling interests arises from the non-owned portion of businesses where we have a controlling interest but less than 100% ownership. This represents both the non-controlling interests that are consolidating entities of EVO, LLC and EVO, LLC non-controlling interest. Net loss attributable to non-controlling interests of EVO Investco, LLC was $21.1 million for the year ended December 31, 2019, compared to net loss attributable to non-controlling interests of EVO Investco, LLC of $90.8 million for the year ended December 31, 2018. This decrease was due to lower net loss before non-controlling interests, as described in the previous paragraph. Segment performance Americas segment profit for the year ended December 31, 2019 was $96.6 million, compared to $85.4 million for the year ended December 31, 2018, an increase of 13.1%. The increase is primarily due to growth in our underlying United States and Mexican markets in the year ended December 31, 2019 and the non-cash impairment charge of $14.6 million recognized in the year ended December 31, 2018. Americas segment profit margin was 31.8% for the year ended December 31, 2019, compared to 26.6% for the year ended December 31, 2018. Excluding the impact of the reclassification of network and processing fees following the adoption of ASC 606, Americas segment profit margin was 28.4% for the year ended December 31, 2019. Europe segment profit was $55.3 million for the year ended December 31, 2019, compared to $61.2 million for the year ended December 31, 2018, a decrease of 9.6%. The decrease is primarily due to revenue declines in Spain and integration expenses related to acquisitions. Europe segment profit margin was 30.4% for the year ended December 31, 2019, compared to 25.1% for the year ended December 31, 2018. Excluding the impact of the reclassification of network and processing fees following the adoption of ASC 606, Europe segment profit margin was 21.5% for the year ended December 31, 2019. Corporate expenses not allocated to a segment were $34.5 million for the year ended December 31, 2019, compared to $41.4 million for the year ended December 31, 2018. The decrease in expense is due to initial public company costs for the year ended December 31, 2018, which we did not incur in the year ended December 31, 2019. Comparison of results for the years ended December 31, 2018 and 2017 The comparison of results for the years ended December 31, 2018 and 2017 that are not included in this Form 10-K are included in “Management’s Discussion and Analysis of Financial Condition and Results of Operations” in Part II, Item 7 of our Annual Report on Form 10-K for the fiscal year ended December 31, 2018. Liquidity and capital resources for the years ended December 31, 2019 and 2018 Overview We have historically funded our operations primarily with cash flow from operations and, when needed, with borrowings, including under our Senior Secured Credit Facilities. Our principal uses for liquidity have been debt service, capital expenditures, working capital and funds required to finance acquisitions. We expect to continue to use capital to innovate and advance our products as new technologies emerge and to accommodate new regulatory requirements in the markets in which we process transactions. We expect these strategies to be funded primarily through cash flow from operations and borrowings from our Senior Secured Credit Facilities, as needed. Short-term liquidity needs will primarily be funded through the revolving credit facility portion of our Senior Secured Credit Facilities. As of December 31, 2019, our capacity under the revolving credit facility portion of our Senior Secured Credit Facilities was $200.0 million, with availability of $138.4 million for additional borrowings. To the extent that additional funds are necessary to finance future acquisitions, and to meet our long-term liquidity needs as we continue to execute on our strategy, we anticipate that they will be obtained through additional indebtedness, equity or debt issuances, or both. We have structured our operations in a manner to allow for cash to be repatriated through tax-efficient methods using dividends from foreign jurisdictions as our main source of repatriation. We follow local government regulations and contractual restrictions which regulate the nature of cash as well as how much and when dividends can be repatriated. As of December 31, 2019, cash and cash equivalents of $304.1 million includes cash in the United States of $110.8 million and $193.3 million in foreign jurisdictions. Of the United States cash balances, $109.9 million is considered merchant reserves and settlement related cash and is therefore unavailable for the Company’s use. Of the foreign cash balances, $5.0 million is related to the non-controlling interest portion of our consolidated entities and $33.5 is available for general purposes. The remaining $154.8 million is considered settlement and merchant reserves related cash and is therefore unable to be repatriated. We do not intend to pay cash dividends on our Class A common stock in the foreseeable future. EVO, Inc. is a holding company that does not conduct any business operations of its own. As a result, EVO, Inc.’s ability to pay cash dividends on its common stock, if any, is dependent upon cash dividends and distributions and other transfers from EVO, LLC. The amounts available to EVO, Inc. to pay cash dividends are subject to the covenants and distribution restrictions in its subsidiaries’ loan agreements. In connection with our IPO, we entered into the Exchange Agreement with certain of the Continuing LLC Owners, under which these Continuing LLC Owners have the right, from time to time, to exchange their units in EVO, LLC and related shares of EVO, Inc. for shares of our Class A common stock or, at our option, cash. If we choose to satisfy the exchange in cash, we anticipate that we will fund such exchange through cash from operations, funds available under the revolving portion of our Senior Secured Credit Facilities, equity or debt issuances or a combination thereof. In addition, in connection with the IPO, we entered into a Tax Receivable Agreement (“TRA”) with the Continuing LLC Owners. Although the actual timing and amount of any payments that may be made under the TRA will vary, we expect that the payments that we will be required to make to the Continuing LLC Owners will be significant. Any payments made by us to non-controlling LLC owners under the TRA will generally reduce the amount of overall cash flow that might have otherwise been available to us and, to the extent that we are unable to make payments under the TRA for any reason, the unpaid amounts generally will be deferred and will accrue interest until paid by us. The following table sets forth summary cash flow information for the years ended December 31, 2019, 2018, and 2017: Operating activities Net cash provided by operating activities was $27.9 million for the year ended December 31, 2019, a decrease of $174.1 million compared to cash provided by operating activities of $202.0 million for the year ended December 31, 2018. This decrease was due primarily to changes in working capital, including the timing of settlement-related assets and liabilities. Investing activities Net cash used in investing activities was $76.6 million for the year ended December 31, 2019, a decrease of $48.9 million compared to net cash used in investing activities of $125.6 million for the year ended December 31, 2018. The decrease was primarily due lower capital expenditures and lower acquisition-related investments during 2019. Capital expenditures were $36.8 million for the year ended December 31, 2019, a decrease of $12.0 million compared to $48.8 million for the year ended December 31, 2018. The decrease was due primarily to fewer terminal purchases in markets outside of the United States. As is customary in those markets, we provide the POS terminal hardware to merchants and charge associated fees related to this hardware. During 2019, we incurred capital expenditures of $19.5 million to provide POS terminal hardware to merchants in these markets. The decrease in terminal expense is attributable to fewer terminal purchases in Poland resulting from the annualization of the cashless program and fewer terminal purchases in Spain related to a large inventory balance at the end of 2018. Additionally, our capital expenditures include hardware and software necessary for our data centers, processing platforms, and information security initiatives. During the year ended December 31, 2019, we spent $38.8 million on assets associated with our business combinations, a decrease of $17.4 million compared to $56.2 million for the year ended December 31, 2018. Financing activities Net cash provided by financing activities was $3.9 million for the year ended December 31, 2019, a decrease of $76.7 million, compared to net cash provided by financing activities of $80.6 million for the year ended December 31, 2018. This decrease was primarily due to the net proceeds received in 2018 from the IPO, which were partially offset by debt repayments and the early repayment of deferred purchase price under the Sterling acquisition. Liquidity and capital resources for the years ended December 31, 2018 and 2017 The discussion of cash flow activities for the year ended December 31, 2018 as compared to the year ended December 31, 2017 that are not included in this Form 10-K are included in “Management’s Discussion and Analysis of Financial Condition and Results of Operations” in Part II, Item 7 of our Annual Report on Form 10-K for the fiscal year ended December 31, 2018. Senior Secured Credit Facilities The Company (through its subsidiary EPI) has entered into a first lien senior secured credit facility and a second lien senior secured credit facility pursuant to a credit agreement dated December 22, 2016, and amended on October 24, 2017, April 3, 2018, and June 14, 2018 (the “Senior Secured Credit Facilities”). On May 25, 2018, the Company repaid all outstanding amounts under the second lien credit facility using a portion of the proceeds from the IPO. As of December 31, 2019, the Senior Secured Credit Facilities include revolver commitments of $200.0 million and a term loan of $665.0 million that are scheduled to mature in June 2023 and December 2023, respectively. In addition, our Senior Secured Credit Facilities also provide us with the option to access incremental credit facilities, refinance the loans with debt incurred outside our Senior Secured Credit Facilities and extend the maturity date of the revolving loans and term loans, subject to certain limitations and terms. Borrowings under the first lien senior secured credit facility bear interest at an annual rate equal to, at EPI’s option, (a) a base rate, plus an applicable margin or (b) LIBOR, plus an applicable margin. The applicable margin for base rate revolving loans ranges from 0.75% to 2.00% per annum and for LIBOR revolving loans ranges from 1.75% to 3.00% per annum, in each case based upon achievement of certain consolidated leverage ratios. The applicable margin for base rate term loans is 2.25% and for LIBOR term loans is 3.25%, subject to a 25 basis point reduction upon an upgrade to the Company’s credit rating by both Moody’s and S&P. In addition to paying interest on outstanding principal, EPI is required to pay a commitment fee to the lenders in respect of the unutilized revolving commitments thereunder ranging from 0.25% to 0.5% per annum based upon achievement of certain consolidated leverage ratios. The first lien senior secured credit facility requires prepayment of outstanding loans with: (1) 100% of the net cash proceeds of non-ordinary course asset sales or other dispositions of assets (including casualty events) by EPI and its restricted subsidiaries, subject to reinvestment rights and certain other exceptions, and (2) 50% of the excess cash flow (subject to step-downs to 25% and 0% based on achievement of certain first lien leverage ratios). Upon a change of control, EPI is required to offer to prepay the loans at par. EPI may voluntarily repay outstanding loans under the first lien senior secured credit facility at any time, without premium, subject to a 1% premium in the event of a repricing event within the six-month anniversary of the date of the Restatement Agreement. All obligations under the first lien senior secured credit facility are unconditionally guaranteed by most of EPI’s direct and indirect, wholly-owned material domestic subsidiaries, subject to certain exceptions. All obligations under the first lien senior secured credit facility, and the guarantees of such obligations, are secured, subject to permitted liens and other exceptions, by: · a first-priority lien on the capital stock owned by EPI or by any guarantor in each of EPI’s or their respective subsidiaries (limited, in the case of capital stock of foreign subsidiaries, to 65% of the voting stock and 100% of the non-voting stock of first tier foreign subsidiaries); and · a first-priority lien on substantially all of EPI’s and each guarantor’s present and future intangible and tangible assets (subject to customary exceptions). The first lien senior secured credit facility contains a number of significant negative covenants. These covenants, among other things, restrict, subject to certain exceptions, EPI’s and its restricted subsidiaries’ ability to incur indebtedness; create liens; engage in mergers or consolidations; make investments, loans and advances; pay dividends and distributions and repurchase capital stock; sell assets; engage in certain transactions with affiliates; enter into sale and leaseback transactions; make certain accounting changes; and make prepayments on junior indebtedness. The first lien senior secured credit facility also contains a springing financial covenant that requires EPI to remain under a maximum consolidated leverage ratio determined on a quarterly basis. In addition, the first lien senior secured credit facility contains certain customary representations and warranties, affirmative covenants and events of default. If an event of default occurs, the lenders will be entitled to take various actions, including the acceleration of amounts due thereunder and the exercise of the remedies on the collateral. Refer to Note 14, “Long-Term Debt and Lines of Credit”, in the notes to the accompanying consolidated financial statements for additional information on our long-term debt and settlement lines of credit. Sterling acquisition deferred purchase price In connection with the acquisition of Sterling on January 4, 2017, we agreed to a deferred purchase price of $70.0 million, which we refer to as the deferred purchase price. The deferred purchase price accrued interest at a rate of 5% per annum, and was payable in quarterly installments of $5.0 million, plus accrued and unpaid interest, beginning September 30, 2017. In May 2018, the Company paid in full the outstanding balance of the Sterling deferred purchase price, utilizing proceeds from the IPO and funds drawn from the revolving credit facility portion of our Senior Secured Credit Facilities. Settlement lines of credit We have specialized lines of credit which are restricted for use in funding settlement. The settlement lines of credit generally have variable interest rates and are subject to annual review. As of December 31, 2019, we had $33.3 million outstanding under these lines of credit with additional capacity of $133.9 million as of December 31, 2019 to fund settlement. Contractual obligations The following table summarizes our contractual obligations as of December 31, 2019. (1) Interest on long-term debt and settlement obligations is based on rates effective and amounts borrowed as of December 31, 2019. Since the contractual rates for our long-term debt and settlement obligations are variable, actual cash payments may differ from the estimates provided. (2) Amounts represent undiscounted contractually committed payments under our operating lease obligations. As of December 31, 2019, operating lease obligations recognized on our consolidated balance sheet are measured at the present value of remaining lease payments, utilizing our incremental borrowing rate based on the remaining lease term, which includes renewal options, if the option is reasonably certain to be exercised. Refer to Note 7, "Leases", in the notes to the accompanying consolidated financial statements for additional information. (3) Amounts represent our estimate of future payments for noncancelable contractual obligations related to purchase of goods or services with suppliers for fixed or minimum amounts. (4) Amounts represent our estimate of future payments related to our acquisitions. Some of these payments depend on future performance, and therefore, actual cash payments and the timing of such payments may differ from the estimates. The table above excludes the obligations arising from our tax receivable agreement that requires us to make payments to the Continuing LLC Owners in the amount equal to 85% of the applicable cash tax savings, if any, because the timing and amount of such payments is not currently determinable. Refer to Note 5, “Tax Receivable Agreement”, in the notes to the accompanying consolidated financial statements for additional information. Off-balance sheet transactions We have not entered into any off-balance sheet arrangements that have, or are reasonably likely to have, a material effect on our financial condition, revenues or expenses, results of operations, liquidity, capital expenditures or capital resources. Critical accounting policies Our discussion and analysis of our historical financial condition and results of operations for the periods described is based on our audited consolidated financial statements, which have been prepared in accordance with U.S. GAAP. The preparation of these historical financial statements in conformity with U.S. GAAP requires management to make estimates, assumptions and judgments in certain circumstances that affect the reported amounts of assets, liabilities and contingencies as of the date of the consolidated financial statements and the reported amounts of revenue and expenses during the reporting periods. We evaluate our assumptions and estimates on an ongoing basis. We base our estimates on historical experience and on various other assumptions that we believe to be reasonable under the circumstances, the results of which form the basis for making judgments about the carrying values of assets and liabilities that are not readily apparent from other sources. Actual results may differ from these estimates under different assumptions or conditions. We have provided a summary of our significant accounting policies, as well as a discussion of our evaluation of the impact of recent accounting pronouncements in Note 1, “Description of Business and Summary of Significant Accounting Policies”, in the notes to the accompanying consolidated financial statements. The following discussion pertains to accounting policies management believes are most critical to the portrayal of our historical financial condition and results of operations and that require significant, difficult, subjective or complex judgments. Other companies in similar businesses may use different estimation policies and methodologies, which may impact the comparability of our financial condition, results of operations and cash flows to those of other companies. Revenue recognition Our primary revenue sources consist of fees for payment processing services. Payment processing service revenue is primarily based on a percentage of transaction value or on a specified amount per transaction or related services. As described in Note 1, “Description of Business and Summary of Significant Accounting Policies”, in the notes to the accompanying consolidated financial statements, we adopted a new revenue accounting standard on January 1, 2019 that resulted in revenue being presented net of certain fees that we pay to third parties. This change in presentation affected our reported revenues and operating expenses during the year ended December 31, 2019 by the same amount and had no effect on operating income. Refer to Note 2, “Revenue”, in the notes to the accompanying consolidated financial statements for further discussion of the Company’s revenue recognition. Goodwill and intangible assets We regularly evaluate whether events and circumstances have occurred that indicate the carrying amounts of goodwill and other intangible assets may not be recoverable. Goodwill represents the excess of the consideration transferred over the fair value of identifiable net assets acquired through business combinations. We evaluate our goodwill for impairment annually as of October 1, or more frequently, if an event occurs or circumstances change that indicate the fair value of a reporting unit is below its carrying amount. Our reporting units are consistent with our segments: the Americas and Europe. As of October 1, 2019 and 2018, we performed a qualitative assessment as prescribed by ASC 350, Intangibles - Goodwill and Other, to evaluate our goodwill for indicators of impairment. A qualitative assessment includes consideration of macroeconomic conditions, industry and market considerations, changes in certain costs, overall financial performance of each reporting unit and other relevant entity-specific events. In performing the qualitative assessment, we considered the results of the quantitative impairment test performed in 2017 and the financial performance of the reporting units during 2019 and 2018. Based upon such assessment, we determined that it was more likely than not that the fair values of these reporting units exceeded their carrying amounts as of October 1, 2019 and 2018. There were no significant events or changes in the circumstances since the timing of our annual impairment tests that would have required us to reassess the results of the annual tests as of December 31, 2019 and 2018. As of October 1, 2017, we utilized the two-step quantitative approach to test goodwill for impairment. As a result of the annual impairment testing for 2017, we did not recognize any impairment. As of the date of the 2017 impairment test, the fair values of the Americas and Europe reporting units exceeded their carrying values by approximately $500 million and $300 million, respectively. For the year ended December 31, 2019, the Company recognized an impairment charge of $13.1 million, primarily related to the termination of Raiffeisen Bank Polska marketing alliance agreement and the retirement of certain trademarks driven by an internal reorganization and the bank consolidations in Spain. For the year ended December 31, 2018, the Company recognized an impairment charge of $14.6 million as a result of the retirement of certain indefinite-lived trademarks, primarily related to the accelerated integration of the Sterling tradename into the EVO portfolio. As of December 31, 2019, there are no indefinite-lived intangible assets other than goodwill. Finite-lived intangible assets include merchant contract portfolios and customer relationships, marketing alliance agreements, trademarks and internally developed and acquired software, and non-competition agreements. Finite-lived assets are reviewed for impairment whenever events or changes in circumstances indicate that the carrying amount of an asset may not be recoverable. Recoverability is measured by a comparison of the carrying amount of an asset to estimated undiscounted future cash flows expected to be generated by the asset. Estimated future cash flows for merchant contract portfolios and customer relationships, represented by merchant or customer contracts acquired from third parties that will generate revenue for us, marketing alliance agreements and trademarks are based on our estimates of revenue, expenses and merchant attrition associated with the underlying portfolios of merchant or customer accounts or expected merchant referrals from our referral partners. Estimating merchant attrition involves analysis of historical attrition rates adjusted for our assumptions about future business closures, transfers of merchants’ accounts to our competitors, unsuccessful contract renewal and changes in our relationships with referral partners. We develop the software that is used in providing services to our customers. Capitalization of internal-use software occurs when we have completed the preliminary project stage. Costs incurred during the preliminary project stage are expensed as incurred. We also acquire the software through our business combinations. Determination of estimated useful lives of internally developed and acquired software requires significant judgment and includes an analysis of potential obsolescence due to new technology, competition and other economic factors. Refer to Note 1, “Description of Business and Summary of Significant Accounting Policies”, and Note 9, “Goodwill and Intangible Assets”, in the notes to the accompanying consolidated financial statements for further discussion of the Company's goodwill and intangible assets. Income taxes EVO, LLC is considered a pass-through entity for U.S. federal and most applicable state and local income tax purposes. As a pass-through entity, taxable income or loss is passed through to and included in the taxable income of its members. EVO, Inc. is subject to U.S. federal, state, and local income taxes with respect to our allocable share of taxable income of EVO, LLC and is taxed at the prevailing corporate tax rates. In addition to tax expense, we also may make payments under the TRA. We account for the income tax effects and corresponding TRA effects resulting from future taxable purchases or redemptions of LLC Interests of the Continuing LLC Owners or exchanges by the Continuing LLC Owners of LLC Interests and paired Class C common stock or paired Class D common stock for Class A common stock by recognizing an increase in our deferred tax assets based on enacted tax rates at the date of the purchase, redemption or exchange. Further, we evaluate the likelihood that we will realize the benefit represented by the deferred tax asset and, to the extent that we estimate that it is more likely than not that we will not realize the benefit, we will reduce the carrying amount of the deferred tax asset with a valuation allowance. The amounts to be recorded for both the deferred tax assets and the liability for our obligations under the TRA are estimated at the time of any purchase, redemption or exchange and are recorded as a reduction to shareholders’ equity; the effects of changes in any of our estimates after this date are included in net earnings. Similarly, the effects of subsequent changes in the enacted tax rates are included in net earnings. We currently believe our deferred tax assets will be realized based upon the projected profitability of our operations, with the exception of our deferred tax assets in certain European jurisdictions and the United States interest expense limitation. Judgement is required in assessing the future tax consequences of events that will be recognized in EVO, Inc.’s consolidated financial statements. A change in the assessment of such consequences (e.g., realization of deferred tax assets, changes in tax laws or interpretations thereof) could materially impact our results. Refer to Note 5, “Tax Receivable Agreement”, and Note 13, “Income Taxes”, in the notes to the accompanying consolidated financial statements for further discussion of the Company’s income taxes and the tax receivable agreement. Redeemable non-controlling interests Redeemable non-controlling interests (“RNCI”) relate to the portion of equity in a consolidated subsidiary not attributable, directly or indirectly, to us, which is realizable upon the occurrence of an event that is not solely within our control. Such interests are reported in the mezzanine section between total liabilities and permanent shareholders’ equity in our consolidated balance sheets, as temporary equity. We adjust the RNCI to reflect our estimate of the maximum redemption amount against our shareholders’ deficit. Such estimate is based on the conditions that exist as of a balance sheet date, including the estimated current fair value of RNCI. Depending on the underlying non-controlling interest, fair value estimate may be based on projected operating performance and satisfying other conditions specified in the related agreements, or our stock value, and may not be what we will eventually pay for the business. Refer to Note 16, “Redeemable Non-controlling Interests”, in the notes to the accompanying consolidated financial statements for additional information on RNCI. Stock compensation plans and share-based compensation awards For our stock options, we utilize the Black-Scholes option-pricing model to compute the estimated fair value. The Black-Scholes model includes assumptions regarding dividend yields, expected volatility, expected lives and risk-free interest rates. These assumptions reflect our best estimates, however, involve uncertainties based on market and other conditions outside of our control. As a result, if other assumptions had been used, stock-based compensation expense could have been materially affected. Furthermore, if different assumptions are used in future periods, share-based compensation expense could be materially affected in future years. Refer to Note 21, “Stock Compensation Plans and Share-Based Compensation Plans”, in the notes to the accompanying consolidated financial statements for further discussion of stock compensation plans and share-based compensation awards. New accounting pronouncements For information regarding new accounting pronouncements, and the impact of these pronouncements on our consolidated financial statements, if any, refer to Note 1, “Description of Business and Summary of Significant Accounting Policies”, in the notes to the accompanying consolidated financial statements. Inflation While inflation may impact our revenue and expenses, we believe the effects of inflation, if any, on our results of operations and financial condition have not been significant. However, there can be no assurance that our results of operations and financial condition will not be materially impacted by inflation in the future.

<s>[INST] This “Management’s Discussion and Analysis of Financial Condition and Results of Operations” (“MD&A”) is intended to provide an understanding of our financial condition, changes in financial condition, cash flow, liquidity and results of operations. This MD&A should be read in conjunction with our consolidated financial statements and the notes to the accompanying consolidated financial statements appearing elsewhere in this Form 10K and the Risk Factors included in Part I, Item 1A of this Form 10K, as well as other cautionary statements and risks described elsewhere in this Form 10K. The following discussion and analysis reflects the historical results of operations and financial position of EVO, LLC and its consolidated subsidiaries prior to the Reorganization Transactions and that of EVO, Inc. and its consolidated subsidiaries (including EVO, LLC) following the completion of the Reorganization Transactions. The historical results of operations and financial condition of EVO, LLC prior to the completion of the Reorganization Transactions, including the IPO, do not reflect certain items that affected our results of operations and financial condition after giving effect to the Reorganization Transactions and the use of proceeds from the IPO. Company background We are a leading payments technology and services provider offering an array of payment solutions to merchants ranging from small and midsize enterprises to multinational companies and organizations across the Americas and Europe. As a fully integrated merchant acquirer and payment processor across more than 50 markets and 150 currencies worldwide, we provide competitive solutions that promote business growth, increase customer loyalty and enhance data security in the markets we serve. Founded in 1989 as an individually owned, independent sales organization in the United States, by 2012, we had transformed into an international payment processor and merchant acquirer. Today, the Company derives more than 60% of its revenues from markets outside of the United States. Our business operations are located across two segments: the Americas and Europe; and are comprised of three sales distribution channels: the Techenabled division, the Direct division, and the Traditional division. Our European segment is comprised of Western Europe (Spain, United Kingdom, Ireland, Germany and Malta) and Eastern Europe (Poland and the Czech Republic). Our Americas segment is comprised of the United States, Canada, and Mexico. In both Europe and the Americas, our payment technology solutions enable our customers to accept all forms of digital payments, including credit and debit card, gift card, and ACH, among other forms of electronic payments, such as marketspecific payment solutions. In both segments, we distribute our products and services through a combination of bank referrals, a direct sales force, and specialized integrated solution companies. Our distribution in the Americas segment also leverages sales agents in the United States (“Traditional”); in our European segment, we also provide ATM processing services to financial institutions and thirdparty ATM providers. These segments are evaluated based on their segment profits. For a full discussion on how we calculate segment profit, please refer to Note 19, “Segment Information.” Our Techenabled division includes our integrated business, our B2B business, and our eCommerce business. Our Direct division includes longterm, exclusive referral relationships with leading financial institutions as well as our direct sales force, such as our direct salespersons and call center representatives. In markets where we do not have an active bank referral network, such as the United States, our direct sales force represents the entirety of this division. Our Traditional Division, unlike our Direct and Techenabled divisions, represents a merchant portfolio which is not actively managed by the Company. This division only exists in the United States, as it represents our heritage ISO relationships, and its profits are used to invest in our growth opportunities, such as techenabled capabilities and M&A. The majority of our revenue is generated from transactionbased fees, calculated as a percentage of transaction value or as a standard fee per transaction. We plan to continue to grow our business and improve our operations by expanding market share in our existing markets and entering new markets. In our current markets, we seek to grow our business through broadening our distribution network, leveraging our innovative payment and technology solutions, and acquiring additional merchant portfolios and techenabled businesses. We seek to enter new markets through acquisitions and partnerships in Latin America, Europe, and certain other markets. Exec [/INST] Negative. </s>

Kodiak Sciences Inc.

2019-03-27

2018-12-31

ITEM 7. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS You should read the following discussion and analysis of our financial condition and results of operations together with the section titled “Selected Consolidated Financial Data” and our consolidated financial statements and the related notes included elsewhere in this report. This discussion and analysis and other parts of this report contain forward-looking statements based upon current beliefs, plans and expectations related to future events and our future financial performance that involve risks, uncertainties and assumptions, such as statements regarding our intentions, plans, objectives, expectations, forecasts and projections. Our actual results and the timing of selected events could differ materially from those anticipated in these forward-looking statements as a result of several factors, including those set forth under the section titled “Risk Factors” and elsewhere in this report. Overview We are a clinical-stage biopharmaceutical company specializing in novel therapeutics to treat chronic, high-prevalence retinal diseases. Our most advanced product candidate is KSI-301, a biologic therapy built with our antibody biopolymer conjugate platform, or ABC platform, which is designed to maintain potent and effective drug levels in ocular tissues. We believe that KSI-301, if approved, has the potential to become an important anti-vascular endothelial growth factor, or anti-VEGF, therapy in wet age-related macular degeneration, or wet AMD, diabetic retinopathy, or DR, including diabetic macular edema, or DME, and other retinal vascular diseases. KSI-301 and our ABC Platform were developed at Kodiak, and we own worldwide rights to those assets, including composition of matter patent protection with respect to KSI-301. We have applied our ABC Platform to develop additional product candidates beyond KSI-301, including KSI-501, our bispecific anti-IL-6/VEGF bioconjugate. We intend to progress these and other product candidates to address high-prevalence ophthalmic diseases. We initiated our first-in-human, single ascending dose Phase 1a clinical study of KSI-301 in the United States in nine patients with severe diabetic macular edema in July 2018. We successfully dosed all patients at the pre-planned dose levels and reached the 12-week last visit in November 2018. The last visit (twelve-week) data demonstrated safety and durability of responses following the single dose of KSI-301. Notably: • Rapid high-magnitude and durable treatment responses were seen at all dose levels tested in a heavily pre-treated Phase 1 patient population. • Twelve weeks after a single dose, median vision improvement from baseline of almost two lines of vision (9 eye chart letters) and median improvement in retinal edema of 121 microns were achieved across all three dose levels tested. • No dose-limiting toxicities, drug-related adverse events, or intraocular inflammation were observed through each patients' last visit at 12 weeks. In the fourth quarter of 2018, we initiated an open-label, multiple-dose Phase 1b study of KSI-301 in the United States in treatment naïve patients with wet AMD, DME/DR, and retinal vein occlusion and expect to complete enrollment of these cohorts of patients in 2019. We intend to present on-going data from the Phase 1b study at medical and investor meetings in 2019. Having successfully demonstrated early safety and tolerability in the Phase 1 study, with the additional observations around bioactivity and durability, we plan to further evaluate the highest dose tested of KSI-301, 5 mg, in a series of Phase 2 studies in wet AMD and DME/DR. We expect to be enrolling patients in a global Phase 2 study of KSI-301 in wet AMD in the second quarter of 2019. This study is intended to evaluate the non-inferiority of intravitreal KSI-301 dosed on an every 12-, 16- or 20-week regimen compared to standard of care aflibercept dosed every 8 weeks. The FDA indicated that this study, if successful, can be supportive of a marketing application for KSI-301, and we are designing and intend to execute this Phase 2 study as a pivotal study, with an option for an administrative interim analysis in 2020. A primary data readout is anticipated in 2021. We additionally plan to initiate two Phase 2 studies in China, one in wet AMD and one in DME, and we are planning for these studies to have the same clinical design frameworks as our United States and European Union studies. We are on track to hold our China pre-IND meeting for KSI-301 in the first half of 2019. Since inception in June 2009, we have devoted substantially all of our resources to discovering and developing product candidates and manufacturing processes, building our ABC Platform and assembling our core capabilities in drug development for ophthalmic disease. We plan to continue to use third-party contract research organizations, or CROs, to carry out our preclinical and clinical development. We rely on third-party contract manufacturing organizations, or CMOs, to manufacture and supply our preclinical and clinical materials to be used during the development of our product candidates. We currently do not need commercial manufacturing capacity. We do not have any products approved for sale and have not generated any product revenue since inception. We have funded our operations primarily through the sale and issuance of common stock, redeemable convertible preferred stock, convertible notes and warrants to purchase Series B redeemable convertible preferred stock. In October 2018, we completed our initial public offering, or IPO. We sold and issued 9,400,000 shares of common stock at a price to the public of $10.00 per share. The aggregate net proceeds from our IPO, inclusive of the partial over-allotment option exercise, were $83.5 million after deducting underwriting discounts and commissions and other offering costs. We have incurred significant operating losses to date and expect that our operating losses will increase significantly as we advance our product candidates, particularly KSI-301, through preclinical and clinical development, seek regulatory approval, prepare for and, if approved, proceed to commercialization; broaden and improve our platform; acquire, discover, validate and develop additional product candidates; obtain, maintain, protect and enforce our intellectual property portfolio; and hire additional personnel. In addition, we expect to incur additional costs associated with operating as a public company. Our net losses were $41.4 million, $27.9 million and $17.1 million for the years ended December 31, 2018, 2017 and 2016, respectively. As of December 31, 2018, we had an accumulated deficit of $110.8 million. Our ability to generate product revenue will depend on the successful development and eventual commercialization of one or more of our product candidates. Until such time as we can generate significant revenue from sales of our product candidates, if ever, we expect to finance our operations through the sale of equity, debt financings or other capital sources, including potential collaborations with other companies or other strategic transactions. Adequate funding may not be available to us on acceptable terms, or at all. If we fail to raise capital or enter into such agreements as, and when, needed, we may have to significantly delay, scale back, or discontinue the development and commercialization of KSI-301 for wet AMD or DME/DR or delay our efforts to advance and expand our product pipeline. As of December 31, 2018, we had cash and cash equivalents of $88.3 million. We currently plan to raise additional funding as required based on the status of its clinical trials and projected cash flows, however we believe that our cash and cash equivalents are sufficient to fund our projected operations for at least the next 12 months. Components of Operating Results Operating Expenses Research and Development Expenses Substantially all of our research and development expenses consist of expenses incurred in connection with the development of our ABC Platform and product candidates. These expenses include certain payroll and personnel expenses, including stock-based compensation, for our research and product development employees; laboratory supplies and facility costs; consulting costs; contract manufacturing and fees paid to CROs to conduct certain research and development activities on our behalf; and allocated overhead, including rent, equipment, depreciation and utilities. We expense both internal and external research and development expenses as they are incurred. Costs of certain activities, such as manufacturing and preclinical and clinical studies, are generally recognized based on an evaluation of the progress to completion of specific tasks. Nonrefundable payments made prior to the receipt of goods or services that will be used or rendered for future research and development activities are deferred and capitalized. The capitalized amounts are recognized as expense as the goods are delivered or the related services are performed. We are focusing substantially all of our resources and development efforts on the development of our product candidates, in particular KSI-301. We expect our research and development expenses to increase substantially during the next few years, as we seek to initiate our Phase 2 studies, complete our clinical program, pursue regulatory approval of our drug candidates and prepare for a possible commercial launch. Predicting the timing or the final cost to complete our clinical program or validation of our commercial manufacturing and supply processes is difficult and delays may occur because of many factors, including factors outside of our control. For example, if the FDA or other regulatory authorities were to require us to conduct clinical trials beyond those that we currently anticipate, or if we experience significant delays in enrollment in any of our clinical trials, we could be required to expend significant additional financial resources and time on the completion of clinical development. Furthermore, we are unable to predict when or if our drug candidates will receive regulatory approval with any certainty. General and Administrative Expenses General and administrative expenses consist principally of payroll and personnel expenses, including stock-based compensation; professional fees for legal, consulting, accounting and tax services; allocated overhead, including rent, equipment, depreciation and utilities; and other general operating expenses not otherwise classified as research and development expenses. We anticipate that our general and administrative expenses will increase as a result of increased personnel costs, including stock-based compensation, expanded infrastructure and higher consulting, legal and accounting services associated with maintaining compliance with requirements of the stock exchange listing and Securities and Exchange Commission, or SEC, investor relations costs and director and officer insurance premiums associated with being a public company. Interest Expense Interest expense consists primarily of interest expense related to our convertible notes, including accretion of debt discount and debt issuance costs, which converted into shares of common stock upon the closing of our IPO. Other Income (Expense), Net Other income (expense), net primarily consists of changes in the fair value of warrants for Series B redeemable convertible preferred stock, changes in fair value of the derivative instruments and interest income. Loss on Extinguishment of Debt Loss on extinguishment of debt was recognized for the year ended December 31, 2018 related to the convertible notes issued in February 2018 which converted into shares of common stock upon closing of our IPO. Results of Operations Comparison of the Years Ended December 31, 2018 and 2017 The following table summarizes our results of operations for the periods indicated: * Percentage is not meaningful Research and Development Expenses Research and development expenses decreased $3.2 million, or 15%, from the year ended December 31, 2017 to the year ended December 31, 2018. The following table summarizes our research and development expenses: (1) ABC Platform external expenses primarily relates to manufacturing of biopolymer intermediate drug substance which can be used with multiple product candidates. These expenses are primarily for services provided by CMOs and CROs. (2) KSI-301 program external expenses relates to development of KSI-301, including manufacturing and clinical trial costs. These expenses are primarily for services provided by CMOs and CROs. (3) Payroll and personnel expenses includes salaries, benefits and stock-based compensation for our personnel involved in research and development activities. These expenses are separately classified and not allocated to specific programs because these expenses relate to multiple programs. (4) Other research and development expenses includes direct costs related to research and development activities other than those listed above. ABC Platform external expenses increased $0.5 million during the year ended December 31, 2018 as compared to 2017. The increase was primarily driven by biopolymer intermediate drug substance manufacturing runs completed during 2018. KSI-301 program external expenses decreased $5.8 million during the year ended December 31, 2018 as compared to 2017. The decrease was primarily due to a decrease in manufacturing runs for KSI-301 from 2018 to 2017. Payroll and personnel expenses increased $3.5 million during the year ended December 31, 2018 as compared to 2017. The increase was a result of increased headcount. Other research and development expenses decreased $1.5 million during the year ended December 31, 2018 as compared to 2017. The decrease was primarily due to increased focus on KSI-301. Our other research and development expenses may fluctuate in future periods as we elect to develop KSI-501 or other product candidates. General and Administrative Expenses General and administrative expenses increased $4.1 million, or 117%, from the year ended December 31, 2017 to the year ended December 31, 2018. The increase in general and administrative expenses was primarily attributable to an increase of $2.2 million in professional services related to accounting, audit, legal and consulting services in connection with our IPO and additional costs associated with operating as a public company, an increase of $1.8 million in salaries, including stock-based compensation, and an increase of $0.1 million in additional allocated overhead expenses due to increased headcount. Interest Expense Interest expense increased $4.3 million from the year ended December 31, 2017 to the year ended December 31, 2018, which was mainly attributable to interest expense on convertible notes issued in August 2017 and February 2018, including accretion of debt discount and issuance costs. Other Income (Expense), Net Other income (expense), net increased $2.8 million from the year ended December 31, 2017 to the year ended December 31, 2018, which was mainly attributable to the movement in fair value of the redeemable convertible preferred stock warrant liability and derivative instrument related to the convertible notes issued in February 2018, offset by interest income of $0.6 million. Loss on Extinguishment of Debt Loss on extinguishment of the convertible notes issued in February 2018 was $5.5 million for the year ended December 31, 2018. Comparison of the Years Ended December 31, 2017 and 2016 The following table summarizes our results of operations for the periods indicated: * Percentage is not meaningful Research and Development Expenses Research and development expenses increased $8.0 million, or 57%, from the year ended December 31, 2016 to the year ended December 31, 2017. The following table summarizes our research and development expenses: (1) ABC Platform external expenses primarily relates to manufacturing of biopolymer intermediate drug substance which can be used with multiple product candidates. These expenses are primarily for services provided by CMOs and CROs. (2) KSI-301 program external expenses relates to development of KSI-301, including manufacturing costs. These expenses are primarily for services provided by CMOs and CROs. (3) Payroll and personnel expenses includes salaries, benefits and stock-based compensation for our personnel involved in research and development activities. These expenses are separately classified and not allocated to specific programs because these expenses relate to multiple programs. (4) Other research and development expenses includes direct costs related to research and development activities other than those listed above. ABC Platform external expenses decreased $6.7 million during the year ended December 31, 2017 as compared to 2016. The decrease was primarily attributable to the increased focus on the development of KSI-301 in fiscal 2017. KSI-301 program external expenses were $14.0 million for the year ended December 31, 2017. Payroll and personnel expenses did not significantly change during the year ended December 31, 2017 as compared to 2016. Other research and development expenses increased $0.7 million during the year ended December 31, 2017 as compared to 2016. The increase is attributable to the increase of $0.7 million in CMO and external contractor expenses, increase of $0.5 million in overhead and depreciation expenses, which was offset by a decrease in lab expenses of $0.5 million. General and Administrative Expenses General and administrative expenses increased $0.4 million, or 13%, from the year ended December 31, 2016 to the year ended December 31, 2017. The increase in general and administrative expenses was primarily attributable to an increase of $0.3 million in professional services related to legal, accounting, consulting services and an increase of $0.1 million in allocated overhead expenses. Interest Expense Interest expense was $1.2 million for the year ended December 31, 2017 which was mainly attributable to interest expense on our convertible notes issued in August 2017, including accretion of debt discount and issuance costs. Other Income (Expense), Net Other income (expense), net was $1.2 million for the year ended December 31, 2017, which was mainly attributable to the change in the fair value of the redeemable convertible preferred stock warrant liability. Liquidity and Capital Resources; Plan of Operations Sources of Liquidity We have funded our operations primarily through the sale and issuance of common stock, redeemable convertible preferred stock, convertible notes and warrants to purchase Series B redeemable convertible preferred stock. In October 2018, we completed our initial public offering, or IPO. We sold and issued 9,400,000 shares of common stock at a price to the public of $10.00 per share. The aggregate net proceeds from our IPO, inclusive of the partial over-allotment option exercise, were $83.5 million after deducting underwriting discounts and commissions and other offering costs. As of December 31, 2018, we had cash and cash equivalents of $88.3 million. Future Funding Requirements We have incurred net losses since our inception. For the years ended December 31, 2018, 2017 and 2016, we had net losses of $41.4 million, $27.9 million and $17.1 million, respectively, and we expect to continue to incur additional losses in future periods. As of December 31, 2018, we had an accumulated deficit of $110.8 million. We currently plan to raise additional funding as required based on the status of its clinical trials and projected cash flows, however based on our current business plan, we believe that our existing cash and cash equivalents are sufficient to fund our projected operations for at least the next 12 months. We believe that our existing cash and cash equivalents, will enable us (i) to advance KSI-301 through completion of enrollment of the global Phase 2 clinical trial in the U.S., the European Union, or EU, and rest of the world in patients with wet AMD as well as through completion of a Phase 1b clinical trial; (ii) to advance KSI-301 into Phase 2 clinical trials in China for wet AMD and DME/DR and through an administrative interim analysis in each of the studies (anticipated to occur when approximately 200 patients have completed approximately six months of treatment duration, per study) subject to successful submission of INDs in China, (iii) to advance KSI-301 into the global Phase 2 clinical trial in the U.S., EU and rest of the world in patients with DME/DR; (iv) towards research and development of our pipeline including KSI-501 and to initiate additional clinical studies in ophthalmology; and (v) to satisfy our working capital needs and other general corporate purposes. We have based these estimates on assumptions that may prove to be wrong, and we could deplete our available capital resources sooner than we expect. Because of the risks and uncertainties associated with research, development and commercialization of product candidates, we are unable to estimate the exact amount of our working capital requirements. Our future funding requirements will depend on and could increase significantly as a result of many factors, including those listed above. To date, we have not generated any product revenue. We do not expect to generate any product revenue unless and until we obtain regulatory approval of and commercialize any of our product candidates or enter into collaborative agreements with third parties, and we do not know when, or if, either will occur. We expect to continue to incur significant losses for the foreseeable future, and we expect our losses to increase as we continue the development of, and seek regulatory approvals for, our product candidates, and begin to commercialize any approved products. We are subject to all of the risks typically related to the development of new product candidates, and we may encounter unforeseen expenses, difficulties, complications, delays and other unknown factors that may adversely affect our business. Moreover, we expect to incur additional costs associated with operating as a public company. We have based these estimates on assumptions that may prove to be wrong, and we could deplete our capital resources sooner than we expect. The timing and amount of our operating expenditures and capital requirements will depend on many factors, including: • the scope, timing, rate of progress and costs of our drug discovery, preclinical development activities, laboratory testing and clinical trials for our product candidates; • the number and scope of clinical programs we decide to pursue; • the scope and costs of manufacturing development and commercial manufacturing activities; • the extent to which we acquire or in-license other product candidates and technologies; • the cost, timing and outcome of regulatory review of our product candidates; • the costs of preparing, filing and prosecuting patent applications, maintaining and enforcing our intellectual property rights and defending intellectual property-related claims; • our ability to establish and maintain collaborations on favorable terms, if at all; • our efforts to enhance operational systems and our ability to attract, hire and retain qualified personnel, including personnel to support the development of our product candidates; • the costs associated with being a public company; and • the cost and timing associated with commercializing our product candidates, if they receive marketing approval. A change in the outcome of any of these or other variables with respect to the development of any of our product candidates could significantly change the costs and timing associated with the development of that product candidate. Furthermore, our operating plans may change in the future, and we will continue to require additional capital to meet operational needs and capital requirements associated with such operating plans. If we raise additional funds by issuing equity securities, our stockholders may experience dilution. Any future debt financing into which we enter may impose upon us additional covenants that restrict our operations, including limitations on our ability to incur liens or additional debt, pay dividends, repurchase our common stock, make certain investments and engage in certain merger, consolidation or asset sale transactions. Any debt financing or additional equity that we raise may contain terms that are not favorable to us or our stockholders. If we are unable to raise additional funds when needed, we may be required to delay, reduce, or terminate some or all of our development programs and clinical trials. We may also be required to sell or license rights to our product candidates in certain territories or indications to others that we would prefer to develop and commercialize ourselves. Adequate additional funding may not be available to us on acceptable terms or at all. Our failure to raise capital as and when needed could have a negative impact on our financial condition and our ability to pursue our business strategies. See the section titled “Risk Factors” for additional risks associated with our substantial capital requirements. 2017 Convertible Notes In August 2017, we received $10.0 million in gross proceeds from the issuance of the 2017 convertible notes and warrants to purchase Series B redeemable convertible preferred stock. Upon the closing of our IPO, 500,000 redeemable convertible preferred stock warrants automatically converted into common stock warrants and 100,000 of such warrants were exercised immediately following the closing of our IPO. The 2017 convertible notes converted into 2,637,292 shares of common stock at the closing of our IPO. 2018 Convertible Notes In February 2018, we received $33.0 million in gross proceeds from the issuance of the 2018 convertible notes. The 2018 convertible notes converted into 4,295,677 shares of common stock at the closing of our IPO. Summary Statement of Cash Flows The following table sets forth the primary sources and uses of cash and cash equivalents for each of the periods presented below: Cash Flows from Operating Activities Net cash used in operating activities was $29.0 million for year ended December 31, 2018. Cash used in operating activities was primarily due to the use of funds in our operations to continue to develop KSI-301 and in connection with our IPO, resulting in a net loss of $41.4 million, adjusted by non-cash charges of $18.8 million offset by a change in operating assets and liabilities of $6.4 million. The non-cash charges consisted of $5.5 million in loss on extinguishment of debt, $2.7 million in loss due to change in fair value of redeemable convertible preferred stock warrant liability, $2.0 million in loss due to change in fair value of derivative instrument related to the convertible notes issued in February 2018, $5.5 million in non-cash interest expense and amortization of debt discount and issuance costs, $0.5 million of depreciation expense, and $2.6 million of stock-based compensation. The change in net operating assets and liabilities was primarily due to a decrease in accrued liabilities of $2.1 million mainly related to a decrease in accrued research and development expenses offset by an increase in accrued compensation expenses, a decrease in accounts payable of $2.3 million due to the timing of vendor payments and an increase in prepaid and other assets of $2.0 million mainly due to an increase in advance payments. Net cash used in operating activities was $17.7 million for the year ended December 31, 2017. Cash used in operating activities was primarily due to the use of funds in our operations to develop KSI-301, resulting in a net loss of $27.9 million, adjusted by non-cash charges of $3.2 million offset by a change in operating assets and liabilities of $7.0 million. The non-cash charges primarily consisted of $1.3 million in expense due to change in fair value of redeemable convertible preferred stock warrant liability, $1.2 million in non-cash interest expense and amortization of debt discount and issuance costs, $0.5 million of depreciation and amortization, and $0.3 million of stock-based compensation. The change in net operating assets and liabilities was primarily due to an increase in accrued liabilities of $4.3 million mainly related to an increase in accrued research and development and accrued compensation expenses, an increase in accounts payable of $2.2 million due to the timing of vendor payments and a decrease in prepaid and other assets of $0.4 million mainly due to amortization of prepaid expenses. Net cash used in operating activities was $16.0 million for the year ended December 31, 2016. Cash used in operating activities was due to the use of funds in our operations to develop our ABC Platform, resulting in a net loss of $17.1 million, offset by non-cash charges of $0.3 million of depreciation expense and $0.3 million of stock-based compensation expense, a decrease in prepaid expense and other current assets of $0.3 million, and an increase in accrued liabilities and other current assets of $0.2 million. Cash Flows from Investing Activities Net cash used in investing activities was $0.6 million for the year ended December 31, 2018 and primarily related to the purchase of property and equipment including advance deposits. Net cash used in investing activities was $0.2 million for the year ended December 31, 2017 and primarily related to purchase of property and equipment. Net cash used in investing activities was $0.8 million for the year ended December 31, 2016, which was related to $0.8 million used in the purchase of property and equipment. Cash Flows from Financing Activities Net cash provided by financing activities was $116.5 million for the year ended December 31, 2018, which consisted primarily of $83.8 million of net proceeds from our IPO, $33.0 million of gross proceeds from issuance of convertible notes, offset by $0.1 million of debt issuance costs, $0.1 million of principal payments under a capital lease agreement and $0.1 million of payments related to tenant improvement allowance payable. Net cash provided by financing activities was $9.6 million for the year ended December 31, 2017, which consisted primarily of $10.0 million of gross proceeds from issuance of convertible notes, offset by $0.2 million of debt issuance costs, $0.1 million of principal payments under a capital lease agreement and $0.1 million of payments related to tenant improvement allowance payable. Net cash used in financing activities was $0.1 million for the year ended December 31, 2016, which consisted primarily of principal payments under a capital lease agreement and payments related to tenant improvement allowance payable. Contractual Obligations and Commitments The following table summarizes our contractual obligations as of December 31, 2018: (1) We lease our facility under a non-cancelable operating lease. In January 2013, we entered into a lease for our current laboratory and office space that commenced in October 2013 and expired in October 2018. In March 2016, we entered into a lease amendment that extended the lease term to October 2023. The minimum lease payments above do not include any related common area maintenance charges or real estate taxes. (2) We have entered into service agreements with a third-party CMO, pursuant to which the CMO agreed to perform activities in connection with the manufacturing process of certain compounds. Such agreements, and related amendments, state that planned activities that are included in some signed work orders are, in some cases, binding and, hence, obligate us to pay the full price of the work order upon satisfactory delivery of products and services. Per the terms of the agreements, we have the option to cancel signed orders at any time upon written notice, which may or may not be subject to payment of a cancellation fee depending on the timing of the written notice in relation to the commencement date of the work, with the maximum cancellation fee equal to the full price of the work order. Although the payment of the cancellation fee will generally be due at the scheduled commencement date, we may record the manufacturing expense and related obligation as an accrued liability at the time of cancellation. (3) We have tenant improvement obligations under our facilities lease agreements, which are required to be paid over the contractually agreed period. We enter into contracts in the normal course of business with third party contract organizations for preclinical and clinical studies and testing, manufacturing, and providing other services and products for operating purposes. These contracts generally provide for termination following a certain period after notice, and therefore we believe that our non-cancelable obligations under these agreements are not material. Critical Accounting Policies, Significant Judgments and Use of Estimates Our consolidated financial statements have been prepared in accordance with U.S. generally accepted accounting principles, or GAAP. The preparation of these consolidated financial statements requires us to make estimates and assumptions that affect the reported amounts of assets and liabilities, the disclosure of contingent assets and liabilities at the date of the consolidated financial statements, as well as the reported expenses incurred during the reporting periods. Our estimates are based on our historical experience and on various other factors that we believe are reasonable under the circumstances, the results of which form the basis for making judgments about the carrying value of assets and liabilities that are not readily apparent from other sources. Actual results may differ from these estimates under different assumptions or conditions. We believe that the accounting policies discussed below are critical to understanding our historical and future performance, as these policies relate to the more significant areas involving management’s judgments and estimates. Accrued Research and Development Our preclinical and clinical accruals are a component of research and development expenses and are based on patient enrollment and related costs as well as estimates for the services received and efforts expended pursuant to contracts with multiple research institutions and CROs. We estimate research and development accruals, including preclinical and clinical expenses, based on the level of services performed, progress of the studies, including the phase or completion of events, and contracted costs. The estimated costs of research and development provided, but not yet invoiced, are included in accrued liabilities and other current liabilities on the consolidated balance sheets. If the actual timing of the performance of services or the level of effort varies from the original estimates, we will adjust the accrual accordingly. Payments made to CROs or CMOs under these arrangements in advance of the performance of the related services are recorded as prepaid expenses and other current assets until the services are rendered. Stock-Based Compensation Expense We measure and recognize compensation expense for all stock-based awards made to employees, directors and non-employees, based on estimated fair values recognized using the straight-line method over the requisite service period. The fair value of options to purchase common stock granted to employees is estimated on the grant date using the Black-Scholes option valuation model. The calculation of stock-based compensation expense requires that we make certain assumptions and judgments about a number of complex and subjective variables used in the Black-Scholes model, including the expected term, expected volatility of the underlying common stock and risk-free interest rate. Changes in these assumptions can materially affect the fair value and ultimately how much stock-based compensation expense is recognized. These inputs are subjective and generally require significant analysis and judgment to develop. Equity instruments issued to non-employees are recorded at their fair value using the Black-Scholes valuation model on the measurement date and are subject to periodic adjustments as the underlying equity instruments vest. Common Stock Valuations Prior to our IPO, the estimated fair value of the common stock underlying our stock options and stock awards was determined at each grant date by our board of directors, with assistance from management and external appraisers. All options to purchase shares of our common stock were intended to be exercisable at a price per share not less than the per-share fair value of our common stock underlying those options on the date of grant. The approach to estimate the fair value of the Company’s common stock was consistent with the methods outlined in the American Institute of Certified Public Accountants’ Practice Aid, Valuation of Privately-Held-Company Equity Securities Issued as Compensation, or Practice Aid. Subsequent to the Company’s IPO, the fair value of the Company’s common stock is determined based on its closing market price. Income Taxes We provide for income taxes under the asset and liability method. Current income tax expense or benefit represents the amount of income taxes expected to be payable or refundable for the current year. Deferred income tax assets and liabilities are determined based on differences between the financial statement reporting and tax bases of assets and liabilities and net operating loss and credit carryforwards, and are measured using the enacted tax rates and laws that will be in effect when such items are expected to reverse. Deferred income tax assets are reduced, as necessary, by a valuation allowance when management determines it is more likely than not that some or all of the tax benefits will not be realized. We assess all material positions taken in any income tax return, including all significant uncertain positions, in all tax years that are still subject to assessment or challenge by relevant taxing authorities. Assessing an uncertain tax position begins with the initial determination of the position’s sustainability and is measured at the largest amount of benefit that is greater than fifty percent likely of being realized upon ultimate settlement. As of each balance sheet date, unresolved uncertain tax positions must be reassessed, and we will determine whether (1) the factors underlying the sustainability assertion have changed and (2) the amount of the recognized tax benefit is still appropriate. The recognition and measurement of tax benefits requires significant judgment. Judgments concerning the recognition and measurement of a tax benefit might change as new information becomes available. Our policy is to recognize interest and penalties related to the underpayment of income taxes as a component of income tax expense or benefit. To date, there have been no interest or penalties charged in relation to the unrecognized tax benefits. Net operating loss carryforwards, or NOLs, and tax credit carryforwards are subject to review and possible adjustment by the Internal Revenue Service, or IRS, and may become subject to an annual limitation in the event of certain cumulative changes in the ownership interest of significant shareholders over a three-year period in excess of 50% as defined under Sections 382 and 383 in the Internal Revenue Code, which could limit the amount of tax attributes that can be utilized annually to offset future taxable income or tax liabilities. The amount of the annual limitation is determined based on our value immediately prior to the ownership change. Subsequent ownership changes may further affect the limitation in future years. We have completed a Section 382 study through December 31, 2018 which concluded no such ownership change had occurred through December 31, 2018 As of December 31, 2018, we had unrecognized tax benefits, all of which would affect income tax expense if recognized, before consideration of our valuation allowance. We do not expect that our uncertain tax positions will materially change in the next twelve months. On December 22, 2017, the U.S. government enacted comprehensive tax legislation through H.R. 1, or Tax Act. The Tax Act significantly revises the future ongoing U.S. corporate income tax by, among other things, lowering the U.S. corporate income tax rates and implementing a territorial tax system. The corporate tax rate will be reduced from 35% to 21% for tax years beginning after December 31, 2017. This rate change resulted in a $2.5 million reduction in our deferred tax assets as of December 31, 2017 with a corresponding offset to valuation allowance. Under the Tax Act, net operating losses arising after December 31, 2017 do not expire and cannot be carried back. However, the Tax Act limits the amount of net operating losses that can be used annually to 80% of taxable income for periods beginning after December 31, 2017. Existing net operating losses arising in years ending on or before December 31, 2017 are not affected by these provisions. The SEC released SAB 118 on December 22, 2017 to provide guidance in the application of U.S. GAAP in situations when a registrant does not have the necessary information available, prepared or analyzed (including computations) in reasonable detail to complete the accounting for certain income tax effects of the tax reform. We had no adjustments related to changes in interpretation of tax reform since December 31, 2017. Off-Balance Sheet Arrangements Since our inception, we have not engaged in any off-balance sheet arrangements, as defined in the rules and regulations of the SEC. JOBS Act Accounting Election The Jumpstart Our Business Startups Act of 2012, or JOBS Act, permits an “emerging growth company” such as us to take advantage of an extended transition period to comply with new or revised accounting standards applicable to public companies until such pronouncements are made applicable to private companies, unless we otherwise irrevocably elect not to avail ourselves of this exemption. However, we have chosen to irrevocably “opt out” of such extended transition period, and as a result, we will comply with new or revised accounting standards on the relevant dates on which adoption of such standards is required for non-emerging growth companies. Section 107 of the JOBS Act provides that our decision to not take advantage of the extended transition period for complying with new or revised accounting standards is irrevocable. Recent Accounting Pronouncements A description of recently issued accounting pronouncements that may potentially impact our financial position and results of operations is discussed under Note 2 to our consolidated financial statements included in this report.

<s>[INST] Overview We are a clinicalstage biopharmaceutical company specializing in novel therapeutics to treat chronic, highprevalence retinal diseases. Our most advanced product candidate is KSI301, a biologic therapy built with our antibody biopolymer conjugate platform, or ABC platform, which is designed to maintain potent and effective drug levels in ocular tissues. We believe that KSI301, if approved, has the potential to become an important antivascular endothelial growth factor, or antiVEGF, therapy in wet agerelated macular degeneration, or wet AMD, diabetic retinopathy, or DR, including diabetic macular edema, or DME, and other retinal vascular diseases. KSI301 and our ABC Platform were developed at Kodiak, and we own worldwide rights to those assets, including composition of matter patent protection with respect to KSI301. We have applied our ABC Platform to develop additional product candidates beyond KSI301, including KSI501, our bispecific antiIL6/VEGF bioconjugate. We intend to progress these and other product candidates to address highprevalence ophthalmic diseases. We initiated our firstinhuman, single ascending dose Phase 1a clinical study of KSI301 in the United States in nine patients with severe diabetic macular edema in July 2018. We successfully dosed all patients at the preplanned dose levels and reached the 12week last visit in November 2018. The last visit (twelveweek) data demonstrated safety and durability of responses following the single dose of KSI301. Notably: Rapid highmagnitude and durable treatment responses were seen at all dose levels tested in a heavily pretreated Phase 1 patient population. Twelve weeks after a single dose, median vision improvement from baseline of almost two lines of vision (9 eye chart letters) and median improvement in retinal edema of 121 microns were achieved across all three dose levels tested. No doselimiting toxicities, drugrelated adverse events, or intraocular inflammation were observed through each patients' last visit at 12 weeks. In the fourth quarter of 2018, we initiated an openlabel, multipledose Phase 1b study of KSI301 in the United States in treatment naïve patients with wet AMD, DME/DR, and retinal vein occlusion and expect to complete enrollment of these cohorts of patients in 2019. We intend to present ongoing data from the Phase 1b study at medical and investor meetings in 2019. Having successfully demonstrated early safety and tolerability in the Phase 1 study, with the additional observations around bioactivity and durability, we plan to further evaluate the highest dose tested of KSI301, 5 mg, in a series of Phase 2 studies in wet AMD and DME/DR. We expect to be enrolling patients in a global Phase 2 study of KSI301 in wet AMD in the second quarter of 2019. This study is intended to evaluate the noninferiority of intravitreal KSI301 dosed on an every 12, 16 or 20week regimen compared to standard of care aflibercept dosed every 8 weeks. The FDA indicated that this study, if successful, can be supportive of a marketing application for KSI301, and we are designing and intend to execute this Phase 2 study as a pivotal study, with an option for an administrative interim analysis in 2020. A primary data readout is anticipated in 2021. We additionally plan to initiate two Phase 2 studies in China, one in wet AMD and one in DME, and we are planning for these studies to have the same clinical design frameworks as our United States and European Union studies. We are on track to hold our China preIND meeting for KSI301 in the first half of 2019. Since inception in June 2009, we have devoted substantially all of our resources to discovering and developing product candidates and manufacturing processes, building our ABC Platform and assembling our core capabilities in drug [/INST] Negative. </s>

Kodiak Sciences Inc.

2020-03-16

2019-12-31

ITEM 7. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS You should read the following discussion and analysis of our financial condition and results of operations together with the section titled “Selected Consolidated Financial Data” and our consolidated financial statements and the related notes included elsewhere in this report. This discussion and analysis and other parts of this report contain forward-looking statements based upon current beliefs, plans and expectations related to future events and our future financial performance that involve risks, uncertainties and assumptions, such as statements regarding our intentions, plans, objectives, expectations, forecasts and projections. Our actual results and the timing of selected events could differ materially from those anticipated in these forward-looking statements as a result of several factors, including those set forth under the section titled “Risk Factors” and elsewhere in this report. Overview Our goal is to prevent and treat the major causes of blindness by developing next-generation therapeutics for chronic, high-prevalence retinal diseases. Throughout 2019 and into 2020, we have generated clinical data with our most advanced product candidate, KSI-301, a biologic therapy built with our antibody biopolymer conjugate platform, or ABC Platform, which is designed to maintain potent and effective drug levels in ocular tissues for longer periods than the currently-marketed biologic medicines used to treat retinal diseases. To date, KSI-301 has been administered more than 500 times to over 200 patients. We believe that KSI-301, if approved, has the potential to be an important therapy to treat patients with wet age-related macular degeneration, or wet AMD, diabetic retinopathy, or DR, including diabetic macular edema, or DME, and macular edema due to retinal vein occlusion, or RVO. In our ongoing Phase 1b clinical study, we have completed enrollment and administered multiple doses of KSI-301 to treatment-naïve patients with wet AMD, DME or RVO, and we are observing promising safety, efficacy, and clinical durability in the emerging data in each of the retinal diseases under study. We believe the data support an acceleration of efforts to bring KSI-301 to the market in these retinal diseases and that the data lend confidence to the design of our current and planned pivotal studies of KSI-301, which studies we believe, if successful, may demonstrate a meaningfully differentiated clinical profile of KSI-301 as compared to current therapies. Based on this encouraging data, we are entering into the manufacturing-related commitments necessary for pre-commercial scale-up and BLA submission. We have completed an end of phase 2 meeting with the U.S. Food and Drug Administration, or FDA, where we agreed on the order and number of clinical studies required to support the licensure of KSI-301 in wet AMD, DME, RVO and DR (without DME). Two pivotal studies will be required in RVO and one study each in wet AMD, DME, and DR in order to support the potential U.S. approval of KSI-301 across these four indications. The pivotal study for wet AMD began recruiting patients in the third quarter of 2019, and we plan to initiate the pivotal studies in DME, RVO and DR in 2020. The ABC Platform and KSI-301 were developed at Kodiak, and we own worldwide rights to these assets. We have applied our ABC Platform to develop additional product candidates beyond KSI-301, including KSI-501, our bispecific anti-IL-6/VEGF bioconjugate, and we are expanding our early research pipeline to include ABC Platform-based triplet inhibitors for multifactorial retinal diseases such as dry AMD and the neurodegenerative aspects of glaucoma. We intend to progress these and other product candidates to address high-prevalence ophthalmic diseases. Our overall objective is to develop our product candidates, seek FDA and worldwide health authority marketing authorization approvals, and ultimately commercialize our product candidates. Recent developments On December 1, 2019, we and our subsidiary, Kodiak Sciences GmbH, entered into a funding agreement with Baker Bros. Advisors, or BBA, pursuant to which BBA purchased the right to receive a capped 4.5% royalty on future net sales of KSI-301 in exchange for $225,000,000 in committed development funding payable to us. Unless earlier terminated or re-purchased by us, the royalty terminates upon the date that BBA has received an aggregate amount equal to 4.5 times the funding amount paid to us. On February 4, 2020, BBA paid us the first $100,000,000 of the funding amount, and the remaining $125,000,000 of the funding amount will be paid following the achievement of 50% enrollment in each of (i) the planned Phase 3 clinical trial of KSI-301 for branch RVO and (ii) the planned Phase 3 clinical trial of KSI-301 for central RVO. We have the option, exercisable at any point during the term of the funding agreement, to repurchase from BBA 100% of the royalties due to BBA under the funding agreement for a purchase price equal to the funding amount paid to us as of such time times 4.5, less amounts paid by us to BBA. The funding agreement was the result of a competitive process overseen by independent and disinterested directors with the assistance of outside counsel. For further details, see the “Business” section above. On December 6, 2019, we completed a follow-on equity offering and issued and sold 6,900,000 shares of the Company’s common stock at a price to the public of $46.00 per share. The gross proceeds from this offering were $317.4 million, resulting in aggregate net proceeds of $297.6 million after deducting underwriting discounts and commissions and other offering costs payable by us. Proceeds from the royalty funding agreement together with our current cash, cash equivalents and marketable securities, which includes proceeds from the equity offering, are expected to advance the clinical programs for KSI-301 towards achieving our “2022 Vision” of a Biologics License Application, or BLA, of KSI-301 in 2022 for wet AMD, DME, RVO and potentially DR without DME, including the manufacturing activities necessary for BLA submission, as well as to advance our pipeline of drug candidates including KSI-501 and our triplet inhibitor drug candidates and for working capital and general corporate purposes. In 2019 and into the first quarter of 2020, highlights of our activities included: • Initiation of enrollment and on-going recruitment in our pivotal DAZZLE clinical trial of KSI-301 in patients with treatment naïve wet AMD. As of March 6, 2020, more than 175 patients have been enrolled in the study randomized 1:1 between KSI-301 and Eylea as active comparator; • Completion of recruitment into our ongoing Phase 1b study of KSI-301 in 121 treatment-naïve patients with wet AMD, DME and RVO; • Presentation of promising on-going clinical safety, efficacy and durability data at the American Society of Retina Specialists 2019 Annual Meeting, the Macula Society 2019 Annual Meeting, the American Academy of Ophthalmology 2019 Annual Meeting Retina Subspecialty Day, and the Angiogenesis, Exudation, and Degeneration 2020 Annual Meeting; • Completion of a Type B (End of Phase 2 or EOP) meeting with the FDA where we discussed and agreed on: • Certain recommended clinical, non-clinical, and manufacturing activities to support the licensure of KSI-301, and • The order and number of clinical studies required to support a BLA in wet AMD, DME, RVO and DR; • Announcement of an accelerated registration strategy for KSI-301 which includes: (i) running our pivotal clinical studies in the major retinal vascular disease indications in parallel (rather than in series), and (ii) engaging in BLA and pre-commercial manufacturing validation and scale-up activities; • Expansion of our Board of Directors with the appointment of Taiyin Yang, Ph.D., Executive Vice President, Pharmaceutical Development and Manufacturing of Gilead Sciences, who brings expertise and experience in the relevant pre-commercial areas of clinical and commercial manufacturing, quality and supply chain operations; • Entry into a royalty funding agreement with BBA in which we sold a capped, pre-payable 4.5% royalty on future net sales of KSI-301 in exchange for $225,000,000 in committed development funding payable to us.; and • Closing of a $317.4 million follow-on offering of our common stock. Based on the emerging clinical data, our productive EOP meeting with the FDA, and our substantive financing events, we are accelerating our BLA- and pre-commercial manufacturing activities to match the clinical timelines for KSI-301, with the goal of demonstrating a meaningfully-differentiated (i.e., first line) clinical profile in each of wet AMD, DME, RVO, and DR as compared to currently-marketed medicines. Our current cash, cash equivalents and marketable securities which includes the net proceeds from the December 2019 public offering, and together with the royalty funding agreement, provide the resources for us to advance the KSI-301 program towards achieving our “2022 Vision,” and also to advance our pipeline of drug candidates including KSI-501 and our triplet inhibitor drug candidates, and for working capital and general corporate purposes. Kodiak’s 2022 Vision and KSI-301 accelerated development strategy We believe that we can achieve our “2022 Vision” of a BLA submission and initial FDA approval for KSI-301 in wet AMD, DME, RVO and DR with a total of five pivotal trials- two in RVO, one in wet AMD, one in DME and one in DR without DME. Consequently, we now intend to initiate at least four US/EU-based pivotal trials in 2020 - one in DME, one in central RVO (CRVO), one in branch RVO (BRVO), and one in DR without DME. These studies, together with our ongoing pivotal study in wet AMD, will be the basis of our intended BLA and sBLA submissions. We currently expect to submit the wet AMD, DME, and RVO indications in a single initial BLA for KSI-301 and the DR indication in a supplemental BLA in the United States. We continue to invest in our science and our pipeline, including our bispecific ABC product candidate KSI-501 for retinal vascular diseases with a strong inflammatory component and our new triplet inhibitors for the high prevalence multifactorial retinal diseases dry AMD and the neurodegenerative aspects of glaucoma. Our 2022 Vision includes the following potential catalysts and milestones in 2020, 2021 and 2022, along with the important milestones achieved in 2019 that support the accelerated development program: Further details of our ongoing KSI-301 Phase 1b trial and our accelerating development strategy are described in the “Business” section above. Since inception in June 2009, we have devoted substantially all of our resources to discovering and developing product candidates and manufacturing processes, building our ABC Platform and assembling our core capabilities in drug development for ophthalmic disease. We plan to continue to use third-party contract research organizations, or CROs, to carry out our preclinical and clinical development. We rely on third-party contract manufacturing organizations, or CMOs, to manufacture and supply our preclinical and clinical materials to be used during the development of our product candidates. We are evaluating investments in commercial manufacturing capacity. We do not have any products approved for sale and have not generated any product revenue since inception. We have funded our operations primarily through the sale and issuance of equity securities. In October 2018, we completed our initial public offering, or IPO. In December 2019, we completed a follow-on offering. We have incurred significant operating losses to date and expect that our operating losses will increase significantly as we advance our product candidates, particularly KSI-301, through preclinical and clinical development, seek regulatory approval, prepare for and, if approved, proceed to commercialization; broaden and improve our platform; acquire, discover, validate and develop additional product candidates; obtain, maintain, protect and enforce our intellectual property portfolio; and hire additional personnel. In addition, we expect to incur additional costs associated with operating as a public company. Our net loss was $47.4 million, $41.4 million and $27.9 million for the years ended December 31, 2019, 2018 and 2017, respectively. As of December 31, 2019, we had an accumulated deficit of $158.1 million. Our ability to generate product revenue will depend on the successful development and eventual commercialization of one or more of our product candidates. Until such time as we can generate significant revenue from sales of our product candidates, if ever, we expect to finance our operations through the sale of equity, debt financings or other capital sources, including potential collaborations with other companies or other strategic transactions. Adequate funding may not be available to us on acceptable terms, or at all. If we fail to raise capital or enter into such agreements as, and when, needed, we may have to significantly delay, scale back, or discontinue the development and commercialization of KSI-301 for wet AMD, RVO, DME or NPDR or delay our efforts to advance and expand our product pipeline. On November 1, 2019, we filed a shelf registration statement on Form S-3 (File No. 333-234443) with the SEC covering the offer and sale of up to $400.0 million of the Company’s securities for a period of up to three years from the date of effectiveness of the shelf registration statement. In December 2019, we completed a follow-on offering pursuant to the shelf registration on Form S-3 and issued and sold 6,900,000 shares of the Company’s common stock, including the underwriters’ full exercise of their over-allotment option, at a price to the public of $46.00 per share. The gross proceeds from this offering were $317.4 million, resulting in aggregate net proceeds of $297.6 million after deducting underwriting discounts and commissions and other offering costs payable by us. As of December 31, 2019, we had cash, cash equivalents and marketable securities of $348.2 million. Components of Operating Results Operating Expenses Research and Development Expenses Substantially all of our research and development expenses consist of expenses incurred in connection with the development of our ABC Platform and product candidates. These expenses include certain payroll and personnel expenses, including stock-based compensation, for our research and product development employees; laboratory supplies and facility costs; consulting costs; contract manufacturing and fees paid to CROs to conduct certain research and development activities on our behalf; and allocated overhead, including rent, equipment, depreciation and utilities. We expense both internal and external research and development expenses as they are incurred. Costs of certain activities, such as manufacturing and preclinical and clinical studies, are generally recognized based on an evaluation of the progress to completion of specific tasks. Nonrefundable payments made prior to the receipt of goods or services that will be used or rendered for future research and development activities are deferred and capitalized. The capitalized amounts are recognized as expense as the goods are delivered or the related services are performed. We are focusing substantially all of our resources and development efforts on the development of our product candidates, in particular KSI-301. We expect our research and development expenses to increase substantially during the next few years as we initiate our Phase 3 studies, complete our clinical program, pursue regulatory approval of our drug candidates and prepare for a possible commercial launch. Predicting the timing or the final cost to complete our clinical program or validation of our commercial manufacturing and supply processes is difficult and delays may occur because of many factors, including factors outside of our control. For example, if the FDA or other regulatory authorities were to require us to conduct clinical trials beyond those that we currently anticipate, or if we experience significant delays in enrollment in any of our clinical trials, we could be required to expend significant additional financial resources and time on the completion of clinical development. Furthermore, we are unable to predict when or if our drug candidates will receive regulatory approval with any certainty. General and Administrative Expenses General and administrative expenses consist principally of payroll and personnel expenses, including stock-based compensation; professional fees for legal, consulting, accounting and tax services; allocated overhead, including rent, equipment, depreciation and utilities; and other general operating expenses not otherwise classified as research and development expenses. We anticipate that our general and administrative expenses will increase as a result of increased personnel costs, including stock-based compensation, expanded infrastructure and higher consulting, legal and accounting services associated with maintaining compliance with requirements of the stock exchange listing and Securities and Exchange Commission, or SEC, investor relations costs and director and officer insurance premiums associated with being a public company. Interest Income Interest income consists primarily of interest income earned on our cash, cash equivalents and marketable securities. Interest Expense Interest expense consists primarily of interest expense related to our convertible notes, including accretion of debt discount and debt issuance costs, which converted into shares of common stock upon the closing of our IPO. Other Income (Expense), Net Other income (expense), net consists primarily of accretion income on marketable debt securities in 2019 and primarily consists of changes in the fair value of warrants for Series B redeemable convertible preferred stock, changes in fair value of the derivative instruments in 2018. Loss on Extinguishment of Debt Loss on extinguishment of debt was recognized for the year ended December 31, 2018 related to the convertible notes issued in February 2018 which converted into shares of common stock upon closing of our IPO. Results of Operations The following table summarizes our results of operations for the periods indicated: * Percentage is not meaningful Research and Development Expenses Research and development expenses increased $18.7 million, or 100%, from the year ended December 31, 2018 to the year ended December 31, 2019. The following table summarizes our research and development expenses: (1) ABC Platform external expenses primarily relates to manufacturing of biopolymer intermediate drug substance which can be used with multiple product candidates. These expenses are primarily for services provided by CMOs and CROs. (2) KSI-301 program external expenses relates to development of KSI-301, including manufacturing and clinical trial costs. These expenses are primarily for services provided by CMOs and CROs. (3) KSI-501 program external expenses relates to research and development of KSI-501. (4) Payroll and personnel expenses includes salaries, benefits and stock-based compensation for our personnel involved in research and development activities. These expenses are separately classified and not allocated to specific programs because these expenses relate to multiple programs. (5) Other research and development expenses includes direct costs related to research and development activities other than those listed above. ABC Platform external expenses increased $0.8 million during the year ended December 31, 2019 as compared to 2018. The increase was primarily driven by manufacturing runs to support our product candidate pipeline. KSI-301 program external expenses increased $11.0 million during the year ended December 31, 2019 as compared to 2018. The increase was primarily due to clinical trial costs as well as manufacturing runs for KSI-301. KSI-501 program external expenses increased $1.2 million during the year ended December 31, 2019, due to ongoing research and development of KSI-501. Payroll and personnel expenses increased $5.2 million during the year ended December 31, 2019 as compared to 2018. The increase was a result of increased headcount and stock-based compensation expense. Other research and development expenses increased $0.5 million during the year ended December 31, 2019 as compared to 2018. Our other research and development expenses may fluctuate in future periods as we elect to develop other product candidates. General and Administrative Expenses General and administrative expenses increased $4.1 million, or 54%, from the year ended December 31, 2018 to the year ended December 31, 2019. The increase in general and administrative expenses was primarily attributable to an increase of $2.1 million in professional services related to accounting, audit, legal and consulting services and additional costs associated with operating as a public company, and an increase of $2.0 million in salaries, including stock-based compensation. Interest Income Interest income increased $1.0 million from the year ended December 31, 2018 to the year ended December 31, 2019 which was mainly attributable to interest income earned on increased cash balances from our IPO in October 2018 and follow-on offering in December 2019. Interest Expense Interest expense decreased $5.5 million from the year ended December 31, 2018 to the year ended December 31, 2019, which was mainly attributable to interest expense in 2018 on convertible notes issued in August 2017 and February 2018, including accretion of debt discount and issuance costs. The convertible notes converted into shares of common stock upon the closing of our IPO. Other Income (Expense), Net Other income (expense), net decreased $5.0 million from the year ended December 31, 2018 to the year ended December 31, 2019, which was mainly attributable to the movement in fair value of the redeemable convertible preferred stock warrant liability and derivative instrument related to the convertible notes issued in February 2018 prior to our IPO in 2018, offset by accretion income on marketable debt securities of $0.3 million in 2019. The preferred stock warrants converted into common stock warrants and the derivative liability was extinguished upon our IPO. Loss on Extinguishment of Debt Loss on extinguishment of the convertible notes issued in February 2018 was $5.5 million for the year ended December 31, 2018. Liquidity and Capital Resources; Plan of Operations Sources of Liquidity We have funded our operations primarily through the sale and issuance of common stock, redeemable convertible preferred stock, convertible notes and warrants. As of December 31, 2019, we had cash, cash equivalents and marketable securities of $348.2 million. 2017 Convertible Notes In August 2017, we received $10.0 million in gross proceeds from the issuance of the 2017 convertible notes and warrants to purchase Series B redeemable convertible preferred stock. Upon the closing of our IPO, 500,000 redeemable convertible preferred stock warrants automatically converted into common stock warrants and 100,000 of such warrants were exercised immediately following the closing of our IPO. The 2017 convertible notes converted into 2,637,292 shares of common stock at the closing of our IPO. 2018 Convertible Notes In February 2018, we received $33.0 million in gross proceeds from the issuance of the 2018 convertible notes. The 2018 convertible notes converted into 4,295,677 shares of common stock at the closing of our IPO. IPO In October 2018, we completed our IPO. We sold and issued 9,400,000 shares of common stock at a price to the public of $10.00 per share. The aggregate net proceeds from our IPO, inclusive of the partial over-allotment option exercise, were $83.5 million after deducting underwriting discounts and commissions and other offering costs. Follow-On Offering In December 2019, we completed a follow-on offering pursuant to the shelf registration on Form S-3 and issued and sold 6,900,000 shares of common stock at a price to the public of $46.00 per share. The gross proceeds from this offering were $317.4 million, resulting in aggregate net proceeds of $297.6 million after deducting underwriting discounts and commissions and other offering costs payable by us. Future Funding Requirements We have incurred net losses since our inception. For the years ended December 31, 2019, 2018 and 2017, we had net losses of $47.4 million, $41.4 million, and $27.9 million, respectively, and we expect to continue to incur additional losses in future periods. As of December 31, 2019, we had an accumulated deficit of $158.1 million. We currently plan to raise additional funding as required based on the status of its clinical trials and projected cash flows, however based on our current business plan, we believe that our existing cash, cash equivalents and marketable securities are sufficient to fund our projected operations for at least the next 12 months. To date, we have not generated any product revenue. We do not expect to generate any product revenue unless and until we obtain regulatory approval of and commercialize any of our product candidates or enter into collaborative agreements with third parties, and we do not know when, or if, either will occur. We expect to continue to incur significant losses for the foreseeable future, and we expect our losses to increase as we continue the development of, and seek regulatory approvals for, our product candidates, and begin to commercialize any approved products. We are subject to all of the risks typically related to the development of new product candidates, and we may encounter unforeseen expenses, difficulties, complications, delays and other unknown factors that may adversely affect our business. Moreover, we expect to continue incurring additional costs associated with operating as a public company. We have based these estimates on assumptions that may prove to be wrong, and we could deplete our capital resources sooner than we expect. The timing and amount of our operating expenditures and capital requirements will depend on many factors, including: • the scope, timing, rate of progress and costs of our drug discovery, preclinical development activities, laboratory testing and clinical trials for our product candidates; • the number and scope of clinical programs we decide to pursue; • the scope and costs of manufacturing development and commercial manufacturing activities; • the extent to which we acquire or in-license other product candidates and technologies; • the cost, timing and outcome of regulatory review of our product candidates; • the costs of preparing, filing and prosecuting patent applications, maintaining and enforcing our intellectual property rights and defending intellectual property-related claims; • our ability to establish and maintain collaborations on favorable terms, if at all; • our efforts to enhance operational systems and our ability to attract, hire and retain qualified personnel, including personnel to support the development of our product candidates; • the costs associated with being a public company; and • the cost and timing associated with commercializing our product candidates, if they receive marketing approval. A change in the outcome of any of these or other variables with respect to the development of any of our product candidates could significantly change the costs and timing associated with the development of that product candidate. Furthermore, our operating plans may change in the future, and we will continue to require additional capital to meet operational needs and capital requirements associated with such operating plans. If we raise additional funds by issuing equity securities, our stockholders may experience dilution. Any future debt financing into which we enter may impose upon us additional covenants that restrict our operations, including limitations on our ability to incur liens or additional debt, pay dividends, repurchase our common stock, make certain investments and engage in certain merger, consolidation or asset sale transactions. Any debt financing or additional equity that we raise may contain terms that are not favorable to us or our stockholders. If we are unable to raise additional funds when needed, we may be required to delay, reduce, or terminate some or all of our development programs and clinical trials. We may also be required to sell or license rights to our product candidates in certain territories or indications to others that we would prefer to develop and commercialize ourselves. Adequate additional funding may not be available to us on acceptable terms or at all. Our failure to raise capital as and when needed could have a negative impact on our financial condition and our ability to pursue our business strategies. See the section titled “Risk Factors” for additional risks associated with our substantial capital requirements. Summary Statement of Cash Flows The following table sets forth the primary sources and uses of cash for each of the periods presented below: Cash Flows from Operating Activities Net cash used in operating activities was $39.1 million for year ended December 31, 2019. Cash used in operating activities was primarily due to the use of funds in our operations to continue to develop KSI-301 and in connection with our operations as a public company, resulting in a net loss of $47.4 million, adjusted by non-cash charges of $6.8 million offset by a change in operating assets and liabilities of $1.4 million. The non-cash charges consisted of $0.5 million of depreciation expense, $6.1 million of stock-based compensation, $0.2 million net accretion of discount on marketable securities, and $0.4 million amortization of the operating lease right-of-use asset. The change in net operating assets and liabilities was primarily due to an increase in accounts payable of $1.6 million due to timing of vendor payments, an increase in accrued liabilities of $4.9 million mainly related to an increase in accrued research and development expenses and an increase in accrued compensation expenses, and an increase in other assets of $4.5 million mainly due to an increase in advance payments. Cash Flows from Investing Activities Net cash used in investing activities was $137.0 million for year ended December 31, 2019 and primarily related to purchases of marketable securities, net of maturities. Cash Flows from Financing Activities Net cash provided in financing activities was $299.7 million for year ended December 31, 2019, which consisted primarily of $297.6 million of net proceeds from our follow-on offering, and $2.3 million of proceeds from the exercise of stock options. Contractual Obligations and Commitments The following table summarizes our contractual obligations as of December 31, 2019: (1) We lease our facility under a non-cancelable operating lease. In January 2013, we entered into a lease for our current laboratory and office space that commenced in October 2013 and expired in October 2018. In March 2016, we entered into a lease amendment that extended the lease term to October 2023. The minimum lease payments above do not include any related common area maintenance charges or real estate taxes. (2) We have entered into service agreements with a third-party CMO, pursuant to which the CMO agreed to perform activities in connection with the manufacturing process of certain compounds. Such agreements, and related amendments, state that planned activities that are included in some signed work orders are, in some cases, binding and, hence, obligate us to pay the full price of the work order upon satisfactory delivery of products and services. Per the terms of the agreements, we have the option to cancel signed orders at any time upon written notice, which may or may not be subject to payment of a cancellation fee depending on the timing of the written notice in relation to the commencement date of the work, with the maximum cancellation fee equal to the full price of the work order. Although the payment of the cancellation fee will generally be due at the scheduled commencement date, we may record the manufacturing expense and related obligation as an accrued liability at the time of cancellation. In the normal course of business, we have entered into purchase commitments to support research and development activities that cannot be terminated without incurring cancellation fees. The level of cancellation fees may vary and are generally based on the passage of time within a 12-month period. (3) We have tenant improvement obligations under our facilities lease agreements, which are required to be paid over the contractually agreed period. We enter into contracts in the normal course of business with third party contract organizations for preclinical and clinical studies and testing, manufacturing, and providing other services and products for operating purposes. These contracts generally provide for termination following a certain period after notice, and therefore we believe that our non-cancelable obligations under these agreements are not material. Critical Accounting Policies, Significant Judgments and Use of Estimates Our consolidated financial statements have been prepared in accordance with U.S. generally accepted accounting principles, or GAAP. The preparation of these consolidated financial statements requires us to make estimates and assumptions that affect the reported amounts of assets and liabilities, the disclosure of contingent assets and liabilities at the date of the consolidated financial statements, as well as the reported expenses incurred during the reporting periods. Our estimates are based on our historical experience and on various other factors that we believe are reasonable under the circumstances, the results of which form the basis for making judgments about the carrying value of assets and liabilities that are not readily apparent from other sources. Actual results may differ from these estimates under different assumptions or conditions. We believe that the accounting policies discussed below are critical to understanding our historical and future performance, as these policies relate to the more significant areas involving management’s judgments and estimates. Accrued Research and Development Our preclinical and clinical accruals are a component of research and development expenses and are based on patient enrollment and related costs as well as estimates for the services received and efforts expended pursuant to contracts with multiple research institutions and CROs. We estimate research and development accruals, including preclinical and clinical expenses, based on the level of services performed, progress of the studies, including the phase or completion of events, and contracted costs. The estimated costs of research and development provided, but not yet invoiced, are included in accrued liabilities and other current liabilities on the consolidated balance sheets. If the actual timing of the performance of services or the level of effort varies from the original estimates, we will adjust the accrual accordingly. Payments made to CROs or CMOs under these arrangements in advance of the performance of the related services are recorded as prepaid expenses and other current assets until the services are rendered. Stock-Based Compensation Expense We measure and recognize compensation expense for all stock-based awards made to employees, directors and non-employees, based on estimated fair values of the awards on the grant date and recognized using the straight-line method over the requisite service period. The fair value of options is estimated on the grant date using the Black-Scholes option valuation model. The calculation of stock-based compensation expense requires that we make certain assumptions and judgments about a number of complex and subjective variables used in the Black-Scholes model, including the expected term, expected volatility of the underlying common stock and risk-free interest rate. Our stock-based awards are subject to either service or performance-based vesting conditions. We evaluate whether achievement of the performance conditions is probable and record expense over the appropriate service period based on this assessment. Changes in these assumptions can materially affect the fair value and ultimately how much stock-based compensation expense is recognized. These inputs are subjective and generally require significant analysis and judgment to develop. Income Taxes We provide for income taxes under the asset and liability method. Current income tax expense or benefit represents the amount of income taxes expected to be payable or refundable for the current year. Deferred income tax assets and liabilities are determined based on differences between the financial statement reporting and tax bases of assets and liabilities and net operating loss and credit carryforwards, and are measured using the enacted tax rates and laws that will be in effect when such items are expected to reverse. Deferred income tax assets are reduced, as necessary, by a valuation allowance when management determines it is more likely than not that some or all of the tax benefits will not be realized. We assess all material positions taken in any income tax return, including all significant uncertain positions, in all tax years that are still subject to assessment or challenge by relevant taxing authorities. Assessing an uncertain tax position begins with the initial determination of the position’s sustainability and is measured at the largest amount of benefit that is greater than fifty percent likely of being realized upon ultimate settlement. As of each balance sheet date, unresolved uncertain tax positions must be reassessed, and we will determine whether (1) the factors underlying the sustainability assertion have changed and (2) the amount of the recognized tax benefit is still appropriate. The recognition and measurement of tax benefits requires significant judgment. Judgments concerning the recognition and measurement of a tax benefit might change as new information becomes available. Our policy is to recognize interest and penalties related to the underpayment of income taxes as a component of income tax expense or benefit. To date, there have been no interest or penalties charged in relation to the unrecognized tax benefits. Net operating loss carryforwards, or NOLs, and tax credit carryforwards are subject to review and possible adjustment by the Internal Revenue Service, or IRS, and may become subject to an annual limitation in the event of certain cumulative changes in the ownership interest of significant shareholders over a three-year period in excess of 50% as defined under Sections 382 and 383 in the Internal Revenue Code, which could limit the amount of tax attributes that can be utilized annually to offset future taxable income or tax liabilities. The amount of the annual limitation is determined based on our value immediately prior to the ownership change. Subsequent ownership changes may further affect the limitation in future years. We have completed a Section 382 study through December 31, 2019 which concluded no such ownership change had occurred through December 31, 2019. As of December 31, 2019 and 2018, we had unrecognized tax benefits, all of which would affect income tax expense if recognized, before consideration of our valuation allowance. We do not expect that our uncertain tax positions will materially change in the next twelve months. Off-Balance Sheet Arrangements Since our inception, we have not engaged in any off-balance sheet arrangements, as defined in the rules and regulations of the SEC. JOBS Act Accounting Election The Jumpstart Our Business Startups Act of 2012, or JOBS Act, permits an “emerging growth company” such as us to take advantage of an extended transition period to comply with new or revised accounting standards applicable to public companies until such pronouncements are made applicable to private companies, unless we otherwise irrevocably elect not to avail ourselves of this exemption. However, we have chosen to irrevocably “opt out” of such extended transition period, and as a result, we will comply with new or revised accounting standards on the relevant dates on which adoption of such standards is required for non-emerging growth companies. Section 107 of the JOBS Act provides that our decision to not take advantage of the extended transition period for complying with new or revised accounting standards is irrevocable. Recent Accounting Pronouncements A description of recently issued accounting pronouncements that may potentially impact our financial position and results of operations is discussed under Note 2 to our consolidated financial statements included in this report.

<s>[INST] Overview Our goal is to prevent and treat the major causes of blindness by developing nextgeneration therapeutics for chronic, highprevalence retinal diseases. Throughout 2019 and into 2020, we have generated clinical data with our most advanced product candidate, KSI301, a biologic therapy built with our antibody biopolymer conjugate platform, or ABC Platform, which is designed to maintain potent and effective drug levels in ocular tissues for longer periods than the currentlymarketed biologic medicines used to treat retinal diseases. To date, KSI301 has been administered more than 500 times to over 200 patients. We believe that KSI301, if approved, has the potential to be an important therapy to treat patients with wet agerelated macular degeneration, or wet AMD, diabetic retinopathy, or DR, including diabetic macular edema, or DME, and macular edema due to retinal vein occlusion, or RVO. In our ongoing Phase 1b clinical study, we have completed enrollment and administered multiple doses of KSI301 to treatmentnaïve patients with wet AMD, DME or RVO, and we are observing promising safety, efficacy, and clinical durability in the emerging data in each of the retinal diseases under study. We believe the data support an acceleration of efforts to bring KSI301 to the market in these retinal diseases and that the data lend confidence to the design of our current and planned pivotal studies of KSI301, which studies we believe, if successful, may demonstrate a meaningfully differentiated clinical profile of KSI301 as compared to current therapies. Based on this encouraging data, we are entering into the manufacturingrelated commitments necessary for precommercial scaleup and BLA submission. We have completed an end of phase 2 meeting with the U.S. Food and Drug Administration, or FDA, where we agreed on the order and number of clinical studies required to support the licensure of KSI301 in wet AMD, DME, RVO and DR (without DME). Two pivotal studies will be required in RVO and one study each in wet AMD, DME, and DR in order to support the potential U.S. approval of KSI301 across these four indications. The pivotal study for wet AMD began recruiting patients in the third quarter of 2019, and we plan to initiate the pivotal studies in DME, RVO and DR in 2020. The ABC Platform and KSI301 were developed at Kodiak, and we own worldwide rights to these assets. We have applied our ABC Platform to develop additional product candidates beyond KSI301, including KSI501, our bispecific antiIL6/VEGF bioconjugate, and we are expanding our early research pipeline to include ABC Platformbased triplet inhibitors for multifactorial retinal diseases such as dry AMD and the neurodegenerative aspects of glaucoma. We intend to progress these and other product candidates to address highprevalence ophthalmic diseases. Our overall objective is to develop our product candidates, seek FDA and worldwide health authority marketing authorization approvals, and ultimately commercialize our product candidates. Recent developments On December 1, 2019, we and our subsidiary, Kodiak Sciences GmbH, entered into a funding agreement with Baker Bros. Advisors, or BBA, pursuant to which BBA purchased the right to receive a capped 4.5% royalty on future net sales of KSI301 in exchange for $225,000,000 in committed development funding payable to us. Unless earlier terminated or repurchased by us, the royalty terminates upon the date that BBA has received an aggregate amount equal to 4.5 times the funding amount paid to us. On February 4, 2020, BBA paid us the first $100,000,000 of the funding amount, and the remaining $125,000,000 of the funding amount will be paid following the achievement of 50% enrollment in each of ( [/INST] Negative. </s>

Lazydays Holdings, Inc.

2019-03-22

2018-12-31

Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations The following discussion and analysis of the Company’s financial condition and results of operations should be read in conjunction with Part I, including matters set forth in the “Risk Factors” section of this Form 10-K, and our Consolidated Financial Statements and notes thereto, included in Part II, Item 8 of this Form 10-K. Forward Looking Statements Certain statements in this Annual Report on Form 10-K (including but not limited to this Item 7 - “Management’s Discussion and Analysis of Financial Condition and Results of Operations”) constitute “forward-looking statements” within the meaning of the Private Securities Litigation Reform Act of 1995. All statements other than statements of historical facts included in this Annual Report on Form 10-K, including, without limitation, statements regarding the Company’s future financial position, business strategy, budgets, projected costs and plans and objectives of management for future operations, are “forward-looking” statements. Forward-looking statements generally can be identified by the use of forward-looking terminology such as “may,” “will,” “expect,” “anticipate,” “intend,” “plan,” “believe,” “seek,” “estimate” or “continue” or the negative of such words or variations of such words and similar expressions. These statements are not guarantees of future performance and involve certain risks, uncertainties and assumptions, which are difficult to predict. Therefore, actual outcomes and results may differ materially from what is expressed or forecasted in such forward-looking statements and the Company can give no assurance that such forward-looking statements will prove to be correct. Important factors that could cause actual results to differ materially from those expressed or implied by the forward-looking statements, or “cautionary statements,” include, but are not limited to: ● The Company’s business is affected by the availability of financing to it and its customers; ● Fuel shortages, or high prices for fuel, could have a negative effect on the Company’s business; ● The Company’s success will depend to a significant extent on the well being, as well as the continued popularity and reputation for quality, of the Company’s manufacturers, particularly, Thor Industries, Inc., Tiffin Motorhomes, Winnebago Industries, Inc., and Forest River, Inc. ● Any change, non-renewal, unfavorable renegotiation or termination of the Company’s supply arrangements for any reason could have a material adverse effect on product availability and cost and the Company’s financial performance. ● The Company’s business is impacted by general economic conditions in its markets, and ongoing economic and financial uncertainties may cause a decline in consumer spending that may adversely affect its business, financial condition and results of operations. ● The Company depends on its ability to attract and retain customers. ● Competition in the market for services, protection plans and products targeting the RV lifestyle or RV enthusiast could reduce the Company’s revenues and profitability. ● The Company’s expansion into new, unfamiliar markets presents increased risks that may prevent it from being profitable in these new markets. Delays in acquiring or opening new retail locations could have a material adverse effect on the Company’s business, financial condition and results of operations. ● Unforeseen expenses, difficulties, and delays encountered in connection with expansion through acquisitions could inhibit the Company’s growth and negatively impact its profitability. ● Failure to maintain the strength and value of the Company’s brands could have a material adverse effect on the Company’s business, financial condition and results of operations. ● The Company’s failure to successfully order and manage its inventory to reflect consumer demand in a volatile market and anticipate changing consumer preferences and buying trends could have a material adverse effect on the Company’s business, financial condition and results of operations. ● The Company’s same store sales may fluctuate and may not be a meaningful indicator of future performance. ● The cyclical nature of the Company’s business has caused its sales and results of operations to fluctuate. These fluctuations may continue in the future, which could result in operating losses during downturns. ● The Company’s business is seasonal and this leads to fluctuations in sales and revenues. ● The Company’s business may be adversely affected by unfavorable conditions in its local markets, even if those conditions are not prominent nationally. ● The Company may not be able to satisfy its debt obligations upon the occurrence of a change in control under its credit facility. ● The Company’s ability to operate and expand its business and to respond to changing business and economic conditions will depend on the availability of adequate capital. ● The documentation governing the Company’s credit facility contain restrictive covenants that may impair the Company’s ability to access sufficient capital and operate its business. ● Natural disasters, whether or not caused by climate change, unusual weather conditions, epidemic outbreaks, terrorist acts and political events could disrupt business and result in lower sales and otherwise adversely affect the Company’s financial performance. ● The Company depends on its relationships with third party providers of services, protection plans, products and resources and a disruption of these relationships or of these providers’ operations could have an adverse effect on the Company’s business and results of operations. ● A portion of the Company’s revenue is from financing, insurance and extended service contracts, which depend on third party lenders and insurance companies. The Company cannot ensure these third parties will continue to provide RV financing and other products. ● If the Company is unable to retain senior executives and attract and retain other qualified employees, the Company’s business might be adversely affected. ● The Company’s business depends on its ability to meet its labor needs. ● The Company primarily leases its retail locations. If the Company is unable to maintain those leases or locate alternative sites for retail locations in its target markets and on terms that are acceptable to it, the Company’s revenues and profitability could be adversely affected. ● The Company’s business is subject to numerous federal, state and local regulations. ● Regulations applicable to the sale of extended service contracts could materially impact the Company’s business and results of operations. ● If state dealer laws are repealed or weakened, the Company’s dealerships will be more susceptible to termination, non-renewal or renegotiation of dealer agreements. ● The Company’s failure to comply with certain environmental regulations could adversely affect the Company’s business, financial condition and results of operations. ● Climate change legislation or regulations restricting emission of “greenhouse gases” could result in increased operating costs and reduced demand for the RVs the Company sells. ● The Company may be unable to enforce its intellectual property rights and/or the Company may be accused of infringing the intellectual property rights of third parties which could have a material adverse effect on the Company’s business, financial condition and results of operations. ● If the Company is unable to maintain or upgrade its information technology systems or if the Company is unable to convert to alternate systems in an efficient and timely manner, the Company’s operations may be disrupted or become less efficient. ● Any disruptions to the Company’s information technology systems or breaches of the Company’s network security could interrupt its operations, compromise its reputation, expose it to litigation, government enforcement actions and costly response measures and could have a material adverse effect on the Company’s business, financial condition and results of operations. ● Increases in the minimum wage or overall wage levels could adversely affect the Company’s financial results. ● The Company may be subject to product liability claims if people or property are harmed by the products the Company sells and may be adversely impacted by manufacturer safety recalls. ● The Company may be named in litigation, which may result in substantial costs and reputational harm and divert management’s attention and resources. ● The Company’s risk management policies and procedures may not be fully effective in achieving their purposes. ● The Company could incur asset impairment charges for goodwill, intangible assets or other long-lived assets. ● Future resales of the shares of common stock of the Company issued to the stockholders and the investors in the PIPE Investment may cause the market price of the Company’s securities to drop significantly, even if the Company’s business is doing well. ● Nasdaq may delist the Company’s common stock on its exchange, which could limit investors’ ability to make transactions in the Company’s common stock and subject the Company to additional trading restrictions. ● The Company’s outstanding convertible preferred stock, warrants and options may have an adverse effect on the market price of its common stock. ● The Company is an “emerging growth company” and it cannot be certain if the reduced disclosure requirements applicable to emerging growth companies will make the Company’s common stock less attractive to investors. ● Stockholders may become diluted as a result of issuance of options under existing or future incentive plans or the issuance of Common Stock as a result of acquisitions or otherwise. ● The price of the Company’s Common Stock may be volatile for a variety of reasons. ● The conversion of the Series A Preferred Stock into Company common stock may dilute the value for the other holders of Company common stock. ● The holders of Series A Preferred Stock own a large portion of the voting power of the Company common stock and have the right to nominate two members to the Company’s board of directors. As a result, these holders may influence the composition of the board of directors of the Company and future actions taken by the board of directors of the Company. ● The holders of the Series A Preferred Stock have certain rights that may not allow the Company to take certain actions. The amounts set forth below are in thousands unless otherwise indicated except for unit (including the average selling price per unit), share, and per share data. Business Overview Our Business The Company operates RV dealerships and offers a comprehensive portfolio of products and services for RV owners and outdoor enthusiasts. The Company generates revenue by providing RV owners and outdoor enthusiasts a full spectrum of products: RV sales, RV repair and services, financing and insurance products, third-party protection plans, after-market parts and accessories, RV rentals and RV camping. The Company provides these offerings through its Lazydays branded dealerships. Lazydays is known nationally as The RV AuthorityTM , a registered trademark that has been consistently used by the Company in its marketing and branding communications since 2013. In this Annual Report on Form 10-K, the Company refers to Lazydays Holdings, Inc. as “Lazydays,” the “Company,” “Holdco,” “we,” “us,” “our,” and similar words. The Company believes, based on industry research and management’s estimates, it operates the world’s largest RV dealership, measured in terms of on-site inventory, located on 126 acres outside Tampa, FL. The Company also operates RV dealerships in Tucson, Arizona; Minneapolis, Minnesota; and two cities in Colorado, Loveland and Denver. Lazydays offers one of the largest selections of RV brands in the nation featuring more than 3,000 new and pre-owned RVs. The Company has over 400 service bays across all locations and has RV parts and accessories stores at all locations. Lazydays also has RV rental fleets in Florida, and Colorado and availability to two on-site campgrounds with over 700 RV campsites. The Company welcomes over 500,000 visitors to its dealership locations annually, and employs over 800 people at the six facilities. The Company’s dealership locations are staffed with knowledgeable local team members, providing customers access to extensive RV expertise. The Company believes its dealership locations are strategically located in key RV markets. Based on information collected by the Company from reports prepared by Statistical Surveys, these key RV markets account for a significant portion of new RV units sold on an annual basis in the U.S. The Company’s dealerships in these key markets attract customers from every state except Hawaii. The Company attracts new customers primarily through Lazydays dealership locations as well as digital and traditional marketing efforts. Once the Company acquires customers, those customers become part of the Company’s customer database where the Company leverages CRM tools and analytics to actively engage, market and sell its products and services. How The Company Generates Revenue The Company derives its revenues from sales of new units, sales of pre-owned units, and other revenue. Other revenue consists of RV parts, service and repairs, commissions earned on sales of third-party financing and insurance products, visitor fees at the Tampa campground and food facilities, and miscellaneous revenues. During the years ended December 31, 2018 and 2017, the Company derived its revenues from these categories in the following percentages: New and pre-owned RV sales accounted for approximately 89% of total revenues for the years ended December 31, 2018 and 2017. These revenue contributions have remained relatively consistent year over year. Key Performance Indicators Gross Profit and Gross Margins (excluding depreciation and amortization). Gross profit is total revenue less total costs applicable to revenue excluding depreciation and amortization. The vast majority of the cost applicable to revenues is related to the cost of vehicles. New and pre-owned vehicles have accounted for 97% of the cost of revenues for the years ended December 31, 2018 and 2017. Gross margin is gross profit as a percentage of revenue. The Company’s gross profit is variable in nature and generally follows changes in revenue. For the years ended December 31, 2018 and 2017, gross profit was $131.7 million and $127.1 million, respectively, and gross margin was 21.6% and 20.7% for the years then ended. Excluding the impact of LIFO adjustments, gross profit was $133.1 million and $130.9 million and gross margin was 21.9% and 21.3%, respectively for the years ended December 31, 2018 and 2017. The Company’s gross margins on pre-owned vehicles are typically higher than gross margins on new vehicles, on a percentage basis. During the years ended December 31, 2018 and 2017, gross margins were also favorably impacted by other revenue, including finance and insurance revenues and parts, service, and accessories revenue. The Company’s margins on these lines of business typically carry higher gross margin percentages than new and pre-owned vehicle sales. These combined revenues were 11.5% and 11.1%, respectively, of total revenues during the years ended December 31, 2018 and 2017. SG&A as a percentage of Gross Profit. Selling, general and administrative (“SG&A”) expenses as a percentage of gross profit allows the Company to monitor its expense control over a period of time. SG&A consists primarily of wage-related expenses, selling expenses related to commissions and advertising, lease expenses and corporate overhead expenses. Historically, salaries, commissions and benefits represent the largest component of the Company’s total selling, general and administrative expense and averages approximately 53% of selling, general and administrative expenses, stock-based compensation, depreciation and amortization, and transaction costs. During the years ended December 31, 2018 and December 31, 2017, salaries, commissions, and benefits represented 53% and 52% of these operating expenses. The Company calculates SG&A expenses as a percentage of gross profit by dividing SG&A expenses for the period by total gross profit. For the years ended December 31, 2018 and 2017, SG&A, excluding transaction costs, depreciation and amortization, and stock-based compensation expense as a percentage of gross profit was 73.5% and 75.8%, respectively. For the years ended December 31, 2018 and 2017, excluding the effect of transaction costs, LIFO adjustments, stock-based compensation and depreciation and amortization expense, SG&A as a percentage of gross profit was 72.7% and 73.6%, respectively. The Company’s operating expenses have increased compared to prior periods in part due to additional stock-based compensation, legal, accounting, insurance and other expenses that the Company expects to incur as a result of being a public company, including compliance with the Securities Act of 1933, as amended, the Securities Exchange Act of 1934, as amended, the Sarbanes-Oxley Act and the related rules and regulations. In addition, as the Company executes its growth strategy the Company may acquire intangible assets and property, plant, and equipment which may result in additional depreciation and amortization expense. Adjusted EBITDA. Adjusted EBITDA is a not a U.S. Generally Accepted Accounting Principle (“GAAP”) financial measure, but it is one of the primary non-GAAP measures management uses to evaluate the financial performance of the business. Adjusted EBITDA is also frequently used by analysts, investors, and other interested parties to evaluate companies in the recreational vehicle industry. The Company uses Adjusted EBITDA and Adjusted EBITDA Margin to supplement GAAP measures of performance as follows: ● as a measurement of operating performance to assist in comparing the operating performance of the Company’s business on a consistent basis, and remove the impact of items not directly resulting from the Company’s core operations; ● for planning purposes, including the preparation of the Company’s internal annual operating budget and financial projections; ● to evaluate the performance and effectiveness of the Company’s operational strategies; and ● to evaluate the Company’s capacity to fund capital expenditures and expand the business. The Company defines Adjusted EBITDA as net (loss) income excluding depreciation and amortization of property and equipment, non-floor plan interest expense, amortization of intangible assets, income tax expense, stock-based compensation, transaction costs and other supplemental adjustments which for the periods presented includes LIFO adjustments, severance costs and gain on sale of property and equipment. The Company believes Adjusted EBITDA, when considered along with other performance measures, is a useful measure as it reflects certain operating drivers of the business, such as sales growth, operating costs, selling and administrative expense and other operating income and expense. The Company believes Adjusted EBITDA can provide a more complete understanding of the underlying operating results and trends and an enhanced overall understanding of financial performance and prospects for the future. While Adjusted EBITDA is not a recognized measure under GAAP, management uses this financial measure to evaluate and forecast business performance. Adjusted EBITDA is not intended to be a measure of liquidity or cash flows from operations, or a measure comparable to net income as it does not take into account certain requirements such as non-recurring gains and losses which are not deemed to be a normal part of the underlying business activities. The Company’s use of Adjusted EBITDA may not be comparable to other companies within the industry. The Company compensates for these limitations by using Adjusted EBITDA as only one of several measures for evaluating business performance. In addition, capital expenditures, which impact depreciation and amortization, interest expense, and income tax expense, are reviewed separately by management. The Company’s measure of Adjusted EBITDA is not necessarily comparable to similarly titled captions of other companies due to different methods of calculation. For a reconciliation of Adjusted EBITDA to net (loss) income, a reconciliation of Adjusted EBITDA Margin to net (loss) income margin, and a further discussion of how the Company utilizes this non-GAAP financial measure, see “Non-GAAP Financial Measures” below. Results of Operations The following table sets forth information comparing the components of net (loss) income for the years ended December 31, 2018 and 2017. Summary Financial Data (in thousands) Revenue Revenue decreased by approximately $6.6 million, or 1.1%, to $608.2 million from $614.8 million for the years ended December 31, 2018 and 2017, respectively. New Vehicles and Pre-Owned Vehicles Revenue Revenue from new and pre-owned vehicles sales decreased by approximately $8.3 million, or 1.5%, to $538.1 million from $546.4 million for the years ended December 31, 2018 and 2017, respectively. Revenue from new vehicle sales decreased by approximately $1.7 million, or 0.5%, to $333.6 million from $335.3 million for the years ended December 31, 2018 and 2017, respectively. This was due to a small decrease in the average selling price per unit sold from $79,100 to $76,800 for the year ended December 31, 2017 as compared to the year ended December 31, 2018. This decrease was partially offset by an increase in the number of new vehicle units sold from 4,221 in 2017 to 4,319 in 2018. Revenue from pre-owned vehicle sales decreased by approximately $6.5 million, or 3.1%, to $204.6 million from $211.1 million for the years ended December 31, 2018 and 2017, respectively. This was due to a decrease in the number of pre-owned vehicles sold from 3,167 to 2,977, excluding wholesale units sold. Excluding the effect of wholesale sales, the impact of the decrease in the number of pre-owned vehicles sold was partially offset by the increase in the average revenue per unit sold from approximately $62,400 in 2017 to $64,900 per unit in 2018. Other Revenue Other revenue consists of sales of parts, accessories, and related services. It also consists of finance and insurance revenues as well as campground and miscellaneous revenues. Other revenue increased by approximately $1.6 million, or 2.4%, to $70.1 million from $68.5 million for the years ended December 31, 2018 and 2017, respectively. As a component of other revenue, excluding e-commerce revenue from 2017, sales of parts, accessories and related services increased by approximately $1.4 million, or 4.7%, to $30.9 million from $29.5 million for the years ended December 31, 2018 and 2017, respectively, due to increased volume. Revenues from the Company’s e-commerce business were $2.3 million during the year ended December 31, 2017. There were no revenues from e-commerce sales in 2018 as the Company no longer operates an e-commerce business. Finance and insurance revenue increased by approximately $2.6 million, or 8.7%, to $32.4 million from $29.8 million for the year ended December 31, 2018 as compared to December 31, 2017, respectively, primarily due to higher penetration rates and higher per unit revenue in our extended warranty products. Campground and other revenue, which includes RV rental revenue, remained flat at approximately $6.7 million for each annual period presented. Gross Profit (excluding depreciation and amortization) Gross profit consists of gross revenues less cost of sales and services and excludes depreciation and amortization. Gross profit increased by approximately $4.6 million, or 3.6%, to $131.7 million from $127.1 million for the years ended December 31, 2018 and 2017, respectively. This increase was partially attributable to a decrease in LIFO adjustments in 2018 compared to 2017 and the increase in the sale of new towable units in our product mix. Excluding the impact of LIFO adjustments, gross profit increased by approximately $2.2 million, or 1.7%, to $133.1 million from $130.9 million for the years ended December 31, 2018 and 2017, respectively. New and Pre-Owned Vehicles Gross Profit Excluding the impact of LIFO adjustments, new and pre-owned vehicle gross profit increased $1.2 million, or 1.5%, to $79.0 million from $77.8 million for the years ended December 31, 2018 and 2017, respectively. This increase is attributable to the increase in towable units sold. Other Gross Profit Other gross profit increased by $1.0 million, or 2.0% to $54.1 million from $53.1 million for the years ended December 31, 2018 and 2017 primarily due to increased finance and insurance revenues. Selling, General and Administrative Expenses Selling, general, and administrative (“SG&A”) expenses, excluding transaction costs, stock-based compensation expense, and depreciation and amortization expense, increased 0.6% to $96.8 million during the year ended December 31, 2018, from $96.3 million during the year ended December 31, 2017. In addition, there was an increase in non-cash expenses including stock-based compensation of $8.4 million primarily attributable to the awards with market conditions issued to management on March 16, 2018 and May 7, 2018. There was also a $3.4 million increase in depreciation and amortization expense primarily as a result of the valuation of fixed assets and intangibles assets associated with the acquisition of Lazy Days’ R.V. Center, Inc. by Andina. Interest Expense Interest expense increased by approximately $1.2 million to $10.0 million for the year ended December 31, 2018 from $8.8 million for the year ended December 31, 2017, respectively. This was due to the increase in floor plan interest due to the increase in the outstanding floor plan balance from acquisitions as well as a build up of inventory at year end. In addition, interest increased as a result of the increase in the term loan with M&T Bank as well as the interest expense from the sale leaseback transaction and note payable associated with the acquisition of the Minnesota location. Income Taxes Income tax expense decreased to $3.0 million during the year ended December 31, 2018 from income tax expense of $5.1 million during the same period of 2017, due to the decrease in book and taxable income. While book income decreased from December 31, 2017 to December 31, 2018, non-deductible expenses such as stock-based compensation and transaction costs associated with acquisitions resulting in significant increases to the Company’s effective tax rate. As book income approaches zero, the impact of each non-deductible item has a larger impact on the effective tax rate. Non-Gaap Financial Measures The Company uses certain non-GAAP financial measures, such as EBITDA and Adjusted EBITDA, to enable it to analyze its performance and financial condition, as described in “Key Performance Indicators”, above. The Company utilizes these financial measures to manage the business on a day-to-day basis and believes that they are relevant measures of performance. The Company believes that these supplemental measures are commonly used in the industry to measure performance. The Company believes these non-GAAP measures provide expanded insight to measure revenue and cost performance, in addition to the standard GAAP-based financial measures. The presentation of non-GAAP financial information should not be considered in isolation or as a substitute for, or superior to, the financial information prepared and presented in accordance with GAAP. You should read this discussion and analysis of the Company’s financial condition and results of operations together with the consolidated financial statements of the Company and the related notes thereto also included herein. EBITDA is defined as net income (loss) excluding depreciation and amortization of property and equipment, interest expense, net, amortization of intangible assets, and income tax expense. Adjusted EBITDA is defined as net (loss) income excluding depreciation and amortization of property and equipment, non-floor plan interest expense, amortization of intangible assets, income tax expense, stock-based compensation, transaction costs and other supplemental adjustments which for the periods presented includes LIFO adjustments, severance costs and other one time charges, and gain or loss on sale of property and equipment. Reconciliations from Net (Loss) Income per the Consolidated Statements of Operations to EBITDA and Adjusted EBITDA for the years ended December 31, 2018 and 2017 are shown in the tables below. Note: Figures in the table may not recalculate exactly due to rounding. Liquidity and Capital Resources Cash Flow Summary Net Cash from Operating Activities The Company used cash in operating activities of approximately $5.3 million during the year ended December 31, 2018 compared to cash provided by operating activities of approximately $24.1 million for the year ended December 31, 2017. Net income decreased by approximately $8.6 million for the year ended December 31, 2018 compared to the year ended December 31, 2017. Adjustments for non-cash expenses, included in net income, increased $12.2 million to $18.4 million for the year ended December 31, 2018. During the year ended December 31, 2018, there was approximately $23.4 million of cash used by changes in operating assets and liabilities as compared to $9.6 million of cash provided by changes in operating assets and liabilities during the year ended December 31, 2017. The fluctuations in assets and liabilities were primarily due to the increase in inventory of $18.9 million during the year ended December 31, 2018. This increase in inventory was due to a seasonal build up of inventory in Tampa. Net Cash from Investing Activities The Company used cash in investing activities of approximately $96.6 million during the year ended December 31, 2018, compared to approximately $2.3 million for the year ended December 31, 2017. The Company used net cash of approximately $92.3 million for the acquisition of Lazy Days’ R.V. Center, Inc., Shorewood RV Center, and Tennessee RV. In addition, there were purchases of property and equipment of approximately $4.3 million. Net Cash from Financing Activities The Company had cash provided by financing activities of approximately $113.7 million during the year ended December 31, 2018, compared to net cash used in financing activities of approximately $12.6 million for the year ended December 31, 2017. During the year ended December 31, 2018, the Company raised net proceeds of $90.4 million through the PIPE offering through the issuance of common stock, Series A Convertible Preferred Stock, and warrants. The Company paid dividends of $2.6 million during the year ended December 31, 2018 on the Series A Convertible Preferred Stock. During the year ended December 31, 2018, the Company also received net proceeds of approximately $20.0 million from the proceeds of a new term loan with M&T Bank which was offset by the repayment of approximately $8.8 million of long-term debt with Bank of America. During 2018 the Company repaid $2.2 million of the new term loan with M&T Bank. The Company also repaid $96.7 million in floor plan notes payable to Bank of America and received net proceeds of $123.6 million from the new floor plan loan with M&T Bank. The Company also made net repayments to Bank of America of $12.3 million during the Predecessor Period (as defined below) prior to the Merger. In addition, the Company entered into a new sales leaseback transaction which resulted in proceeds from the resulting financing liability of approximately $5.6 million. Net cash used in financing activities for the year ended December 31, 2017 primarily consisted of a $15.0 million dividend payment, a $3.0 million repayment of the line of credit, and $9.2 million of proceeds under the floor plan loan. Funding Needs and Sources The Company has historically satisfied its liquidity needs through cash from operations and various borrowing arrangements. Cash requirements consist principally of scheduled payments of principal and interest on outstanding indebtedness (including indebtedness under its existing floor plan credit facility), the acquisition of inventory, capital expenditures, salary and sales commissions and lease expenses. As of December 31, 2018, the Company had liquidity of approximately $26.6 million in cash and had working capital of approximately $44.3 million. Capital expenditures include expenditures to extend the useful life of current facilities and expand operations. For the years ended December 31, 2018 and 2017, the Company invested approximately $4.3 million and $2.6 million in capital expenditures, respectively. The Company maintains sizable inventory in order to meet the expectations of its customers and believes that it will continue to require working capital consistent with past experience. Historically, the Company has funded its operations with internally generated cash flow and borrowings. Changes in working capital are driven primarily by levels of business activity. The Company maintains a floor plan credit facility to finance its vehicle inventory. At times, the Company has made repayments on its existing floor plan credit facility using excess cash flow from operations. As a result of the Mergers on March 15, 2018, approximately $105.5 million of incremental cash was made available from various sources, of which $86.7 million was paid out to the Stockholders leaving approximately $9.0 million of cash available for future opportunities, including potential acquisitions. M&T Credit Facility On March 15, 2018, the Company replaced its existing debt agreements with Bank of America with a $200 million Senior Secured Credit Facility (the “M&T Facility”). The M&T Facility includes a $175 million M&T floor plan line of credit (“M&T Floor Plan Line of Credit”), a $20 million M&T term loan (“M&T Term Loan”), and a $5 million M&T revolver (“M&T Revolver”). The M&T Facility will mature on March 15, 2021. The M&T Facility requires the Company to meet certain financial covenants and is secured by substantially all of the assets of the Company. The M&T Floor Plan Line of Credit may be used to finance new vehicle inventory, but only $45.0 million may be used to finance pre-owned vehicle inventory and $4.5 million may be used to finance rental units. Principal becomes due upon the sale of the respective vehicle. The M&T Floor Plan Line of Credit shall accrue interest at either (a) the fluctuating 30-day London Interbank Offered Rate (“LIBOR”) rate plus an applicable margin which ranges from 2.00% to 2.30% based upon the Company’s total leverage ratio (as defined in the M&T Facility) or (b) the Base Rate plus an applicable margin ranging from 1.00% to 1.30% based upon the Company’s total leverage ratio (as defined in the M&T Facility). The Base Rate is defined in the agreement as the highest of M&T’s prime rate, the Federal Funds rate plus 0.50% or one-month LIBOR plus 1.00%. In addition, the Company will be charged for unused commitments at a rate of 0.15%. The M&T Term Loan will be repaid in equal monthly principal installments of $0.242 million plus accrued interest through the maturity date. At the maturity date, the Company will pay a principal balloon payment of $11.3 million plus any accrued interest. The M&T Term Loan shall bear interest at (a) LIBOR plus an applicable margin of 2.25% to 3.00% based on the total leverage ratio (as defined in the agreement) or (b) the Base Rate plus a margin of 1.25% to 2.00% based on the total leverage ratio (as defined in the agreement). The M&T Revolver allows the Company to draw up to $5.0 million. The M&T Revolver shall bear interest at (a) 30-day LIBOR plus an applicable margin of 2.25% to 3.00% based on the total leverage ratio (as defined in the M&T Facility) or (b) the Base Rate plus a margin of 1.25% to 2.00% based on the total leverage ratio (as defined in the M&T Facility). The M&T Revolver is also subject to the unused commitment fees at rates varying from 0.25% to 0.50% based on the total leverage ratio (as defined). As of December 31, 2018, there was $143.9 million outstanding under the M&T Floor Plan Line of Credit and $17.8 million outstanding under the M&T Term Loan. Off-Balance Sheet Arrangements As of December 31, 2018, there were no off-balance sheet arrangements as defined in Item 303(a)(4)(ii) of Regulation S-K. Inflation Although the Company cannot accurately anticipate the effect of inflation on its operations, it believes that inflation has not had, and is not likely in the foreseeable future to have, a material impact on its results of operations. Cyclicality Unit sales of RV vehicles historically have been cyclical, fluctuating with general economic cycles. During economic downturns, the RV retailing industry tends to experience similar periods of decline and recession as the general economy. The Company believes that the industry is influenced by general economic conditions and particularly by consumer confidence, the level of personal discretionary spending, fuel prices, interest rates and credit availability. Seasonality and Effects of Weather The Company’s operations generally experience modestly higher volumes of vehicle sales in the first half of each year due in part to consumer buying trends and the hospitable warm climate during the winter months at our largest location in Tampa, Florida. The Company’s largest RV dealership is located near Tampa, Florida, which is in close proximity to the Gulf of Mexico. A severe weather event, such as a hurricane, could cause severe damage to property and inventory and decrease the traffic to our dealerships. Although the Company believes that it has adequate insurance coverage, if the Company were to experience a catastrophic loss, the Company may exceed its policy limits, and/or may have difficulty obtaining similar insurance coverage in the future. Critical Accounting Policies and Estimates The Company prepares its consolidated financial statements in accordance with GAAP, and in doing so, it has to make estimates, assumptions and judgments affecting the reported amounts of assets, liabilities, revenues and expenses, as well as the related disclosure of contingent assets and liabilities. The Company bases its estimates, assumptions and judgments on historical experience and on various other factors it believes to be reasonable under the circumstances. Different assumptions and judgments would change estimates used in the preparation of the consolidated financial statements, which, in turn, could change the results from those reported. The Company evaluates its critical accounting estimates, assumptions and judgments on an ongoing basis. We believe that, of our significant accounting policies (see Note 2 of the financial statements included in this Form 10-K), the following policies are the most critical: Basis of Presentation Predecessor and Successor Periods As a result of the Mergers, Holdco is the acquirer for accounting purposes and Lazydays R.V. Center, Inc. is the acquiree and the accounting predecessor. The financial statement presentation distinguishes the results into two distinct periods, the period up to March 15, 2018 (the “Acquisition Date”) (“Predecessor Periods”) and the period including and after that date (the “Successor Period”). The Mergers were accounted for as a business combination using the acquisition method of accounting and the Successor Period financial statements reflect a new basis of accounting that is based on the fair value of the net assets acquired. As a result of the application of the acquisition method of accounting as of the effective time of the Transaction Merger, the accompanying consolidated financial statements include a black line division which indicates that the Predecessor and Successor reporting entities shown are presented on a different basis and are, therefore, not directly comparable. The historical financial information of Andina, (which was a special purpose acquisition company) prior to the business combination has not been reflected in the Predecessor Period financial statements as these historical amounts have been considered immaterial. Accordingly, no other activity in the Company was reported in the Predecessor Period other than the activity of Lazydays RV. Use of Estimates in the Preparation of Financial Statements The preparation of financial statements in conformity with GAAP requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the consolidated financial statements and the reported amounts of revenues and expenses during the reporting period. Actual results could differ from those estimates. Significant estimates include the assumptions used in the valuation of the net assets acquired in business combinations, goodwill and other intangible assets, provision for charge-backs, inventory write-downs, the allowance for doubtful accounts and stock-based compensation. Revenue Recognition The Company recognizes revenue when the following four criteria are met: (1) delivery has occurred or services rendered; (2) persuasive evidence of an arrangement exists; (3) fees are fixed or determinable, and (4) the collection of related accounts receivable is probable. Revenue from the sale of vehicles is recognized on delivery, transfer of title and completion of financing arrangements. Revenue from parts, sales, and service is recognized on delivery of the service or product. Revenue from parts, sales, and service is recognized in other revenue in the accompanying consolidated statements of operations. Revenue from the rental of vehicles is recognized pro rata over the period of the rental agreement. The rental agreements are generally short-term in nature. Revenue from rentals is included in other revenue in the accompanying consolidated statements of operations. The Company receives commissions from the sale of insurance and vehicle service contracts to customers. In addition, the Company arranges financing for customers through various financial institutions and receives commissions. The Company may be charged back (“charge-backs”) for financing fees, insurance or vehicle service contract commissions in the event of early termination of the contracts by the customers. The revenues from financing fees and commissions are recorded at the time of the sale of the vehicles and an allowance for future charge-backs is established based on historical operating results and the termination provision of the applicable contracts. Cumulative Redeemable Convertible Preferred Stock The Company’s Series A Preferred Stock (See Note 15 - Preferred Stock) is cumulative redeemable convertible preferred stock. Accordingly, it is classified as temporary equity and is shown net of issuance costs and the relative fair value of warrants issued in conjunction with the issuance of the Series A Preferred Stock. Unpaid preferred dividends are accumulated, compounded at each quarterly dividend date and presented within the carrying value of the Series A Preferred Stock until a dividend is declared by the Board of Directors. Stock Based Compensation The Company accounts for stock-based compensation for employees and directors in accordance with Accounting Standards Codification (“ASC”) 718, Compensation (“ASC 718”). ASC 718 requires all share-based payments to employees, including grants of employee stock options, to be recognized in the statement of operations based on their fair values. Under the provisions of ASC 718, stock-based compensation costs are measured at the grant date, based on the fair value of the award, and are recognized as expense over the employee’s requisite or derived service period. In accordance with ASC 718, excess tax benefits realized from the exercise of stock-based awards are classified as cash flows from operating activities. All excess tax benefits and tax deficiencies (including tax benefits of dividends on share-based payment awards) are recognized as income tax expense or benefit in the consolidated statements of operations.

<s>[INST] Forward Looking Statements Certain statements in this Annual Report on Form 10K (including but not limited to this Item 7 “Management’s Discussion and Analysis of Financial Condition and Results of Operations”) constitute “forwardlooking statements” within the meaning of the Private Securities Litigation Reform Act of 1995. All statements other than statements of historical facts included in this Annual Report on Form 10K, including, without limitation, statements regarding the Company’s future financial position, business strategy, budgets, projected costs and plans and objectives of management for future operations, are “forwardlooking” statements. Forwardlooking statements generally can be identified by the use of forwardlooking terminology such as “may,” “will,” “expect,” “anticipate,” “intend,” “plan,” “believe,” “seek,” “estimate” or “continue” or the negative of such words or variations of such words and similar expressions. These statements are not guarantees of future performance and involve certain risks, uncertainties and assumptions, which are difficult to predict. Therefore, actual outcomes and results may differ materially from what is expressed or forecasted in such forwardlooking statements and the Company can give no assurance that such forwardlooking statements will prove to be correct. Important factors that could cause actual results to differ materially from those expressed or implied by the forwardlooking statements, or “cautionary statements,” include, but are not limited to: The Company’s business is affected by the availability of financing to it and its customers; Fuel shortages, or high prices for fuel, could have a negative effect on the Company’s business; The Company’s success will depend to a significant extent on the well being, as well as the continued popularity and reputation for quality, of the Company’s manufacturers, particularly, Thor Industries, Inc., Tiffin Motorhomes, Winnebago Industries, Inc., and Forest River, Inc. Any change, nonrenewal, unfavorable renegotiation or termination of the Company’s supply arrangements for any reason could have a material adverse effect on product availability and cost and the Company’s financial performance. The Company’s business is impacted by general economic conditions in its markets, and ongoing economic and financial uncertainties may cause a decline in consumer spending that may adversely affect its business, financial condition and results of operations. The Company depends on its ability to attract and retain customers. Competition in the market for services, protection plans and products targeting the RV lifestyle or RV enthusiast could reduce the Company’s revenues and profitability. The Company’s expansion into new, unfamiliar markets presents increased risks that may prevent it from being profitable in these new markets. Delays in acquiring or opening new retail locations could have a material adverse effect on the Company’s business, financial condition and results of operations. Unforeseen expenses, difficulties, and delays encountered in connection with expansion through acquisitions could inhibit the Company’s growth and negatively impact its profitability. Failure to maintain the strength and value of the Company’s brands could have a material adverse effect on the Company’s business, financial condition and results of operations. The Company’s failure to successfully order and manage its inventory to reflect consumer demand in a volatile market and anticipate changing consumer preferences and buying trends could have a material adverse effect on the Company’s business, financial condition and results of operations. The Company’s same store sales may fluctuate and may not be a meaningful indicator of future performance. The cyclical nature of the Company’s business has caused its sales and results of operations to fluctuate. These fluctuations may continue in the future, which could result in operating losses during downturns. The Company’s business is seasonal and this leads to fluctuations in sales and revenues. The Company’s business may be adversely affected by unfavorable conditions in its local markets, even if those conditions are not prominent nationally. The Company may not be able to satisfy its debt obligations upon the occurrence of a change in control under its credit facility. The Company’s ability to operate and expand its business and to respond to changing business and economic conditions will depend on the availability of adequate capital. The documentation governing the Company’s credit facility contain restrictive covenants that may impair the Company’s ability to access sufficient capital and operate its business. [/INST] Negative. </s>

Lazydays Holdings, Inc.

2020-03-20

2019-12-31

Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations The following discussion and analysis of the Company’s financial condition and results of operations should be read in conjunction with Part I, including matters set forth in the “Risk Factors” section of this Form 10-K, and our Consolidated Financial Statements and notes thereto, included in Part II, Item 8 of this Form 10-K. Forward Looking Statements Certain statements in this Annual Report on Form 10-K (including but not limited to this Item 7 - “Management’s Discussion and Analysis of Financial Condition and Results of Operations”) constitute “forward-looking statements” within the meaning of the Private Securities Litigation Reform Act of 1995. All statements other than statements of historical facts included in this Annual Report on Form 10-K, including, without limitation, statements regarding the Company’s future financial position, business strategy, budgets, projected costs and plans and objectives of management for future operations, are “forward-looking” statements. Forward-looking statements generally can be identified by the use of forward-looking terminology such as “may,” “will,” “expect,” “anticipate,” “intend,” “plan,” “believe,” “seek,” “estimate” or “continue” or the negative of such words or variations of such words and similar expressions. These statements are not guarantees of future performance and involve certain risks, uncertainties and assumptions, which are difficult to predict. Therefore, actual outcomes and results may differ materially from what is expressed or forecasted in such forward-looking statements and the Company can give no assurance that such forward-looking statements will prove to be correct. Important factors that could cause actual results to differ materially from those expressed or implied by the forward-looking statements, or “cautionary statements,” include, but are not limited to: ● The Company’s business is affected by the availability of financing to it and its customers; ● Fuel shortages, or high prices for fuel, could have a negative effect on the Company’s business; ● The Company’s success will depend to a significant extent on the well being, as well as the continued popularity and reputation for quality, of the Company’s manufacturers, particularly, Thor Industries, Inc., Tiffin Motorhomes, Winnebago Industries, Inc., and Forest River, Inc. ● Any change, non-renewal, unfavorable renegotiation or termination of the Company’s supply arrangements for any reason could have a material adverse effect on product availability and cost and the Company’s financial performance. ● The Company’s business is impacted by general economic conditions in its markets, and ongoing economic and financial uncertainties may cause a decline in consumer spending that may adversely affect its business, financial condition and results of operations. ● The Company depends on its ability to attract and retain customers. ● Competition in the market for services, protection plans and products targeting the RV lifestyle or RV enthusiast could reduce the Company’s revenues and profitability. ● The Company’s expansion into new, unfamiliar markets presents increased risks that may prevent it from being profitable in these new markets. Delays in opening or acquiring new retail locations could have a material adverse effect on the Company’s business, financial condition and results of operations. ● Unforeseen expenses, difficulties, and delays encountered in connection with expansion through acquisitions could inhibit the Company’s growth and negatively impact its profitability. ● Failure to maintain the strength and value of the Company’s brands could have a material adverse effect on the Company’s business, financial condition and results of operations. ● The Company’s failure to successfully procure and manage its inventory to reflect consumer demand in a volatile market and anticipate changing consumer preferences and buying trends could have a material adverse effect on the Company’s business, financial condition and results of operations. ● The Company’s same store sales may fluctuate and may not be a meaningful indicator of future performance. ● The cyclical nature of the Company’s business has caused its sales and results of operations to fluctuate. These fluctuations may continue in the future, which could result in operating losses during downturns. ● The Company’s business is seasonal and this leads to fluctuations in sales and revenues. ● The Company’s business may be adversely affected by unfavorable conditions in its local markets, even if those conditions are not prominent nationally. ● The Company may not be able to satisfy its debt obligations upon the occurrence of a change in control under its credit facility. ● The Company’s ability to operate and expand its business and to respond to changing business and economic conditions will depend on the availability of adequate capital. ● The documentation governing the Company’s credit facility contain restrictive covenants that may impair the Company’s ability to access sufficient capital and operate its business. ● Uncertainty relating to the LIBOR calculation process and potential phasing out of LIBOR may adversely affect the Company. ● Natural disasters, whether or not caused by climate change, unusual weather conditions, epidemic outbreaks, terrorist acts and political events could disrupt business and result in lower sales and otherwise adversely affect the Company’s financial performance. ● The Company depends on its relationships with third party providers of services, protection plans, products and resources and a disruption of these relationships or of these providers’ operations could have an adverse effect on the Company’s business and results of operations. ● A portion of the Company’s revenue is from financing, insurance and extended service contracts, which depend on third party lenders and insurance companies. The Company cannot ensure these third parties will continue to provide RV financing and other products. ● If the Company is unable to retain senior executives and attract and retain other qualified employees, the Company’s business might be adversely affected. ● The Company’s business depends on its ability to meet its labor needs. ● The Company primarily leases its retail locations. If the Company is unable to maintain those leases or locate alternative sites for retail locations in its target markets and on terms that are acceptable to it, the Company’s revenues and profitability could be adversely affected. ● The Company’s business is subject to numerous federal, state and local regulations. ● Regulations applicable to the sale of extended service contracts could materially impact the Company’s business and results of operations. ● If state dealer laws are repealed or weakened, the Company’s dealerships will be more susceptible to termination, non-renewal or renegotiation of dealer agreements. ● The Company’s failure to comply with certain environmental regulations could adversely affect the Company’s business, financial condition and results of operations. ● Climate change legislation or regulations restricting emission of “greenhouse gases” could result in increased operating costs and reduced demand for the RVs the Company sells. ● The Company may be unable to enforce its intellectual property rights and/or the Company may be accused of infringing the intellectual property rights of third parties which could have a material adverse effect on the Company’s business, financial condition and results of operations. ● If the Company is unable to protect, maintain or upgrade its information technology systems or if the Company is unable to convert to alternate systems in an efficient and timely manner, the Company’s operations may be disrupted or become less efficient. ● Any disruptions to the Company’s information technology systems or breaches of the Company’s network security could interrupt its operations, compromise its reputation, expose it to litigation, government enforcement actions and costly response measures and could have a material adverse effect on the Company’s business, financial condition and results of operations. ● Increases in the minimum wage or overall wage levels could adversely affect the Company’s financial results. ● The Company may be subject to product liability claims if people or property are harmed by the products the Company sells and may be adversely impacted by manufacturer safety recalls. ● The Company may be named in litigation, which may result in substantial costs and reputational harm and divert management’s attention and resources. ● The Company’s risk management policies and procedures may not be fully effective in achieving their purposes. ● The Company could incur asset impairment charges for goodwill, intangible assets or other long-lived assets. ● Future resales of the shares of common stock of the Company issued to the stockholders and the investors in the PIPE Investment may cause the market price of the Company’s securities to drop significantly, even if the Company’s business is doing well. ● Nasdaq may delist the Company’s common stock on its exchange, which could limit investors’ ability to make transactions in the Company’s common stock and subject the Company to additional trading restrictions. ● The Company’s outstanding convertible preferred stock, warrants and options may have an adverse effect on the market price of its common stock. ● The Company is an “emerging growth company” and it cannot be certain if the reduced disclosure requirements applicable to emerging growth companies will make the Company’s common stock less attractive to investors. ● Stockholders may become diluted as a result of issuance of options under existing or future incentive plans, the issuance of stock under the ESPP or the issuance of Common Stock as a result of acquisitions or otherwise. ● The price of the Company’s Common Stock may be volatile for a variety of reasons. ● The conversion of the Series A Preferred Stock into Company common stock may dilute the value for the other holders of Company common stock. ● The holders of Series A Preferred Stock own a large portion of the voting power of the Company common stock and have the right to nominate two members to the Company’s board of directors. As a result, these holders may influence the composition of the board of directors of the Company and future actions taken by the board of directors of the Company. ● The holders of the Series A Preferred Stock have certain rights that may not allow the Company to take certain actions. ● The Company’s stock repurchase program could increase the volatility of the price of the Company’s Common Stock. ● The Company’s amended and restated certificate of incorporation provides to the fullest extent permitted by law that the Court of Chancery of the State of Delaware will be the exclusive forum for certain legal actions between the Company and it’s stockholders, which could limit the Company’s stockholders’ ability to obtain a judicial forum viewed by the stockholders as more favorable for disputes with the Company or the Company’s directors, officers or employees. Business Overview The amounts set forth below are in thousands unless otherwise indicated except for unit (including the average selling price per unit), share, and per share data. Our Business The Company operates RV dealerships and offers a comprehensive portfolio of products and services for RV owners and outdoor enthusiasts. The Company generates revenue by providing RV owners and outdoor enthusiasts a full spectrum of products: RV sales, RV repair and services, financing and insurance products, third-party protection plans, after-market parts and accessories, and RV camping. The Company provides these offerings through its Lazydays branded dealerships. Lazydays is known nationally as The RV Authority ®, a registered trademark that has been consistently used by the Company in its marketing and branding communications since 2013. In this Annual Report on Form 10-K, the Company refers to Lazydays Holdings, Inc. as “Lazydays,” the “Company,” “Holdco,” “we,” “us,” “our,” and similar words. The Company believes, based on industry research and management’s estimates, it operates the world’s largest RV dealership, measured in terms of on-site inventory, located on 126 acres outside Tampa, Florida. The Company also has dealerships located at The Villages, Florida; Tucson, Arizona; Minneapolis, Minnesota; Knoxville, Tennessee; and Loveland and Denver, Colorado. Lazydays offers one of the largest selections of RV brands in the nation featuring more than 3,000 new and pre-owned RVs. The Company has over 400 service bays across all locations and has RV parts and accessories stores at all locations. Lazydays also has availability to two on-site campgrounds with over 700 RV campsites. The Company employs over 900 people at the seven facilities. The Company’s dealership locations are staffed with knowledgeable local team members, providing customers access to extensive RV expertise. The Company believes its dealership locations are strategically located in key RV markets. Based on information collected by the Company from reports prepared by Statistical Surveys, these key RV markets account for a significant portion of new RV units sold on an annual basis in the U.S. The Company’s dealerships in these key markets attract customers from every state except Hawaii. The Company attracts new customers primarily through Lazydays dealership locations as well as digital and traditional marketing efforts. Once the Company acquires customers, those customers become part of the Company’s customer database where the Company leverages CRM tools and analytics to actively engage, market and sell its products and services. How The Company Generates Revenue The Company derives its revenues from sales of new units, sales of pre-owned units, and other revenue. Other revenue consists of RV parts, service and repairs, commissions earned on sales of third-party financing and insurance products, visitor fees at the Tampa campground and food facilities, and miscellaneous revenues. During the years ended December 31, 2019 and 2018, the Company derived its revenues from these categories in the following percentages: New and pre-owned RV sales accounted for approximately 88% and 89% of total revenues for the years ended December 31, 2019 and 2018. These revenue contributions have remained relatively consistent year over year. Key Performance Indicators Gross Profit and Gross Margins (excluding depreciation and amortization). Gross profit is total revenue less total costs applicable to revenue excluding depreciation and amortization. The vast majority of the cost applicable to revenues is related to the cost of vehicles. New and pre-owned vehicles have accounted for 96% and 97% of the cost of revenues for the years ended December 31, 2019 and 2018, respectively. Gross margin is gross profit as a percentage of revenue. The Company’s gross profit is variable in nature and generally follows changes in revenue. For the years ended December 31, 2019 and 2018, gross profit was $132.2 million and $131.7 million, respectively, and gross margin was 20.5% and 21.6% for the years then ended. Last-in, first-out (“LIFO”) adjustments did not have a material impact on the variance in the Company’s gross margin during the periods presented. The margin decreases were driven by reduced per vehicle margins due to competitive pricing in the industry, primarily during the second half of 2019. During the years ended December 31, 2019 and 2018, gross margins were also impacted by other revenue, including finance and insurance revenues and parts, service, and accessories revenue. The Company’s margins on these lines of business typically carry higher gross margin percentages than new and pre-owned vehicle sales. These combined revenues were 12.0% and 11.5%, respectively, of total revenues during the years ended December 31, 2019 and 2018. SG&A as a percentage of Gross Profit. Selling, general and administrative (“SG&A”) expenses as a percentage of gross profit allows the Company to monitor its expense control over a period of time. SG&A consists primarily of wage-related expenses, selling expenses related to commissions and advertising, lease expenses and corporate overhead expenses. Historically, salaries, commissions and benefits represent the largest component of the Company’s total selling, general and administrative expense and averages approximately 50-53% of selling, general and administrative expenses, stock-based compensation, depreciation and amortization, and transaction costs. During the years ended December 31, 2019 and December 31, 2018, salaries, commissions, and benefits represented 50% and 53%, respectively, of these operating expenses. The Company calculates SG&A expenses as a percentage of gross profit by dividing SG&A expenses for the period by total gross profit. For the years ended December 31, 2019 and 2018, SG&A, excluding transaction costs, depreciation and amortization, and stock-based compensation expense as a percentage of gross profit was 78.0% and 73.5%, respectively. These increases are driven by the decreased gross margins discussed above as well as overhead associated with new dealerships. In addition, as the Company executes its growth strategy, the Company may acquire property, plant, and equipment and intangible assets, and the related depreciation and amortization expense may negatively impact our net income or loss in future periods. Adjusted EBITDA. Adjusted EBITDA is a not a U.S. Generally Accepted Accounting Principle (“GAAP”) financial measure, but it is one of the primary non-GAAP measures management uses to evaluate the financial performance of the business. Adjusted EBITDA is also frequently used by analysts, investors, and other interested parties to evaluate companies in the recreational vehicle industry. The Company uses Adjusted EBITDA and Adjusted EBITDA Margin to supplement GAAP measures of performance as follows: ● as a measurement of operating performance to assist in comparing the operating performance of the Company’s business on a consistent basis, and remove the impact of items not directly resulting from the Company’s core operations; ● for planning purposes, including the preparation of the Company’s internal annual operating budget and financial projections; ● to evaluate the performance and effectiveness of the Company’s operational strategies; and ● to evaluate the Company’s capacity to fund capital expenditures and expand the business. The Company defines Adjusted EBITDA as net income (loss) excluding depreciation and amortization of property and equipment, non-floor plan interest expense, amortization of intangible assets, income tax expense, stock-based compensation, transaction costs and other supplemental adjustments which for the periods presented includes LIFO adjustments, severance costs and other one-time charges and gain on sale of property and equipment. The Company believes Adjusted EBITDA, when considered along with other performance measures, is a useful measure as it reflects certain operating drivers of the business, such as sales growth, operating costs, selling and administrative expense and other operating income and expense. The Company believes Adjusted EBITDA can provide a more complete understanding of the underlying operating results and trends and an enhanced overall understanding of financial performance and prospects for the future. While Adjusted EBITDA is not a recognized measure under GAAP, management uses this financial measure to evaluate and forecast business performance. Adjusted EBITDA is not intended to be a measure of liquidity or cash flows from operations, or a measure comparable to net income as it does not take into account certain requirements such as non-recurring gains and losses which are not deemed to be a normal part of the underlying business activities. The Company’s use of Adjusted EBITDA may not be comparable to other companies within the industry. The Company compensates for these limitations by using Adjusted EBITDA as only one of several measures for evaluating business performance. In addition, capital expenditures, which impact depreciation and amortization, interest expense, and income tax expense, are reviewed separately by management. The Company’s measure of Adjusted EBITDA is not necessarily comparable to similarly titled captions of other companies due to different methods of calculation. For a reconciliation of Adjusted EBITDA to net income (loss), a reconciliation of Adjusted EBITDA Margin to net (loss) income margin, and a further discussion of how the Company utilizes this non-GAAP financial measure, see “Non-GAAP Financial Measures” below. Results of Operations The following table sets forth information comparing the components of net loss for the years ended December 31, 2019 and 2018. Summary Financial Data (in thousands) Revenue Revenue increased by approximately $36.7 million, or 6.0%, to $644.9 million from $608.2 million for the years ended December 31, 2019 and 2018, respectively. New Vehicles and Pre-Owned Vehicles Revenue Revenue from new and pre-owned vehicles sales increased by approximately $29.0 million, or 5.4%, to $567.1 million from $538.1 million for the years ended December 31, 2019 and 2018, respectively. Revenue from new vehicle sales increased by approximately $19.6 million, or 5.9%, to $353.2 million from $333.6 million for the years ended December 31, 2019 and 2018, respectively. This was due to an increase in the number of new vehicle units sold from 4,319 to 4,652 which was driven by the acquisitions of three dealerships located in Tennessee, Minnesota, and The Villages, Florida (“New Locations”) since August 2018. This increase was offset by a decrease in the average unit selling price from $76,800 for the year ended December 31, 2018 as compared to $75,500 for the year ended December 31, 2019. Revenue from pre-owned vehicle sales increased by approximately $9.2 million, or 4.5%, to $213.8 million from $204.6 million for the years ended December 31, 2019 and 2018, respectively. This was due to a 38% increase in wholesale revenue. Excluding the effect of wholesale sales, additionally there was an increase in the average revenue per unit sold from approximately $64,900 in 2018 to $65,500 per unit in 2019, offset by a slight decrease in units sold from 2,977 to 2,939 in 2019. Other Revenue Other revenue consists of sales of parts, accessories, and related services. It also consists of finance and insurance revenues as well as campground and miscellaneous revenues. Other revenue increased by approximately $7.8 million, or 11.1%, to $77.9 million from $70.1 million for the years ended December 31, 2019 and 2018, respectively. As a component of other revenue, sales of parts, accessories and related services increased by approximately $4.7 million, or 15.2%, to $35.6 million from $30.9 million for the years ended December 31, 2019 and 2018, respectively, primarily due to the Company’s New Locations. Finance and insurance revenue increased by approximately $4.3 million, or 13.3%, to $36.7 million from $32.4 million for the years ended December 31, 2019 as compared to December 31, 2018, respectively, due to finance and insurance revenue at the Company’s New Locations. In addition, the Company has had improved penetration rates and per unit revenue on its finance and insurance products. Campground and other revenue, which includes RV rental revenue, campground, restaurant, and consignment revenue decreased by approximately $1.2 million, or 17.9%, to $5.5 million from $6.7 million for the year ended December 31, 2019 as compared to December 31, 2018, respectively. The decrease is primarily due to the Company phasing out its rental operations over 2019. Gross Profit (excluding depreciation and amortization) Gross profit consists of gross revenues less cost of sales and services and excludes depreciation and amortization. Gross profit increased by approximately $0.5 million, or 0.4%, to $132.2 million from $131.7 million for the years ended December 31, 2019 and 2018, respectively. This increase was due to increased sales related to the Company’s New Locations. Gross margin was 20.5% and 21.6% for the years ended December 31, 2019 and 2018, respectively. The decrease was due to competitive pricing on new vehicles during the second half of 2019, and a decline in pre-owned motorized sales. New and Pre-Owned Vehicles Gross Profit New and pre-owned vehicle gross profit decreased $2.6 million, or 3.3%, to $76.4 million from $79.0 million for the years ended December 31, 2019 and 2018, respectively. The decrease is primarily attributable to the decreased gross margin on new vehicles from late model year pricing competition. Other Gross Profit Other gross profit increased by $4.1 million, or 7.6% to $58.2 million from $54.1 million for the years ended December 31, 2019 and 2018 primarily due to increased finance and insurance revenues from the Company’s New Locations as well as increased penetration rates on the Company’s finance and insurance products. Selling, General and Administrative Expenses Selling, general, and administrative (“SG&A”) expenses, excluding transaction costs, stock-based compensation expense, and depreciation and amortization expense, increased 6.9% to $103.5 million during the year ended December 31, 2019, from $96.8 million during the year ended December 31, 2018. The increase in SG&A expenses was related to overhead associated with the New Locations acquired since August 2018. Stock-based compensation, a non-cash expense, decreased by $3.9 million as a result of the graded vesting of the awards with market conditions which were issued to members of management in 2018, with the majority of the expense being recorded in the early portion of the derived service period. Interest Expense Interest expense increased by approximately $0.3 million to $10.3 million from $10.0 million for the years ended December 31, 2019 and 2018, respectively. This was due to the increase in floor plan interest due to the increase in the outstanding floor plan balance from acquisitions. In addition, interest increased as a result of the interest expense from the sale leaseback transaction in Minnesota and notes payable associated with the acquisition of the New Locations since August 2018. Income Taxes Income tax expense decreased to $1.1 million during the year ended December 31, 2019 from income tax expense of $3.0 million during the same period of 2018, due to the decrease in book income. While book income decreased from December 31, 2018 to December 31, 2019, non-deductible expenses such as stock-based compensation resulted in significant increases to the Company’s effective tax rate. As book income approaches zero, the impact of each non-deductible item has a larger impact on the effective tax rate. Non-Gaap Financial Measures The Company uses certain non-GAAP financial measures, such as EBITDA and Adjusted EBITDA, to enable it to analyze its performance and financial condition, as described in “Key Performance Indicators”, above. The Company utilizes these financial measures to manage the business on a day-to-day basis and believes that they are relevant measures of performance. The Company believes that these supplemental measures are commonly used in the industry to measure performance. The Company believes these non-GAAP measures provide expanded insight to measure revenue and cost performance, in addition to the standard GAAP-based financial measures. The presentation of non-GAAP financial information should not be considered in isolation or as a substitute for, or superior to, the financial information prepared and presented in accordance with GAAP. You should read this discussion and analysis of the Company’s financial condition and results of operations together with the consolidated financial statements of the Company and the related notes thereto also included herein. EBITDA is defined as net income (loss) excluding depreciation and amortization of property and equipment, interest expense, net, amortization of intangible assets, and income tax expense. Adjusted EBITDA is defined as net income (loss) excluding depreciation and amortization of property and equipment, non-floor plan interest expense, amortization of intangible assets, income tax expense, stock-based compensation, transaction costs and other supplemental adjustments which for the periods presented includes LIFO adjustments, severance costs and other one time charges, and gain or loss on sale of property and equipment. Reconciliations from Net Income (Loss) per the Consolidated Statements of Operations to EBITDA and Adjusted EBITDA for the years ended December 31, 2019 and 2018 are shown in the tables below. During 2019, the Company retired the RV rental units and moved the rental units to used inventory for sale. Upon transfer to used inventory, the carrying value of these units was adjusted to market value for similar units acquired by the Company for resale. Note: Figures in the table may not recalculate exactly due to rounding. Liquidity and Capital Resources Cash Flow Summary Net Cash from Operating Activities The Company generated cash from operating activities of approximately $38.9 million during the year ended December 31, 2019, compared to cash used in operating activities of approximately $5.3 million for the year ended December 31, 2018. Net income increased by approximately $1.0 million for the year ended December 31, 2019 compared to the year ended December 31, 2018. Adjustments for non-cash expenses, included in net income, decreased $4.4 million to $14.0 million for the year ended December 31, 2019. During the year ended December 31, 2019, there was approximately $24.3 million of cash provided by changes in operating assets and liabilities as compared to $23.4 million of cash used due to changes in operating assets and liabilities during the year ended December 31, 2018. The fluctuations in assets and liabilities were primarily due to the decrease in inventory of $21.5 million during the year ended December 31, 2019, excluding the impact of the August 2019 acquisition in The Villages, Florida, as the Company managed same store inventories down from highs as of December 31, 2018. Net Cash from Investing Activities The Company used cash in investing activities of approximately $19.4 million during the year ended December 31, 2019, compared to approximately $96.6 million for the year ended December 31, 2018. During 2019, the company used net cash of approximately $2.6 million for the purchase of Alliance Coach, Inc. in The Villages, Florida. In addition, the Company made purchases of property and equipment of approximately $16.9 million which included land and development purchases near Houston, Texas and Nashville, Tennessee. During 2018, the Company used net cash of approximately $92.3 million for the acquisition of Lazy Days’ R.V. Center, Inc., Shorewood RV Center, and Tennessee RV. In addition, there were purchases of property and equipment of approximately $4.3 million. Net Cash from Financing Activities The Company used cash in financing activities of approximately $14.7 million during the year ended December 31, 2019, compared to net cash provided by financing activities of approximately $113.7 million for the year ended December 31, 2018. During the year ended December 31, 2019, the Company made net repayments on the M&T Floor Plan Line of Credit of $11.2 million. During the year ended December 31, 2018, the Company raised net proceeds of $90.4 million through the PIPE offering through the issuance of common stock, Series A Convertible Preferred Stock, and warrants. The Company paid dividends of $2.6 million during the year ended December 31, 2018 on the Series A Convertible Preferred Stock. During the year ended December 31, 2018, the Company also received net proceeds of approximately $20.0 million from the proceeds of a new term loan with M&T Bank which was offset by the repayment of approximately $8.8 million of long-term debt with Bank of America. During 2018, the Company repaid $2.2 million of the new term loan with M&T Bank. The Company also repaid $96.7 million in floor plan notes payable to Bank of America and received net proceeds of $123.6 million from the new floor plan loan with M&T Bank. The Company also made net repayments to Bank of America of $12.3 million during the Predecessor Period (as defined below) prior to the Merger. In addition, the Company entered into a new sales leaseback transaction which resulted in proceeds from the resulting financing liability of approximately $5.6 million. Funding Needs and Sources The Company has historically satisfied its liquidity needs through cash from operations and various borrowing arrangements. Cash requirements consist principally of scheduled payments of principal and interest on outstanding indebtedness (including indebtedness under its existing floor plan credit facility), the acquisition of inventory, capital expenditures, salary and sales commissions and lease expenses. The company expects that it has adequate cash on hand, cash from operations and borrowing capacity to meet it liquidity needs through 2020. As of December 31, 2019, the Company had liquidity of approximately $31.5 million in cash and had working capital of approximately $36.9 million. Capital expenditures include expenditures to extend the useful life of current facilities, purchases of new capital assets and construction, and to expand operations. For the years ended December 31, 2019 and 2018, the Company invested approximately $16.9 million and $4.3 million in capital expenditures, respectively. The Company maintains sizable inventory in order to meet the expectations of its customers and believes that it will continue to require working capital consistent with past experience. Historically, the Company has funded its operations with internally generated cash flow and borrowings. Changes in working capital are driven primarily by levels of business activity. The Company maintains a floor plan credit facility to finance its vehicle inventory. At times, the Company has made repayments on its existing floor plan credit facility using excess cash flow from operations. M&T Credit Facility On March 15, 2018, the Company replaced its existing debt agreements with Bank of America with a $200 million Senior Secured Credit Facility (the “M&T Facility”). The M&T Facility includes a $175 million M&T floor plan line of credit (“M&T Floor Plan Line of Credit”), a $20 million M&T term loan (“M&T Term Loan”), and a $5 million M&T revolver (“M&T Revolver”). The M&T Facility will mature on March 15, 2021. The M&T Facility requires the Company to meet certain financial covenants and is secured by substantially all of the assets of the Company. The M&T Floor Plan Line of Credit may be used to finance new vehicle inventory, but only $45.0 million may be used to finance pre-owned vehicle inventory and $4.5 million may be used to finance rental units. Principal becomes due upon the sale of the respective vehicle. The M&T Floor Plan Line of Credit shall accrue interest at either (a) the fluctuating 30-day London Interbank Offered Rate (“LIBOR”) rate plus an applicable margin which ranges from 2.00% to 2.30% based upon the Company’s total leverage ratio (as defined in the M&T Facility) or (b) the Base Rate plus an applicable margin ranging from 1.00% to 1.30% based upon the Company’s total leverage ratio (as defined in the M&T Facility). The Base Rate is defined in the agreement as the highest of M&T’s prime rate, the Federal Funds rate plus 0.50% or one-month LIBOR plus 1.00%. In addition, the Company will be charged for unused commitments at a rate of 0.15%. The M&T Term Loan will be repaid in equal monthly principal installments of $0.242 million plus accrued interest through the maturity date. At the maturity date, the Company will pay a principal balloon payment of $11.3 million plus any accrued interest. The M&T Term Loan shall bear interest at (a) LIBOR plus an applicable margin of 2.25% to 3.00% based on the total leverage ratio (as defined in the agreement) or (b) the Base Rate plus a margin of 1.25% to 2.00% based on the total leverage ratio (as defined in the agreement). The M&T Revolver allows the Company to draw up to $5.0 million. The M&T Revolver shall bear interest at (a) 30-day LIBOR plus an applicable margin of 2.25% to 3.00% based on the total leverage ratio (as defined in the M&T Facility) or (b) the Base Rate plus a margin of 1.25% to 2.00% based on the total leverage ratio (as defined in the M&T Facility). The M&T Revolver is also subject to the unused commitment fees at rates varying from 0.25% to 0.50% based on the total leverage ratio (as defined in the M&T Facility). As of December 31, 2019, there was $144.1 million outstanding under the M&T Floor Plan Line of Credit and $14.9 million outstanding under the M&T Term Loan. Off-Balance Sheet Arrangements As of December 31, 2019, there were no off-balance sheet arrangements as defined in Item 303(a)(4)(ii) of Regulation S-K. Inflation Although the Company cannot accurately anticipate the effect of inflation on its operations, it believes that inflation has not had, and is not likely in the foreseeable future to have, a material impact on its results of operations. Cyclicality Unit sales of RV vehicles historically have been cyclical, fluctuating with general economic cycles. During economic downturns, the RV retailing industry tends to experience similar periods of decline and recession as the general economy. The Company believes that the industry is influenced by general economic conditions and particularly by consumer confidence, the level of personal discretionary spending, fuel prices, interest rates and credit availability. Seasonality and Effects of Weather The Company’s operations generally experience modestly higher volumes of vehicle sales in the first half of each year due in part to consumer buying trends and the hospitable warm climate during the winter months at our largest location in Tampa, Florida. The Company’s largest RV dealership is located near Tampa, Florida, which is in close proximity to the Gulf of Mexico. A severe weather event, such as a hurricane, could cause severe damage to property and inventory and decrease the traffic to our dealerships. Although the Company believes that it has adequate insurance coverage, if the Company were to experience a catastrophic loss, the Company may exceed its policy limits, and/or may have difficulty obtaining similar insurance coverage in the future. Critical Accounting Policies and Estimates The Company prepares its consolidated financial statements in accordance with GAAP, and in doing so, it has to make estimates, assumptions and judgments affecting the reported amounts of assets, liabilities, revenues and expenses, as well as the related disclosure of contingent assets and liabilities. The Company bases its estimates, assumptions and judgments on historical experience and on various other factors it believes to be reasonable under the circumstances. Different assumptions and judgments would change estimates used in the preparation of the consolidated financial statements, which, in turn, could change the results from those reported. The Company evaluates its critical accounting estimates, assumptions and judgments on an ongoing basis. We believe that, of our significant accounting policies (see Note 2 of the financial statements included in this Form 10-K), the following policies are the most critical: Basis of Presentation Predecessor and Successor Periods As a result of the Mergers, Holdco is the acquirer for accounting purposes and Lazydays R.V. Center, Inc. is the acquiree and the accounting predecessor. The financial statement presentation distinguishes the results into two distinct periods, the period up to March 15, 2018 (the “Acquisition Date”) (“Predecessor Periods”) and the period including and after that date (the “Successor Period”). The Mergers were accounted for as a business combination using the acquisition method of accounting and the Successor Period financial statements reflect a new basis of accounting that is based on the fair value of the net assets acquired. As a result of the application of the acquisition method of accounting as of the effective time of the Transaction Merger, the accompanying consolidated financial statements include a black line division which indicates that the Predecessor and Successor reporting entities shown are presented on a different basis and are, therefore, not directly comparable. The historical financial information of Andina, which was a special purpose acquisition company prior to the business combination, has not been reflected in the Predecessor Period financial statements as these historical amounts have been considered immaterial. Accordingly, no other activity in the Company was reported in the Predecessor Period other than the activity of Lazydays RV. Use of Estimates in the Preparation of Financial Statements The preparation of financial statements in conformity with GAAP requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the consolidated financial statements and the reported amounts of revenues and expenses during the reporting period. Actual results could differ from those estimates. Significant estimates include the assumptions used in the valuation of the net assets acquired in business combinations, goodwill and other intangible assets, provision for charge-backs, inventory write-downs, the allowance for doubtful accounts and stock-based compensation. Revenue Recognition In May 2014, the Financial Accounting Standards Board (“FASB”) issued accounting standard updates which clarified principles for recognizing revenue arising from contracts with customers (Accounting Standards Codification (“ASC”) 606 (“ASC 606”). The core principle of the revenue standard is that an entity recognizes revenue to depict the transfer of promised goods or services to clients in an amount that reflects the consideration to which the entity expects to be entitled in exchange for those goods or services. The new guidance applies a five-step model for revenue measurement and recognition and also requires increased disclosures including the nature, amount, timing, and uncertainty of revenue and cash flows related to contracts with clients. The Company adopted the new revenue recognition standard at the beginning of the first quarter of fiscal 2019 using the modified retrospective method of adoption and applied the guidance to those contracts that were not completed as of December 31, 2018. Based on the evaluation, the Company did not identify customer contracts which will require different recognition under the new guidance. Revenues are recognized when control of the promised goods or services is transferred to the customers at the expected amount the Company is entitled to for such goods and services. Taxes collected on revenue producing transactions are excluded from revenue in the consolidated statements of operations. Revenue from the sale of vehicle contracts is recognized at a point in time on delivery, transfer of title and completion of financing arrangements. Revenue from the sale of parts, accessories, and related service is recognized as services and parts are delivered or as a customer approves elements of the completion of service. Revenue from the sale of parts, accessories, and related service is recognized in other revenue in the accompanying consolidated statements of operations. Revenue from the rental of vehicles is recognized pro rata over the period of the rental agreement. The rental agreements are generally short-term in nature. Revenue from rentals is included in other revenue in the accompanying consolidated statements of operations. Campground revenue is also recognized over the time period of use of the campground. The Company receives commissions from the sale of insurance and vehicle service contracts to customers. In addition, the Company arranges financing for customers through various financial institutions and receives commissions. The Company may be charged back (“charge-backs”) for financing fees, insurance or vehicle service contract commissions in the event of early termination of the contracts by the customers. The revenues from financing fees and commissions are recorded at the time of the sale of the vehicles and an estimated allowance for future charge-backs is established based on historical operating results and the termination provision of the applicable contracts. The estimates for future chargebacks require judgment by management, and as a result, there may be an element of risk associated with these revenue streams. Cumulative Redeemable Convertible Preferred Stock The Company’s Series A Preferred Stock (See Note 15 - Preferred Stock) is cumulative redeemable convertible preferred stock. Accordingly, it is classified as temporary equity and is shown net of issuance costs and the relative fair value of warrants issued in conjunction with the issuance of the Series A Preferred Stock. Unpaid preferred dividends are accumulated, compounded at each quarterly dividend date and presented within the carrying value of the Series A Preferred Stock until a dividend is declared by the Board of Directors. Stock Based Compensation The Company accounts for stock-based compensation for employees and directors in accordance with Accounting Standards Codification (“ASC”) 718, Compensation (“ASC 718”). ASC 718 requires all share-based payments to employees, including grants of employee stock options, to be recognized in the statement of operations based on their fair values. Under the provisions of ASC 718, stock-based compensation costs are measured at the grant date, based on the fair value of the award, and are recognized as expense over the employee’s requisite or derived service period. In accordance with ASC 718, excess tax benefits realized from the exercise of stock-based awards are classified as cash flows from operating activities. All excess tax benefits and tax deficiencies (including tax benefits of dividends on share-based payment awards) are recognized as income tax expense or benefit in the consolidated statements of operations.

<s>[INST] Forward Looking Statements Certain statements in this Annual Report on Form 10K (including but not limited to this Item 7 “Management’s Discussion and Analysis of Financial Condition and Results of Operations”) constitute “forwardlooking statements” within the meaning of the Private Securities Litigation Reform Act of 1995. All statements other than statements of historical facts included in this Annual Report on Form 10K, including, without limitation, statements regarding the Company’s future financial position, business strategy, budgets, projected costs and plans and objectives of management for future operations, are “forwardlooking” statements. Forwardlooking statements generally can be identified by the use of forwardlooking terminology such as “may,” “will,” “expect,” “anticipate,” “intend,” “plan,” “believe,” “seek,” “estimate” or “continue” or the negative of such words or variations of such words and similar expressions. These statements are not guarantees of future performance and involve certain risks, uncertainties and assumptions, which are difficult to predict. Therefore, actual outcomes and results may differ materially from what is expressed or forecasted in such forwardlooking statements and the Company can give no assurance that such forwardlooking statements will prove to be correct. Important factors that could cause actual results to differ materially from those expressed or implied by the forwardlooking statements, or “cautionary statements,” include, but are not limited to: The Company’s business is affected by the availability of financing to it and its customers; Fuel shortages, or high prices for fuel, could have a negative effect on the Company’s business; The Company’s success will depend to a significant extent on the well being, as well as the continued popularity and reputation for quality, of the Company’s manufacturers, particularly, Thor Industries, Inc., Tiffin Motorhomes, Winnebago Industries, Inc., and Forest River, Inc. Any change, nonrenewal, unfavorable renegotiation or termination of the Company’s supply arrangements for any reason could have a material adverse effect on product availability and cost and the Company’s financial performance. The Company’s business is impacted by general economic conditions in its markets, and ongoing economic and financial uncertainties may cause a decline in consumer spending that may adversely affect its business, financial condition and results of operations. The Company depends on its ability to attract and retain customers. Competition in the market for services, protection plans and products targeting the RV lifestyle or RV enthusiast could reduce the Company’s revenues and profitability. The Company’s expansion into new, unfamiliar markets presents increased risks that may prevent it from being profitable in these new markets. Delays in opening or acquiring new retail locations could have a material adverse effect on the Company’s business, financial condition and results of operations. Unforeseen expenses, difficulties, and delays encountered in connection with expansion through acquisitions could inhibit the Company’s growth and negatively impact its profitability. Failure to maintain the strength and value of the Company’s brands could have a material adverse effect on the Company’s business, financial condition and results of operations. The Company’s failure to successfully procure and manage its inventory to reflect consumer demand in a volatile market and anticipate changing consumer preferences and buying trends could have a material adverse effect on the Company’s business, financial condition and results of operations. The Company’s same store sales may fluctuate and may not be a meaningful indicator of future performance. The cyclical nature of the Company’s business has caused its sales and results of operations to fluctuate. These fluctuations may continue in the future, which could result in operating losses during downturns. The Company’s business is seasonal and this leads to fluctuations in sales and revenues. The Company’s business may be adversely affected by unfavorable conditions in its local markets, even if those conditions are not prominent nationally. The Company may not be able to satisfy its debt obligations upon the occurrence of a change in control under its credit facility. The Company’s ability to operate and expand its business and to respond to changing business and economic conditions will depend on the availability of adequate capital. The documentation governing the Company’s credit facility contain restrictive covenants that may impair the Company’s ability to access sufficient capital and operate its business. [/INST] Negative. </s>

Translate Bio, Inc.

2019-03-21

2018-12-31

Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations. You should read the following discussion and analysis of our financial condition and results of operations together with our audited consolidated financial statements and related notes appearing at the end of this Annual Report on Form 10-K. In addition to historical information, this discussion and analysis contains forward-looking statements that involve risks, uncertainties and assumptions. Our actual results may differ materially from those anticipated in these forward-looking statements as a result of certain factors. We discuss factors that we believe could cause or contribute to these differences below and at the end of this report, including those set forth under Item 1A. “Risk Factors” in this Annual Report on Form 10-K. Overview We are a clinical-stage messenger RNA, or mRNA, therapeutics company developing a new class of potentially transformative medicines to treat diseases caused by protein or gene dysfunction. Using our proprietary mRNA therapeutic platform, or MRT platform, we create mRNA that encodes functional proteins. We believe that the mRNA design, delivery and manufacturing capabilities of our MRT platform provide us with the most advanced platform for developing product candidates that deliver mRNA encoding functional proteins for therapeutic uses. Our mRNA is delivered to the target cell where the cell’s own machinery recognizes it and translates it, restoring or augmenting protein function to treat or prevent disease. We believe that our MRT platform is broadly applicable across multiple diseases in which the production of a desirable protein can have a therapeutic effect. We are initially focused on restoring the expression of intracellular and transmembrane proteins, areas that have eluded conventional protein therapeutics, in patients with genetic diseases where there is high unmet medical need. We are developing our lead MRT product candidate for the lung, MRT5005, for the treatment of cystic fibrosis, or CF. We are conducting a Phase 1/2 clinical trial to evaluate the safety and efficacy of MRT5005 and anticipate reporting interim data from this trial in the second half of 2019. We are developing our lead MRT product candidate for the liver, MRT5201, for the treatment of ornithine transcarbamylase, or OTC, deficiency. In December 2018, we submitted an investigational new drug application, or IND, for MRT5201, which the U.S. Food and Drug Administration, or FDA, has placed on clinical hold. The FDA is requiring additional preclinical toxicology data. We have identified the additional preclinical studies required, and plan to complete these studies and submit a response to the FDA in the fourth quarter of 2019. Additionally, we intend to leverage the broad applicability of our platform by identifying lead preclinical candidates for additional lung and liver disease targets, and through a collaboration with Sanofi Pasteur Inc., or Sanofi, the vaccines global business unit of Sanofi S.A., to develop infectious disease vaccines using mRNA technology for up to five infectious disease pathogens. We have several discovery-stage programs to identify additional potential mRNA therapeutic candidates. We believe that our MRT platform is distinct from other mRNA-based technologies and has the potential to provide clinical benefits by transforming life-threatening illnesses into manageable chronic conditions. Since our inception in 2011, we have devoted substantially all of our focus and financial resources to organizing and staffing our company, business planning, raising capital, acquiring or discovering product candidates and securing related intellectual property rights and conducting discovery, research and development activities for our programs. We do not have any products approved for sale and have not generated any revenue from product sales. On June 27, 2018, our registration statement on Form S-1 relating to our initial public offering of our common stock, or the IPO, was declared effective by the Securities and Exchange Commission, or SEC. In the IPO, which closed on July 2, 2018, we issued and sold 9,350,000 shares of common stock at a public offering price of $13.00 per share. On July 24, 2018, we issued and sold an additional 364,371 shares of common stock at a price of $13.00 per share pursuant to the exercise of the underwriters’ over-allotment option. The aggregate net proceeds we received from the IPO, inclusive of the proceeds from the over-allotment exercise, were $113.2 million after deducting underwriting discounts and commissions of $8.8 million and offering expenses of $4.3 million. Upon closing of the IPO, all 142,288,292 shares of our redeemable convertible preferred stock then outstanding converted into an aggregate of 25,612,109 shares of common stock. On June 8, 2018, we entered into a collaboration and license agreement, or the Sanofi Agreement, with Sanofi to develop mRNA vaccines for up to five infectious disease pathogens. The Sanofi Agreement became effective on July 9, 2018. Under the Sanofi Agreement, we and Sanofi will jointly conduct research and development activities to advance mRNA vaccines and mRNA vaccine platform development during a three-year research term, which may be extended by mutual agreement. We are eligible to receive up to $805.0 million in payments, which includes an upfront payment of $45.0 million, which we received in July 2018, certain development, regulatory and sales-related milestones across several vaccine targets, and option exercise fees if Sanofi exercises its option related to development of vaccines for additional pathogens. We are also eligible to receive tiered royalty payments associated with worldwide sales of the developed vaccines, if any. We have funded our operations primarily with proceeds from the sale of redeemable convertible preferred stock and the sale of bridge units, which ultimately converted into shares of our preferred stock, the proceeds from our IPO and an upfront payment received under the Sanofi Agreement. Through December 31, 2018, we had received net cash proceeds of $113.2 million from our IPO, net cash proceeds of $189.2 million from sales of our preferred stock and bridge units and $45.0 million in an upfront payment from Sanofi. Since our inception, we have incurred significant operating losses. Our ability to achieve profitability will depend heavily on the successful development and eventual commercialization of one or more of our current or future product candidates. Our net losses were $97.4 million and $66.4 million for the years ended December 31, 2018 and 2017, respectively. As of December 31, 2018, we had an accumulated deficit of $246.2 million. We expect to continue to incur significant expenses for at least the next several years as we advance our product candidates from discovery through preclinical development and clinical trials and seek regulatory approval of our product candidates. In addition, if we obtain marketing approval for any of our product candidates, we expect to incur significant commercialization expenses related to product manufacturing, marketing, sales and distribution. We may also incur expenses in connection with the in-licensing or acquisition of additional product candidates. As a result, we will need substantial additional funding to support our continuing operations and pursue our growth strategy. Until such time as we can generate significant revenue from product sales, if ever, we expect to finance our operations through the sale of equity, debt financings or other capital sources, including collaborations, strategic partnerships or marketing, distribution or licensing arrangements with third parties or grants from organizations and foundations. We may be unable to raise additional funds or enter into such other agreements or arrangements when needed on favorable terms, or at all. If we fail to raise capital or enter into such agreements as, and when, needed, we may have to significantly delay, scale back or discontinue the development and commercialization of one or more of our product candidates or delay our pursuit of potential in-licenses or acquisitions. Because of the numerous risks and uncertainties associated with product development, we are unable to predict the timing or amount of increased expenses or when or if we will be able to achieve or maintain profitability. Even if we are able to generate product sales, we may not become profitable. If we fail to become profitable or are unable to sustain profitability on a continuing basis, then we may be unable to continue our operations at planned levels and be forced to reduce or terminate our operations. As of December 31, 2018, we had cash, cash equivalents and short-term investments of $144.1 million. We believe that our existing cash, cash equivalents and short-term investments will enable us to fund our operating expenses and capital expenditure requirements into the second quarter of 2020. In accordance with the requirements of Accounting Standards Update, or ASU, No. 2014-15, Disclosure of Uncertainties about an Entity’s Ability to Continue as a Going Concern (Subtopic 205-40), or ASC 205-40, we have determined that there is substantial doubt about our ability to continue as a going concern. The financial statements do not include any adjustments that might result from the outcome of this uncertainty. There is no assurance that we will be successful in obtaining additional financing on terms acceptable to us, if at all, nor is it considered probable under the accounting standards. As such, under the requirements of ASC 205-40, management may not consider the potential for future capital raises or management plans to reduce costs that are not considered probable in their assessment of our ability to meet our obligations. If we are unable to obtain funding, we may be required to delay, reduce or eliminate our product development or future commercialization efforts, or grant rights to develop and market product candidates that we would otherwise prefer to develop and market ourselves, which could adversely affect our business prospects, and we may be unable to continue operations. See “-Liquidity and Capital Resources-Funding Requirements.” Acquisition of MRT Program On December 22, 2016, we entered into an asset purchase agreement with Shire Human Genetic Therapies, Inc., or Shire, a subsidiary of Shire plc, which, as amended on June 7, 2018, we refer to as the Shire Agreement. Pursuant to the Shire Agreement, we acquired Shire’s mRNA therapy platform, or the MRT Program, for an aggregate purchase price of $112.2 million, consisting of 5,815,560 shares of common stock with an aggregate fair value of $41.1 million and contingent consideration with a fair value of $71.1 million on the acquisition date. The contingent consideration includes the obligation to issue additional shares of common stock to Shire in connection with the closing of subsequent equity financings required under the terms of the Shire Agreement, which had a fair value of $8.4 million on the acquisition date, as well as the obligation to make future milestone and earnout payments upon the occurrence of specified commercial milestones, which had a fair value of $62.7 million on the acquisition date. As of December 31, 2018, we have fully satisfied our obligation to issue shares of common stock to Shire under the Shire Agreement. Under the Shire Agreement, we are obligated to use commercially reasonable efforts to develop and seek and obtain regulatory approval for products that include or are composed of MRT compounds acquired from Shire, or MRT Products, and to achieve specific developmental milestones. In June 2017, we implemented a strategy to primarily devote our resources to the advancement of our MRT platform. Thereafter, we then devoted substantially fewer resources to the advancement of our oligonucleotide discovery program, which seeks to develop RNA-targeted product candidates that selectively upregulate gene expression to increase endogenous protein levels for therapeutic benefit. We expect to continue to primarily devote our resources to the advancement of our MRT platform for the foreseeable future. Components of Our Results of Operations Revenue from Product Sales To date, we have not generated any revenue from product sales, and we do not expect to generate any revenue from the sale of products in the near future. If our development efforts for our product candidates are successful and result in regulatory approval, we may generate revenue in the future from product sales. Collaboration Revenue In June 2018, we entered into the Sanofi Agreement, a collaboration and license agreement with Sanofi to develop mRNA vaccines and mRNA vaccine platform development for up to five infectious disease pathogens, or the Licensed Fields. The Sanofi Agreement became effective in July 2018. Under the terms of the Sanofi Agreement, we have granted to Sanofi exclusive, worldwide licenses under applicable patents, patent applications, know-how and materials, including those arising under the collaboration, to develop, commercialize and manufacture mRNA vaccines to prevent, treat or cure diseases, disorders or conditions in humans caused by any of three Licensed Fields. In addition, pursuant to the terms of the Sanofi Agreement and subject to certain limitations, Sanofi has options to add up to two additional infectious disease pathogens within the granted licenses to the Licensed Fields. Under revenue recognition guidance, we account for: (i) the license we conveyed to Sanofi with respect to the Licensed Fields, (ii) the licensed know-how to be conveyed to Sanofi with respect to the Licensed Fields, (iii) our obligations to perform research and development on the Licensed Fields, (iv) our obligation to transfer licensed materials to Sanofi, (v) our obligation to manufacture and supply certain non-clinical and clinical mRNA vaccines and materials containing mRNA until we transfer such manufacturing capabilities to Sanofi and (vi) the technology and process transfer as a single performance obligation. We recognize revenue using the cost-to-cost input method, which we believe best depicts the transfer of control to the customer. Under the cost-to-cost input method, the extent of progress towards completion is measured based on the ratio of actual costs incurred to the total estimated costs expected upon satisfying the identified performance obligation. Under this method, revenue is recorded as a percentage of the estimated transaction price based on the extent of progress towards completion. Operating Expenses Research and Development Expenses Research and development expenses consist primarily of costs incurred in connection with the discovery and development of our product candidates. We expense research and development costs as incurred. These expenses include: • employee-related expenses, including salaries, related benefits and stock-based compensation expense for employees engaged in research and development functions; • expenses incurred in connection with the preclinical and clinical development of our product candidates, including under agreements with third parties, such as consultants and contract research organizations, or CROs; • the cost of manufacturing drug products for use in our preclinical studies and clinical trials, including under agreements with third parties, such as consultants and contract manufacturing organizations, or CMOs; • laboratory supplies; • facilities, depreciation and other expenses, which include direct or allocated expenses for rent and maintenance of facilities and insurance; • costs to fulfill our obligations under the Sanofi Agreement; • costs related to compliance with regulatory requirements; and • payments made under third-party licensing agreements. We recognize external development costs based on an evaluation of the progress to completion of specific tasks using information provided to us by our service providers. Nonrefundable advance payments for goods or services to be received in the future for use in research and development activities are recorded as prepaid expenses. Such amounts are recognized as an expense when the services have been performed or the goods have been delivered, or when it is no longer expected that the goods will be delivered or the services rendered. Upfront payments, milestone payments (other than those deemed contingent consideration in a business combination) and annual maintenance fees under license agreements are expensed in the period in which they are incurred. Our direct research and development expenses are tracked on a program-by-program basis and consist primarily of external costs, such as fees paid to outside consultants, CROs, CMOs and central laboratories in connection with our preclinical development, process development, manufacturing and clinical development activities. Our direct research and development expenses by program also include costs of laboratory supplies incurred for each program as well as fees incurred under license agreements. We do not allocate employee costs or facility expenses, including depreciation or other indirect costs, to specific programs because these costs are deployed across multiple programs and, as such, are not separately classified. We use internal resources primarily to conduct our research and discovery and to manage our preclinical development, process development, manufacturing and clinical development activities. The table below summarizes our research and development expenses incurred by program: Research and development activities are central to our business model. Product candidates in later stages of clinical development generally have higher development costs than those in earlier stages, primarily due to the increased size and duration of later-stage clinical trials. As a result, we expect that our research and development expenses will increase substantially over the next several years as we conduct our clinical trials of MRT5005 for the treatment of patients with CF; conduct additional preclinical studies to support our IND for MRT5201, and if the FDA’s clinical hold is lifted, conduct clinical trials for MRT5201; conduct research and development activities to advance mRNA vaccines and develop an mRNA vaccine platform under the Sanofi Agreement; prepare regulatory filings for our product candidates; continue to discover and develop additional product candidates; and potentially advance product candidates from our MRT platform into later stages of clinical development. We expect to continue to devote a substantial portion of our resources to our MRT platform for the foreseeable future. The successful development and commercialization of our product candidates is highly uncertain. At this time, we cannot reasonably estimate or know the nature, timing and costs of the efforts that will be necessary to complete the preclinical and clinical development of any of our product candidates. This uncertainty is due to the numerous risks and uncertainties associated with product development and commercialization, including the uncertainty of: • the timing and progress of preclinical and clinical development activities; • the number and scope of preclinical and clinical programs we decide to pursue; • our ability to maintain our current research and development programs and to establish new ones; • establishing an appropriate safety profile with IND-enabling studies; • successful patient enrollment in, and the initiation and completion of, clinical trials; • the successful completion of clinical trials with safety, tolerability and efficacy profiles that are satisfactory to the FDA or any comparable foreign regulatory authority; • the receipt of regulatory approvals from applicable regulatory authorities; • the timing, receipt and terms of any marketing approvals from applicable regulatory authorities; • our ability to establish new licensing or collaboration arrangements; • the success of our collaboration with Sanofi; • the performance of our future collaborators, if any; • establishing commercial manufacturing capabilities or making arrangements with third-party manufacturers; • development and timely delivery of commercial-grade drug formulations that can be used in our clinical trials and for commercial launch; • obtaining, maintaining, defending and enforcing patent claims and other intellectual property rights; • launching commercial sales of our product candidates, if approved, whether alone or in collaboration with others; and • maintaining a continued acceptable safety profile of the product candidates following approval. Any changes in the outcome of any of these variables with respect to the development of our product candidates in preclinical and clinical development could mean a significant change in the costs and timing associated with the development of these product candidates. For example, in December 2018, we submitted an IND to the FDA supporting the initiation of a Phase 1/2 clinical trial for MRT5201 in patients with OTC deficiency. Subsequently, the FDA notified us that our IND for MRT5201 was placed on clinical hold. In addition, if the FDA or another regulatory authority were to delay our planned start of clinical trials or require us to conduct clinical trials or other testing beyond those that we currently expect, or if we experience significant delays in enrollment in any of our planned clinical trials, we could be required to expend significant additional financial resources and time to complete clinical development of that product candidate. We may never obtain regulatory approval for any of our product candidates. Drug commercialization will take several years and millions of dollars in development costs. General and Administrative Expenses General and administrative expenses consist primarily of salaries, related benefits and stock-based compensation expense for personnel in executive, finance and administrative functions. General and administrative expenses also include facilities, depreciation and other expenses, which include direct or allocated expenses for rent and maintenance of facilities and insurance, as well as professional fees for legal, patent, consulting, investor and public relations, accounting and audit services. We anticipate that our general and administrative expenses will increase compared to 2018 as we anticipate increased accounting, audit, legal, regulatory, compliance, director and officer insurance and investor and public relations costs associated with being a public company. Change in Fair Value of Contingent Consideration In connection with our acquisition of the MRT Program, we recognized contingent consideration liabilities for future potential milestone and earnout payment obligations and, prior to the IPO, anti-dilution rights with respect to common stock issued to Shire. The contingent consideration was initially recorded at fair value on the acquisition date and is subsequently remeasured to fair value at each reporting date. Any changes in the fair value of the contingent consideration liabilities are recognized as operating income or expenses. Other Income (Expense), Net Interest Income Interest income consists of income recognized in connection with our investments in money market funds and U.S. government agency bonds. Other Income (Expense), Net Other income (expense), net consists of miscellaneous income and expense unrelated to our core operations. Income Taxes On December 22, 2017, the U.S. government enacted the Tax Cuts and Jobs Act, or the Tax Act. The Tax Act includes a number of changes to existing tax law, including, among other things, a permanent reduction in the federal corporate income tax rate from a top marginal rate of 35% to a flat rate of 21%, effective as of January 1, 2018, as well as limitation of the deduction for net operating losses to 80% of annual taxable income and elimination of net operating loss carrybacks. We recognized an income tax benefit of $5.6 million and $12.5 million during the years ended December 31, 2018 and 2017, respectively. The $5.6 million income tax benefit recognized during the year ended December 31, 2018, resulted from a reduction in the deferred tax liabilities recorded as part of our acquisition of the MRT Program. The $12.5 million income tax benefit recognized during the year ended December 31, 2017 consisted of (i) a $6.4 million benefit due to a reduction of the same amount in the deferred tax liabilities recorded as part of our acquisition of the MRT Program and (ii) a $6.1 million benefit resulting from the impact of the Tax Act. During 2017, we recorded tax charges for the impact of the Tax Act effects using the current available information and technical guidance on the interpretations of the Tax Act. As permitted by the SEC Staff Accounting Bulletin 118, Income Tax Accounting Implications of the Tax Cuts and Jobs Act, we recorded provisional estimates and have subsequently finalized our accounting analysis based on the guidance, interpretations and data available as of December 31, 2018 with no material changes to our initial estimates. As of December 31, 2018, we had U.S. federal net operating loss carryforwards of $190.8 million, of which $122.1 million will, if not utilized, begin to expire in 2031. As of December 31, 2018, we had U.S. state net operating loss carryforwards of $171.7 million, which will, if not utilized, begin to expire in 2031. As of December 31, 2018, we also had U.S. federal and state research and development tax credit carryforwards of $5.1 million and $2.0 million, respectively, which will, if not utilized, begin to expire in 2032 and 2028, respectively, and orphan drug tax credit carryforwards of $6.6 million, which begin to expire in 2037. We also have state investment tax credit carryforwards of $0.4 million, which will, if not utilized, begin to expire in 2019. As of December 31, 2018, we recorded a full valuation allowance against our deferred tax assets, except for $0.8 million related primarily to indefinite-lived net operating loss carryforwards. As of December 31, 2017, we recorded a full valuation allowance against our deferred tax assets, except for $2.4 million of deferred tax assets related to deductible temporary differences that will generate unlimited net operating loss carryforwards when they reverse in future periods. Results of Operations Comparison of the Years Ended December 31, 2018 and 2017 The following table summarizes our results of operations for the years ended December 31, 2018 and 2017: Collaboration Revenue Collaboration revenue was $1.4 million for the year ended December 31, 2018, which was derived from the Sanofi Agreement. There was no collaboration revenue recognized in the year ended December 31, 2017. Research and Development Expenses Research and development expenses were $58.0 million for the year ended December 31, 2018, compared to $47.0 million for the year ended December 31, 2017. The increase of $11.0 million was primarily due to increases in external research and development service costs resulting from the continued development of our CF and OTC deficiency programs, an increase in spending on our MRT discovery program as well as an increase in personnel-related costs, partially offset by a decrease in our oligonucleotide discovery program. Direct expenses of our CF program increased by $2.6 million in the year ended December 31, 2018 compared to the year ended December 31, 2017 primarily due to increased clinical trial costs related to our Phase 1/2 clinical trial of MRT5005 for the treatment of patients with CF as well as increased manufacturing and raw material costs. Direct expenses of our OTC deficiency program increased by $2.0 million in the year ended December 31, 2018 compared to the year ended December 31, 2017 primarily due to increased manufacturing activities as well as the initial costs of CROs to conduct our planned Phase 1/2 clinical trial of MRT5201 for the treatment of patients with OTC deficiency, which was placed on clinical hold in January 2019 while we conduct additional preclinical studies. Direct expenses of our MRT discovery program increased by $3.6 million in the year ended December 31, 2018 compared to the year ended December 31, 2017 primarily due to increased costs related to our ongoing exploratory research in the program. Direct expenses of our vaccine discovery program increased by $0.4 million in the year ended December 31, 2018 compared to the year ended December 31, 2017 as a result of the Sanofi Agreement which became effective in July 2018. The expenses in the year ended December 31, 2018 were related to our exploratory research in the program. Direct expenses of our oligonucleotide discovery program decreased by $2.4 million in the year ended December 31, 2018 compared to the year ended December 31, 2017 due to a shift in our focus from the oligonucleotide discovery program to our MRT platform in June 2017. Unallocated research and development expenses increased by $4.8 million in the year ended December 31, 2018 compared to the year ended December 31, 2017. The increase of $3.3 million in personnel-related costs was primarily due to an increase in stock-based compensation expense, resulting from options granted during the years ended December 31, 2018 and 2017. Additionally, there was an increase in headcount during the year ended December 31, 2018 compared to the same period in 2017. The increase of $1.4 million in other unallocated research and development expenses was primarily due to a $0.7 million payment owed to the Massachusetts Institute of Technology, or MIT, as its share of sublicense income with respect to the upfront payment received under the Sanofi Agreement and $0.4 million of amortization expense recorded in the year ended December 31, 2018 related to the definite-lived in-process research and development, or IPR&D, MRT intangible asset. Upon commencement of the Sanofi Agreement, the IPR&D - MRT intangible asset was reclassified from indefinite-lived to definite-lived intangible assets and we began amortization of this intangible asset. General and Administrative Expenses General and administrative expenses were $22.6 million for the year ended December 31, 2018, compared to $14.3 million for the year ended December 31, 2017. The increase of $8.3 million was primarily due to increases of $3.7 million in personnel-related costs, $2.0 million in professional fees, $0.7 million in depreciation expense and $0.6 million in insurance costs. The $3.7 million increase in personnel-related costs was primarily due to an increase in stock-based compensation expense, resulting from options granted during the years ended December 31, 2018 and 2017, as well as an increase in headcount in the year ended December 31, 2018 compared to the same period in 2017. The $2.0 million increase in professional fees was due to an increase in legal fees primarily associated with filing patent applications and prosecuting our intellectual property portfolio. The $0.7 million increase in depreciation expense was primarily due to the acceleration of unamortized leasehold improvements related to the real estate lease we acquired in connection with our acquisition of the MRT Program in December 2016 which we surrendered in June 2018. The $0.6 million increase in insurance costs was a result of additional insurance coverage associated with operating as a public company. Change in Fair Value of Contingent Consideration In the years ended December 31, 2018 and 2017, we recognized operating expenses of $25.0 million and $17.9 million, respectively, for changes in the fair value of the contingent consideration liabilities we recorded in connection with our acquisition of the MRT Program in December 2016. The contingent consideration liabilities relate to future potential milestone and earnout payment obligations and, prior to the IPO, anti-dilution rights with respect to common stock issued to Shire. The $7.1 million increase in the expense was attributed primarily to an increase in the fair value of the contingent consideration liability for future earnout payments that could be due. The increase in the fair value of contingent consideration during the year ended December 31, 2018 was primarily due to the continued progress of MRT5005, including the initiation in May 2018 of our Phase 1/2 clinical trial of MRT5005 for the treatment of patients with CF, the continued advancement of MRT5201 for the treatment of patients with OTC deficiency, the IND for which has been placed on clinical hold by the FDA, the time value of money due to the passage of time, as well as a decrease in the discount rate. Benefit from Income Taxes During the years ended December 31, 2018 and 2017, we recognized income tax benefits of $5.6 million and $12.5 million, respectively. The $5.6 million income tax benefit recognized during the year ended December 31, 2018, resulted from a reduction in the deferred tax liabilities recorded as part of our acquisition of the MRT Program. The $12.5 million income tax benefit recognized during the year ended December 31, 2017 consisted of (i) a $6.4 million benefit due to a reduction of the same amount in the deferred tax liabilities recorded as part of our acquisition of the MRT Program and (ii) a $6.1 million benefit resulting from the impact of the Tax Act. Liquidity and Capital Resources Since our inception, we have not generated any revenue from product sales, generated limited revenue from the Sanofi Agreement and have incurred significant operating losses and negative cash flows from our operations. We have not yet commercialized any of our product candidates, and we do not expect to generate revenue from sales of any product candidates for several years, if at all. See “-Funding Requirements” and Note 1 to the consolidated financial statements appearing at the end of this Annual Report on Form 10-K for a further discussion of our liquidity and the conditions and events that raise substantial doubt regarding our ability to continue as a going concern. We have funded our operations primarily with proceeds from the sale of redeemable convertible preferred stock and the sale of bridge units, which ultimately converted into shares of our preferred stock, the proceeds from our IPO and an upfront payment received under the Sanofi Agreement. Through December 31, 2018, we had received net cash proceeds of $113.2 million from our IPO, net cash proceeds of $189.2 million from sales of our preferred stock and bridge units and $45.0 million in an upfront payment from Sanofi. On June 27, 2018, our registration statement on Form S-1 relating to our IPO was declared effective by the SEC. In the IPO, which closed on July 2, 2018, we issued and sold 9,350,000 shares of common stock at a public offering price of $13.00 per share. On July 24, 2018, we issued and sold an additional 364,371 shares of common stock at a price of $13.00 per share pursuant to the exercise of the underwriters’ over-allotment option. The aggregate net proceeds we received from the IPO, inclusive of the proceeds from the over-allotment exercise, were $113.2 million after deducting underwriting discounts and commissions of $8.8 million and offering expenses of $4.3 million. Upon closing of the IPO, all 142,288,292 shares of our redeemable convertible preferred stock then outstanding converted into an aggregate of 25,612,109 shares of common stock. Cash Flows The following table summarizes our sources and uses of cash for each of the periods presented: Operating Activities During the year ended December 31, 2018, operating activities used $22.1 million of cash, resulting from our net loss of $97.4 million, partially offset by net cash provided by changes in our operating assets and liabilities of $45.6 million and net non-cash charges of $29.6 million. Net cash provided by changes in our operating assets and liabilities for the year ended December 31, 2018 included a $43.6 million increase in deferred revenue resulting from the $45.0 million received under Sanofi Agreement, which became effective in July 2018. Net non-cash charges for the year ended December 31, 2018 primarily consisted of a $25.0 million increase in the change in the fair value of contingent consideration which was primarily due to the continued progress of MRT5005, including the initiation in May 2018 of our Phase 1/2 clinical trial of MRT5005 for the treatment of patients with CF, the continued advancement of MRT5201 for the treatment of patients with OTC deficiency, the IND for which has been placed on clinical hold by the FDA, the time value of money due to the passage of time, as well as a decrease in the discount rate. During the year ended December 31, 2017, operating activities used $50.8 million of cash, resulting from our net loss of $66.4 million, partially offset by net non-cash charges of $10.6 million and net cash provided by changes in our operating assets and liabilities of $5.0 million. Net cash provided by changes in our operating assets and liabilities for the year ended December 31, 2017 consisted primarily of a $4.0 million increase in accounts payable, a $2.3 million increase in accrued expenses and a $1.0 million increase in deferred rent, all partially offset by a $2.3 million increase in prepaid expenses and other assets. The increases in accounts payable and accrued expenses were primarily due to the increases in research and development activities and costs associated with our MRT platform as well as personnel-related costs due to an increase in headcount in 2017 compared to 2016. The increase in prepaid expenses and other assets was primarily due to increased prepaid amounts paid to CMOs for manufacturing drug product materials and CROs for research contracts related to our MRT platform. The increase in deferred rent was due to a facilities lease we entered into in June 2017 for office and laboratory space in Lexington, Massachusetts. Investing Activities During the year ended December 31, 2018, net cash used in investing activities was $85.3 million, consisting of $136.7 million of purchases of short-term investments as well as $6.6 million of purchases of property and equipment, which primarily consisted of leasehold improvements and other property and equipment related to the lease of our new headquarters in Lexington, Massachusetts, partially offset by $58.0 million of sales and maturities of short-term investments. During the year ended December 31, 2017, net cash provided by investing activities was $0.3 million, consisting of $73.8 million of sales and maturities of short-term investments, partially offset by $70.8 million of purchases of short-term investments and $2.8 million of purchases of property and equipment. Financing Activities During the year ended December 31, 2018, net cash provided by financing activities was $113.6 million, consisting of, in part, net proceeds from our IPO, inclusive of the proceeds from the over-allotment exercise, of $113.3 million after deducting underwriting discounts and commissions and offering expenses. During the year ended December 31, 2017, net cash provided by financing activities was $41.7 million, consisting of gross proceeds of $42.0 million from our sale of Series C preferred stock in December 2017, net of $0.1 million of issuance costs, partially offset by $0.2 million of payments of initial public offering costs. Funding Requirements We expect our expenses to increase in connection with our ongoing activities, particularly as we continue the research and development of, continue ongoing and initiate new clinical trials of and seek marketing approval for our product candidates. In addition, we expect to incur additional costs associated with operating as a public company. Our expenses will also increase if, and as, we: • leverage our programs to advance our other product candidates into preclinical and clinical development; • seek regulatory approvals for any product candidates that successfully complete clinical trials; • seek to discover and develop additional product candidates; • establish a sales, marketing, medical affairs and distribution infrastructure to commercialize any product candidates for which we may obtain marketing approval and intend to commercialize on our own or jointly; • hire additional clinical, quality control and scientific personnel; • expand our operational, financial and management systems and increase personnel, including personnel to support our clinical development, manufacturing and commercialization efforts and our operations as a public company; • maintain, expand and protect our intellectual property portfolio; and • acquire or in-license other product candidates and technologies. We believe that our existing cash, cash equivalents and short-term investments of $144.1 million as of December 31, 2018 will enable us to fund our operating expenses and capital expenditure requirements into the second quarter of 2020. We have based this estimate on assumptions that may prove to be wrong, and we could exhaust our available capital resources sooner than we expect. In accordance with the requirements of ASC 205-40, based on our recurring losses and cash outflows from operations since inception, expectation of continuing operating losses and cash outflows from operations for the foreseeable future and the need to raise additional capital to finance our future operations, we have concluded that there is substantial doubt about our ability to continue as a going concern. The financial statements do not include any adjustments that might result from the outcome of this uncertainty. There is no assurance that we will be successful in obtaining additional financing on terms acceptable to us, if at all, nor is it considered probable under the accounting standards. As such, under the requirements of ASC 205-40, management may not consider the potential for future capital raises or management plans to reduce costs that are not considered probable in their assessment of our ability to meet our obligations. We will need to raise additional capital or incur indebtedness to continue to fund our operations in the future. Our ability to raise additional funds will depend on financial, economic and market conditions, many of which are outside of our control, and we may be unable to raise financing when needed, or on terms favorable to us. If we are unable to raise additional funds when needed, we may be required to delay, reduce or eliminate our product development or future commercialization efforts, or grant rights to develop and market product candidates that we would otherwise prefer to develop and market ourselves, which could adversely affect our business prospects, and we may be unable to continue our operations. Factors that may affect our planned future capital requirements and accelerate our need for additional working capital include the following: • the scope, progress, results and costs of researching and developing our product candidates, and conducting preclinical studies and clinical trials; • the costs, timing and outcome of regulatory review of our product candidates; • the costs of future activities, including product sales, medical affairs, marketing, manufacturing and distribution, for any of our product candidates for which we receive marketing approval; • the costs of manufacturing commercial-grade products and sufficient inventory to support commercial launch; • the ability to receive additional non-dilutive funding, including grants from organizations and foundations; • the revenue, if any, received from commercial sale of our products, should any of our product candidates receive marketing approval; • the cost and timing of hiring new employees to support our continued growth; • the costs of preparing, filing and prosecuting patent applications, maintaining and enforcing our intellectual property rights and defending intellectual property-related claims; • the ability to establish and maintain collaborations on favorable terms, if at all; • the extent to which we acquire or in-license other product candidates and technologies; and • the timing, receipt and amount of sales of, or milestone payments related to or royalties on, our current or future product candidates, if any. A change in the outcome of any of these or other variables with respect to the development of any of our product candidates could significantly change the costs and timing associated with the development of that product candidate. Further, our operating plans may change in the future, and we may need additional funds to meet operational needs and capital requirements associated with such operating plans. Until such time, if ever, as we can generate substantial product revenue, we expect to finance our cash needs through a combination of public or private equity offerings, debt financings, collaborations, strategic partnerships or marketing, distribution or licensing arrangements with third parties and grants from organizations and foundations. To the extent that we raise additional capital through the sale of equity or convertible debt securities, the ownership interests of our common stockholders may be materially diluted, and the terms of such securities could include liquidation or other preferences that could adversely affect the rights of our common stockholders. Debt financing and preferred equity financing, if available, may involve agreements that include restrictive covenants that limit our ability to take specified actions, such as incurring additional debt, making capital expenditures or declaring dividends. In addition, debt financing would result in increased fixed payment obligations. If we raise funds through collaborations, strategic partnerships or marketing, distribution or licensing arrangements with third parties, we may have to relinquish valuable rights to our technologies, future revenue streams, research programs or product candidates or grant licenses on terms that may not be favorable to us. Contractual Obligations and Commitments The following table summarizes our contractual obligations as of December 31, 2018 and the effects that such obligations are expected to have on our liquidity and cash flows in future periods: (1) Reflects minimum payments due under our operating lease for office and laboratory space, which expires April 2028. (2) Reflects minimum purchase commitments under a master supply agreement expiring in December 2024 with Roche Diagnostics Corporation, which we engaged to manufacture drug product materials. (3) Reflects sponsored research commitments under our research agreement with MIT, which expires October 2019. (4) Reflects the annual license maintenance fees payable under our license agreement with MIT. Amounts in the table represent reflect such fees payable through 2024, but we will be obligated to make such payments until the license agreement is terminated. In addition, under various licensing and related agreements to which we are a party, we may be required to make milestone and earnout payments and to pay royalties and other amounts to third parties. We have not included any such contingent payment obligations in the table above as the amount, timing and likelihood of such payments are not known. Such contingent payment obligations are described below. Under the Shire Agreement, as amended, we are obligated to make milestone payments to Shire of up to $60.0 million in the aggregate upon the occurrence of specified commercial milestones, including upon the first commercial sale of an MRT Product for the treatment of CF and upon the achievement of a specified level of annual net sales with respect to an MRT Product. We are also obligated to make additional milestone payments of $10.0 million for each non-CF MRT Product upon the first commercial sale of a non-CF MRT Product; provided that such milestone payments will only be due once for any two non-CF MRT Products that contain the same MRT compounds or once per non-CF MRT Product that is a vaccine developed under our collaboration with Sanofi. Under the Shire Agreement, we are also obligated to pay a quarterly earnout payment of a mid-single-digit percentage of net sales of each MRT Product. The earnout period, which is determined on a product-by-product and country-by-country basis, will begin on the date of the first commercial sale of such MRT Product in such country and will end on the later of (1) 10 years after such first commercial sale and (2) the expiration of the last valid claim of the patent rights acquired from Shire or derived from patent rights or know-how acquired from Shire covering such MRT Product in such country. We and Shire entered into an amendment to the asset purchase agreement on June 7, 2018 to align certain terms of the asset purchase agreement with the Sanofi Agreement, which we entered into with Sanofi on June 8, 2018. Under our license agreement with MIT, we are obligated to make milestone payments to MIT aggregating up to $1.375 million upon the achievement of specified clinical and regulatory milestones with respect to each licensed product and $1.250 million upon our first commercial sale of each licensed product, and to pay royalties of a low-single-digit percentage to MIT based on our, and any of our affiliates’ and sublicensees’, net sales of licensed products. The royalties are payable on a product-by-product and country-by-country basis, and may be reduced in specified circumstances. In addition, we are obligated to pay MIT a low-double-digit percentage of the portion of income from sublicensees that we ascribe to the MIT-licensed patents, excluding royalties on net sales and research support payments. In 2019, pursuant to such provision, we have agreed to pay $0.7 million to MIT as its share of sublicense income with respect to the upfront payment received under the Sanofi Agreement, which is included in accrued expenses in our consolidated balance sheet as of December 31, 2018. The amounts that we may owe to MIT will depend upon the relative value of the patents we licensed from MIT and sublicensed to Sanofi as compared to the other rights that we licensed to Sanofi. The determination of the relative value of such rights is subject to a process described in our license agreement with MIT. Under the Sanofi Agreement, we and Sanofi have agreed to collaborate to perform certain research and development activities to advance mRNA vaccines and mRNA vaccine platform development during a three-year research term, which may be extended by mutual agreement. Under the Sanofi Agreement, if we commercialize any product covered by a Sanofi patent right, we will be required to pay to Sanofi a royalty of a low-single-digit percentage. The amount, timing and likelihood of such payments are not known. We have entered into contracts in the normal course of business with CROs, CMOs and other third parties for preclinical research studies and testing, clinical trials and manufacturing services. These contracts do not contain any minimum purchase commitments and are cancelable by us upon prior notice and, as a result, are not included in the table of contractual obligations and commitments above. Payments due upon cancellation consist only of payments for services provided and expenses incurred, including non-cancelable obligations of our service providers, up to the date of cancellation. Critical Accounting Policies and Significant Judgments and Estimates Our consolidated financial statements are prepared in accordance with generally accepted accounting principles in the United States. The preparation of our consolidated financial statements and related disclosures requires us 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 base our estimates on historical experience, known trends and events and various other factors that we believe are reasonable under the circumstances, the results of which form the basis for making judgments about the carrying values of assets and liabilities that are not readily apparent from other sources. We evaluate our estimates and assumptions on an ongoing basis. Our actual results may differ from these estimates under different assumptions or conditions. While our significant accounting policies are described in more detail in Note 2 to our consolidated financial statements appearing at the end of this Annual Report on Form 10-K, we believe that the following accounting policies are those most critical to the judgments and estimates used in the preparation of our consolidated financial statements. Accrued Research and Development Expenses As part of the process of preparing our consolidated financial statements, we are required to estimate our accrued research and development expenses. This process involves reviewing open contracts and purchase orders, communicating with our personnel to identify services that have been performed on our behalf and estimating the level of service performed and the associated cost incurred for the service when we have not yet been invoiced or otherwise notified of actual costs. The majority of our service providers invoice us in arrears for services performed, on a pre-determined schedule or when contractual milestones are met; however, some require advance payments. We make estimates of our accrued expenses as of each balance sheet date in the consolidated financial statements based on facts and circumstances known to us at that time. We periodically confirm the accuracy of these estimates with the service providers and make adjustments, if necessary. Examples of estimated accrued research and development expenses include fees paid to: • vendors in connection with preclinical development activities; • CROs and investigative sites in connection with preclinical studies and clinical trials; and • CMOs in connection with the production of preclinical and clinical trial materials. We base our expenses related to external research and development services on our estimates of the services received and efforts expended pursuant to quotes and contracts with multiple CMOs and CROs that supply, conduct and manage preclinical studies and clinical trials on our behalf. The financial terms of these agreements are subject to negotiation, vary from contract to contract and may result in uneven payment flows. There may be instances in which payments made to our vendors will exceed the level of services provided and result in a prepayment of the expense. Payments under some of these contracts depend on factors such as the successful enrollment of patients and the completion of clinical trial milestones. In accruing service fees, we estimate the time period over which services will be performed and the level of effort to be expended in each period. If the actual timing of the performance of services or the level of effort varies from the estimate, we adjust the accrual or the amount of prepaid expenses accordingly. Although we do not expect our estimates to be materially different from amounts actually incurred, our understanding of the status and timing of services performed relative to the actual status and timing of services performed may vary and may result in reporting amounts that are too high or too low in any particular period. To date, there have not been any material adjustments to our prior estimates of accrued research and development expenses. Revenue Recognition The terms of our collaboration agreements may include consideration such as non-refundable license fees, funding of research and development services, payments due upon the achievement of clinical and pre-clinical performance-based development milestones, regulatory milestones, manufacturing services, sales-based milestones and royalties on product sales. We recognize revenue under Accounting Standards Codification 606, or ASC 606, Revenue from Contracts with Customers, which applies to all contracts with customers, except for contracts that are within the scope of other standards, such as leases, insurance, collaboration arrangements and financial instruments. ASC 606 provides a five-step framework whereby revenue is recognized when control of promised goods or services is transferred to a customer at an amount that reflects the consideration to which the entity expects to be entitled in exchange for those goods or services. To determine revenue recognition for arrangements that we determine are within the scope of the new revenue standard, we perform the following five steps: (i) identify the promised goods or services in the contract; (ii) determine whether the promised goods or services are performance obligations including whether they are distinct in the context of the contract; (iii) measure the transaction price, including the constraint on variable consideration; (iv) allocate the transaction price to the performance obligations; and (v) recognize revenue when (or as) we satisfy each performance obligation. We only apply the five-step model to contracts when collectability of the consideration to which we are entitled in exchange for the goods or services we transfer to the customer is determined to be probable. At contract inception, once the contract is determined to be within the scope of ASC 606, we assess whether the goods or services promised within each contract are distinct and, therefore, represent a separate performance obligation. Goods and services that are determined not to be distinct are combined with other promised goods and services until a distinct bundle is identified. We then allocate the transaction price (the amount of consideration we expect to be entitled to from a customer in exchange for the promised goods or services) to each performance obligation and recognize the associated revenue when (or as) each performance obligation is satisfied. Our estimate of the transaction price for each contract includes all variable consideration to which we expect to be entitled. We recognize the transaction price allocated to upfront license payments as revenue upon delivery of the license to the customer and resulting ability of the customer to use and benefit from the license, if the license is determined to be distinct from the other performance obligations identified in the contract. If the license is considered to not be distinct from other performance obligations, we utilize judgment to assess the nature of the combined performance obligation to determine whether the combined performance obligation is satisfied (i) at a point in time, but only for licenses determined to be distinct from other performance obligations in the contract, or (ii) over time; and, if over time, the appropriate method of measuring progress for purposes of recognizing revenue from license payments. We evaluate the measure of progress each reporting period and, if necessary, adjust the measure of performance and related revenue recognition. For each collaboration that includes development milestone payments, we evaluate whether it is probable that the consideration associated with each milestone will not be subject to a significant reversal in the cumulative amount of revenue recognized. Amounts that meet this threshold are included in the transaction price using the most likely amount method, whereas amounts that do not meet this threshold are considered constrained and excluded from the transaction price until they meet this threshold. Milestones tied to regulatory approval, and therefore not within our control, are considered constrained until such approval is received. Upfront and ongoing development milestones per our collaboration agreements are not subject to refund if the development activities are not successful. At the end of each subsequent reporting period, we re-evaluate the probability of a significant reversal of the cumulative revenue recognized for the milestones, and, if necessary, adjust the estimate of the overall transaction price. Any such adjustments are recorded on a cumulative catch-up basis, which would affect revenues from collaborators in the period of adjustment. We exclude sales-based milestone payments and royalties from the transaction price until the sale occurs (or, if later, until the underlying performance obligation to which some or all of the royalty has been allocated has been satisfied or partially satisfied), because the license to our intellectual property is deemed to be the predominant item to which the royalties relate as it is the primary driver of value. ASC 606 requires us to allocate the arrangement consideration on a relative standalone selling price basis for each performance obligation after determining the transaction price of the contract and identifying the performance obligations to which that amount should be allocated. The relative standalone selling price is defined in ASC 606 as the price at which an entity would sell a promised good or service separately to a customer. If other observable transactions in which we have sold the same performance obligation separately are not available, we are required to estimate the standalone selling price of each performance obligation. Key assumptions to determine the standalone selling price may include forecasted revenues, development timelines, reimbursement rates for personnel costs, discount rates and probabilities of technical and regulatory success. Whenever we determine that a contract should be accounted for as a combined performance obligation we will utilize the cost-to-cost input method. Revenue will be recognized over time using the cost-to-cost input method, based on the total estimated costs to fulfill the obligations. We will recognize revenue as services are being delivered. Significant management judgment is required in determining the level of effort required under an arrangement and the period over which we are expected to complete our performance obligations under an arrangement. We evaluate our collaborative agreements for proper classification in the consolidated statements of operations based on the nature of the underlying activity. Transactions between collaborators recorded in our consolidated statements of operations are recorded on either a gross or net basis, depending on the characteristics of the collaborative relationship. For revenue generating arrangements where we, as a vendor, provide consideration to a licensor or collaborator, as a customer, we apply the accounting standard that governs such transactions. This standard addresses the accounting for revenue arrangements where both the vendor and the customer make cash payments to each other for services and/or products. A payment to a customer is presumed to be a reduction of the transaction price unless we receive an identifiable benefit for the payment and we can reasonably estimate the fair value of the benefit received. Payments to a customer that are deemed a reduction of the transaction price are recorded first as a reduction of revenue, to the extent of both cumulative revenue recorded to date and probable future revenues, which include any unamortized deferred revenue balances, under all arrangements with such customer, and then as an expense. Payments that are not deemed to be a reduction of the transaction price are recorded as an expense. Consideration that does not meet the requirements to satisfy the above revenue recognition criteria is a contract liability and is recorded as deferred revenue in the consolidated balance sheets. Although we follow detailed guidelines in measuring revenue, certain judgments affect the application of our revenue policy. For example, in connection with the Sanofi Agreement, we have recorded short-term and long-term deferred revenue on our consolidated balance sheets based on our best estimate of when such revenue will be recognized. Short-term deferred revenue consists of amounts that are expected to be recognized as revenue in the next 12 months. Amounts that we expect will not be recognized within the next 12 months are classified as long-term deferred revenue. The estimate of deferred revenue also reflects management’s estimate of the periods of our involvement in certain of our collaborations. Our performance obligations under these collaborations consist of participation on steering committees and the performance of other research and development services. In certain instances, the timing of satisfying these obligations can be difficult to estimate. Accordingly, our estimates may change in the future. Such changes to estimates would result in a change in revenue recognition amounts. If these estimates and judgments change over the course of these agreements, it may affect the timing and amount of revenue that we will recognize and record in future periods. Under ASC 606, we will recognize revenue and record a receivable when we fulfill our performance obligations under the Sanofi Agreement. When no further performance obligation is required to be satisfied, we will recognize revenue for the portion satisfied and record a receivable. Amounts are recorded as accounts receivable when our right to consideration is unconditional. A contract liability is recognized when a customer prepays consideration or owes prepayment to an entity according to a contract. We do not assess whether a contract has a significant financing component if the expectation at contract inception is that the period between payment by the customer and the transfer of the promised goods or services to the customer will be one year or less. We expense incremental costs of obtaining a contract as and when incurred if the expected amortization period of the asset that we would have recognized is one year or less or the amount is immaterial. Business Combinations We accounted for our acquisition of the MRT Program as a business combination. We account for business combinations using the acquisition method of accounting. Application of this method of accounting requires that (1) identifiable assets acquired (including identifiable intangible assets) and liabilities assumed generally be measured and recognized at fair value as of the acquisition date and (2) the excess of the purchase price over the net fair value of identifiable assets acquired and liabilities assumed be recognized as goodwill, which is not amortized for accounting purposes but is subject to testing for impairment at least annually. Acquired IPR&D is recognized at fair value and initially characterized as an indefinite-lived intangible asset, irrespective of whether the acquired IPR&D has an alternative future use. Transaction costs related to business combinations are expensed as incurred. Determining the fair value of assets acquired and liabilities assumed in a business combination requires that we use significant judgment and estimates, especially with respect to intangible assets. Critical estimates in valuing certain identifiable assets include, but are not limited to, the selection of valuation methodologies, estimates of future revenue and cash flows, expected long-term market growth, future expected operating expenses, costs of capital and appropriate discount rates. Our estimates of fair value are based upon assumptions we believed to be reasonable, but which are inherently uncertain and, as a result, actual results may differ materially from estimates. During the measurement period, which extends no later than one year from the acquisition date, we may record certain adjustments to the carrying value of the assets acquired and liabilities assumed with the corresponding offset to goodwill. After the measurement period, all adjustments are recorded in the consolidated statements of operations as operating expenses or income. Valuation of Contingent Consideration Contingent consideration reflected on our consolidated balance sheets consists of liabilities for potential milestone and earnout payment obligations and anti-dilution rights recorded in connection with our acquisition of the MRT Program in December 2016. Contingent consideration is initially recognized at fair value at the acquisition date and is subsequently remeasured to fair value at each reporting date, with changes recorded in our consolidated statements of operations. Significant judgment is required in estimating fair value. Our estimates of fair value are based upon assumptions we believed to be reasonable, but which are inherently uncertain and, as a result, actual results may differ materially from estimates. The fair value of the contingent consideration related to the potential future milestone and earnout payments was estimated by us on the acquisition date and is estimated by us at each reporting date based, in part, on the results of a third-party valuation. The third-party valuation is prepared using a discounted cash flow analysis based on various assumptions, including the probability of achieving specified events, discount rates and the period of time until the earnout payments are payable and the conditions triggering the milestone payments are met. The fair value of the contingent consideration related to the anti-dilution rights was estimated by us on the acquisition date and was estimated by us at each reporting date based, in part, on the results of a third-party valuation. The third-party valuation was prepared using a probability-weighted expected return method, or PWERM, which considers as inputs the probability of occurrence of events that would trigger the issuance of additional shares, the expected timing of such events, the expected value of the contingently issuable equity upon the occurrence of a triggering event and a risk-adjusted discount rate. As a result of our IPO, we have fully satisfied our obligation to issue shares of common stock to Shire under the Shire Agreement and as a result there is no liability related to the anti-dilution rights as of December 31, 2018. Impairment of In-Process Research and Development IPR&D reflected on our consolidated balance sheets consists of indefinite- and definite-lived intangible assets recorded in connection with our acquisition of the MRT Program in December 2016. Indefinite-lived IPR&D is not subject to amortization, but is tested annually for impairment or more frequently if there are indicators of impairment. We test our indefinite-lived IPR&D annually for impairment on October 1st. In testing indefinite-lived IPR&D for impairment, we have the option to first assess qualitative factors to determine whether the existence of events or circumstances would indicate that it is more likely than not that its fair value is less than its carrying amount, or we can perform a quantitative impairment analysis to determine the fair value of the indefinite-lived IPR&D without performing a qualitative assessment. Qualitative factors that we consider include significant underperformance of the business in relation to expectations, significant negative industry or economic trends and significant changes or planned changes in the use of the assets. If we choose to first assess qualitative factors and we determine that it is more likely than not that the fair value of the indefinite-lived IPR&D is less than its carrying amount, we would then determine the fair value of the indefinite-lived IPR&D. Under either approach, if the fair value of the indefinite-lived IPR&D is less than its carrying amount, an impairment charge would be recognized for the difference between the fair value and the carrying amount in the consolidated statements of operations. Significant judgment is required in testing IPR&D for impairment, and changes in estimates and assumptions could materially affect the determination of whether impairment exists and, if so, the amount of that impairment. During the years ended December 31, 2018 and 2017, we did not recognize any impairment charges related to our indefinite-lived IPR&D. In December 2018, we submitted an IND to the FDA to support the initiation of a Phase 1/2 clinical trial for MRT5201 in patients with OTC deficiency. In January 2019, the FDA notified us that our IND for MRT5201 was placed on clinical hold. We determined this clinical hold was an indicator of impairment and as a result we retested the indefinite-lived IPR&D asset related to the OTC program for impairment. We performed a quantitative impairment analysis of the indefinite-lived IPR&D related to the OTC program and determined it was not impaired. Therefore, we did not recognize an impairment charge Impairment of Goodwill Goodwill reflected on our consolidated balance sheets consists of an intangible asset recorded in connection with our acquisition of the MRT Program in December 2016. Goodwill is not subject to amortization, but is tested annually for impairment or more frequently if there are indicators of impairment. We test our goodwill annually for impairment on October 1st. We have determined that there is a single reporting unit for purposes of testing goodwill for impairment. We have the option to first assess qualitative factors to determine whether the existence of events or circumstances would indicate that it is more likely than not that the fair value of the reporting unit was less than its carrying amount, or we can perform a two-step quantitative impairment analysis without performing a qualitative assessment. Examples of such events or circumstances considered in our qualitative assessment include, but are not limited to, a significant adverse change in legal or business climate, an adverse regulatory action or unanticipated competition. If we choose to first assess qualitative factors and we determine that it is more likely than not that the fair value of the reporting unit is less than its carrying amount, we would then perform a two-step quantitative impairment test. The two-step test starts with comparing the fair value of the reporting unit to the carrying amount of the reporting unit, including goodwill. If the fair value of the reporting unit exceeds the carrying amount, no impairment loss is recognized. However, if the fair value of the reporting unit is less than the carrying value, we must perform the second step of the impairment test to determine if goodwill is impaired. If we determine that goodwill is impaired, the carrying value of the goodwill is written down to its fair value and an impairment charge is recognized in the consolidated statements of operations. Significant judgment is required in testing goodwill for impairment, and changes in estimates and assumptions could materially affect the determination of whether impairment exists and, if so, the amount of that impairment. During the years ended December 31, 2018 and 2017, we did not recognize any impairment charges related to goodwill. Stock-Based Compensation We measure stock-based awards granted to employees and directors based on their fair value on the date of the grant and recognize compensation expense for those awards over the requisite service period, which is generally the vesting period of the respective award. For stock-based awards with service-based vesting conditions, we recognize compensation expense using the straight-line method. For stock-based awards with both performance-based and service-based vesting conditions, we recognize compensation expense using the graded-vesting method over the requisite service period, commencing when achievement of the performance condition becomes probable. We recognize adjustments to compensation expense for forfeitures as they occur. The fair value of each stock option grant is estimated on the date of grant using the Black-Scholes option-pricing model, which requires inputs based on certain subjective assumptions, including the expected stock price volatility, the expected term of the option, the risk-free interest rate for a period that approximates the expected term of the option, and our expected dividend yield. The fair value of each restricted common stock award is estimated on the date of grant based on the fair value of our common stock on that same date. Through December 31, 2018, for stock-based awards granted to non-employee consultants, we recognize compensation expense over the period during which services are rendered by such non-employee consultants until completed. At the end of each financial reporting period prior to completion of the service, the fair value of these awards is remeasured using the then-current fair value of our common stock and updated assumption inputs in the Black-Scholes option-pricing model. Determination of the Fair Value of Common Stock Prior to our IPO, there was no public market for our common stock. The estimated fair value of our common stock was determined by our board of directors as of the date of each option grant, with input from management, considering third-party valuations of our common stock as well as our board of directors’ assessment of additional objective and subjective factors that it believed were relevant and which may have changed from the date of the most recent third-party valuation to the date of the grant. These third-party valuations were performed in accordance with the guidance outlined in the American Institute of Certified Public Accountants’ Accounting and Valuation Guide, Valuation of Privately-Held-Company Equity Securities Issued as Compensation. Following the closing of our IPO, the fair value of our common stock is determined based on the quoted market price of our common stock. Emerging Growth Company Status The Jumpstart Our Business Startups Act of 2012 permits an “emerging growth company” such as us to take advantage of an extended transition period to comply with new or revised accounting standards applicable to public companies until those standards would otherwise apply to private companies. We have irrevocably elected to “opt out” of this provision and, as a result, we will comply with new or revised accounting standards when they are required to be adopted by public companies that are not emerging growth companies. Off-Balance Sheet Arrangements We did not have during the periods presented, and we do not currently have, any off-balance sheet arrangements, as defined in the rules and regulations of the SEC. Recently Issued Accounting Pronouncements A description of recently issued accounting pronouncements that may potentially impact our financial position and results of operations is disclosed in Note 2 to our consolidated financial statements appearing at the end of this Annual Report on Form 10-K.

<s>[INST] Overview We are a clinicalstage messenger RNA, or mRNA, therapeutics company developing a new class of potentially transformative medicines to treat diseases caused by protein or gene dysfunction. Using our proprietary mRNA therapeutic platform, or MRT platform, we create mRNA that encodes functional proteins. We believe that the mRNA design, delivery and manufacturing capabilities of our MRT platform provide us with the most advanced platform for developing product candidates that deliver mRNA encoding functional proteins for therapeutic uses. Our mRNA is delivered to the target cell where the cell’s own machinery recognizes it and translates it, restoring or augmenting protein function to treat or prevent disease. We believe that our MRT platform is broadly applicable across multiple diseases in which the production of a desirable protein can have a therapeutic effect. We are initially focused on restoring the expression of intracellular and transmembrane proteins, areas that have eluded conventional protein therapeutics, in patients with genetic diseases where there is high unmet medical need. We are developing our lead MRT product candidate for the lung, MRT5005, for the treatment of cystic fibrosis, or CF. We are conducting a Phase 1/2 clinical trial to evaluate the safety and efficacy of MRT5005 and anticipate reporting interim data from this trial in the second half of 2019. We are developing our lead MRT product candidate for the liver, MRT5201, for the treatment of ornithine transcarbamylase, or OTC, deficiency. In December 2018, we submitted an investigational new drug application, or IND, for MRT5201, which the U.S. Food and Drug Administration, or FDA, has placed on clinical hold. The FDA is requiring additional preclinical toxicology data. We have identified the additional preclinical studies required, and plan to complete these studies and submit a response to the FDA in the fourth quarter of 2019. Additionally, we intend to leverage the broad applicability of our platform by identifying lead preclinical candidates for additional lung and liver disease targets, and through a collaboration with Sanofi Pasteur Inc., or Sanofi, the vaccines global business unit of Sanofi S.A., to develop infectious disease vaccines using mRNA technology for up to five infectious disease pathogens. We have several discoverystage programs to identify additional potential mRNA therapeutic candidates. We believe that our MRT platform is distinct from other mRNAbased technologies and has the potential to provide clinical benefits by transforming lifethreatening illnesses into manageable chronic conditions. Since our inception in 2011, we have devoted substantially all of our focus and financial resources to organizing and staffing our company, business planning, raising capital, acquiring or discovering product candidates and securing related intellectual property rights and conducting discovery, research and development activities for our programs. We do not have any products approved for sale and have not generated any revenue from product sales. On June 27, 2018, our registration statement on Form S1 relating to our initial public offering of our common stock, or the IPO, was declared effective by the Securities and Exchange Commission, or SEC. In the IPO, which closed on July 2, 2018, we issued and sold 9,350,000 shares of common stock at a public offering price of $13.00 per share. On July 24, 2018, we issued and sold an additional 364,371 shares of common stock at a price of $13.00 per share pursuant to the exercise of the underwriters’ overallotment option. The aggregate net proceeds we received from the IPO, inclusive of the proceeds from the overallotment exercise, were $113.2 million after deducting underwriting discounts and commissions of $8.8 million and offering expenses of $4.3 million. Upon closing of the IPO, all 142,288,292 shares of our redeemable convertible preferred stock then outstanding converted into an aggregate of 25,612,109 shares of common stock. On June [/INST] Negative. </s>

Translate Bio, Inc.

2020-03-12

2019-12-31

Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations. You should read the following discussion and analysis of our financial condition and results of operations together with our audited consolidated financial statements and related notes appearing at the end of this Annual Report on Form 10-K. In addition to historical information, this discussion and analysis contains forward-looking statements that involve risks, uncertainties and assumptions. Our actual results may differ materially from those anticipated in these forward-looking statements as a result of certain factors. We discuss factors that we believe could cause or contribute to these differences below and at the end of this report, including those set forth under Item 1A. “Risk Factors” in this Annual Report on Form 10-K. Overview We are a clinical-stage messenger RNA, or mRNA, therapeutics company developing a new class of potentially transformative medicines to treat diseases caused by protein or gene dysfunction. Using our proprietary mRNA therapeutic platform, or MRT platform, we create mRNA that encodes functional proteins. Our mRNA is designed to be delivered to the target cell where the cell’s own machinery recognizes it and translates it, restoring or augmenting protein function to treat or prevent disease. We believe that the mRNA design, delivery and manufacturing capabilities of our MRT platform provide us with the most advanced platform for developing product candidates that deliver mRNA encoding functional proteins for therapeutic uses. We believe that our MRT platform is broadly applicable across multiple diseases in which the production of a desirable protein can have a therapeutic effect, with the potential to transform life-threatening illnesses into manageable chronic conditions. We are primarily focused on applying our MRT platform to treat pulmonary diseases caused by insufficient protein production or where production of proteins can modify disease. We also believe our technology is applicable to a broad range of diseases, including diseases that affect the liver. Additionally, our MRT platform may be applied to produce various classes of treatments, such as therapeutic antibodies or vaccines in areas such as infectious disease and oncology. We are developing MRT5005 for the treatment of cystic fibrosis, or CF. We believe MRT5005 is the first clinical-stage mRNA product candidate designed to deliver mRNA encoding fully functional cystic fibrosis transmembrane conductance regulator, or CFTR, protein to the lung. We have designed MRT5005 to be inhaled via a handheld nebulizer and to be administered in a once-weekly dose. Once the inhaled MRT5005 has entered the epithelial cells lining the patient’s lungs, our therapeutic mRNA uses the cells’ own machinery for translation and expression of fully functional CFTR protein, thereby restoring this essential ion channel, which we believe will address the pathology of CF directly. The U.S. Food and Drug Administration, or FDA, has granted both orphan drug and fast track designation for MRT5005 for the treatment of CF. We are conducting a Phase 1/2 clinical trial to evaluate the safety and tolerability of MRT5005. Percent predicted forced expiratory volume in one second, or ppFEV1, which is a well-defined and accepted endpoint measuring lung function, is also being measured at pre-defined timepoints throughout the trial. In April 2019, we completed dosing of patients in the single-ascending dose, or SAD, portion of the Phase 1/2 clinical trial and in July 2019, we reported interim data from the SAD portion of the clinical trial through one-month follow up post dosing. MRT5005 was generally well-tolerated at low and mid-dose levels with no serious adverse events reported at any dose level. Marked increases in ppFEV1 were observed after a single dose of MRT5005, primarily at the mid-dose level. Based on the analysis of the interim results, we have amended the clinical trial protocol to include one additional SAD dose group and two additional dose groups in the ongoing multiple-ascending dose, or MAD, portion of this trial. We began dosing patients in the MAD portion of this trial in early 2019. We expect to report data from the additional SAD dose group and the MAD portion of the clinical trial in the third quarter of 2020. We are leveraging our lung delivery platform and focusing our preclinical research efforts on identifying lead product candidates for a next-generation CF program, as well as beyond CF in additional pulmonary diseases with unmet medical need. Building upon the MRT5005 program’s success to date, we are exploring innovation in the MRT platform including novel lipid nanoparticles, protein engineering approaches and manufacturing process enhancements to identify next-generation CF candidates that can support expansion of our pipeline opportunities. Beyond CF, we have discovery efforts underway to identify lead product candidates in additional pulmonary diseases, including primary ciliary dyskinesia, pulmonary arterial hypertension and idiopathic pulmonary fibrosis. Additionally, we intend to leverage the broad applicability of our platform through a collaboration with Sanofi Pasteur Inc., or Sanofi, the vaccines global business unit of Sanofi S.A., to develop infectious disease vaccines using our mRNA technology for up to five infectious disease pathogens. We are conducting preclinical studies with lead candidates from our vaccine program to support an anticipated investigational new drug, or IND, filing in 2021. We have also begun to explore ways to leverage our delivery platform and expertise to apply different modalities to diseases where the knock-down/reduction or degradation of a protein would lead to therapeutic benefit, including small interfering RNA, or siRNA, or biological protein degradation. For example, in IPF, we are conducting preclinical studies to evaluate the delivery of siRNA and the resulting knock-down effect of a specific target of interest. In September 2019, we announced our decision to discontinue the development of MRT5201, a liver targeted treatment for ornithine transcarbamylase, or OTC, deficiency. Our decision to discontinue the development of MRT5201 for OTC deficiency was based on data from preclinical studies completed in 2019, the results of which did not support the desired pharmacokinetic and safety profile for advancement of the program. These data are related to the first-generation liver lipid nanoparticle, or LNP, designed to be delivered to the liver via intravenous administration from the program. As such, this LNP is different from that used in our CF and other pulmonary development programs, which are designed to deliver the LNP-encapsulated mRNA through nebulization. Since our inception in 2011, we have devoted substantially all of our focus and financial resources to organizing and staffing our company, business planning, raising capital, acquiring or discovering product candidates and securing related intellectual property rights and conducting discovery, research and development activities for our programs. We do not have any products approved for sale and have not generated any revenue from product sales. In 2018, we entered into a collaboration and license agreement with Sanofi, or the Sanofi Agreement, to develop mRNA vaccines for up to five infectious disease pathogens. Under the Sanofi Agreement, we and Sanofi are jointly conducting research and development activities to advance mRNA vaccines and mRNA vaccine platform development during a three-year research term, which may be extended by mutual agreement. We are eligible to receive up to $805.0 million in payments, including an upfront payment of $45.0 million, which we received in 2018, certain development, regulatory and sales-related milestones across several vaccine targets, and option exercise fees if Sanofi exercises its option related to development of vaccines for additional pathogens. We are also eligible to receive reimbursable development costs and tiered royalty payments associated with worldwide sales of the developed vaccines, if any. Through December 31, 2019, we have funded our operations primarily with net cash proceeds of $189.2 million from the sale of redeemable convertible preferred stock and the sale of bridge units, which ultimately converted into shares of our common stock, net cash proceeds of $113.2 million from our initial public offering of our common stock, or IPO, $45.0 million from the upfront payment received under the Sanofi Agreement, net cash proceeds of $44.1 million from a private placement of our common stock and net cash proceeds of $84.0 million from a public offering of our common stock. Since our inception, we have incurred significant operating losses. Our ability to achieve profitability will depend heavily on the successful development and eventual commercialization of one or more of our current or future product candidates. Our net losses were $113.3 million and $97.4 million for the years ended December 31, 2019 and 2018, respectively. As of December 31, 2019, we had an accumulated deficit of $359.5 million. We expect to continue to incur significant expenses for at least the next several years as we advance our product candidates from discovery through preclinical development and clinical trials and seek regulatory approval of our product candidates. In addition, if we obtain marketing approval for any of our product candidates, we expect to incur significant commercialization expenses related to product manufacturing, marketing, sales and distribution. We may also incur expenses in connection with the in-licensing or acquisition of additional product candidates. As a result, we will need substantial additional funding to support our continuing operations and pursue our growth strategy. Until such time as we can generate significant revenue from product sales, if ever, we expect to finance our operations through the sale of equity, debt financings or other capital sources, including collaborations, strategic partnerships or marketing, distribution or licensing arrangements with third parties or grants from organizations and foundations. We may be unable to raise additional funds or enter into such other agreements or arrangements when needed on favorable terms, or at all. If we fail to raise capital or enter into such agreements as, and when, needed, we may have to significantly delay, scale back or discontinue the development and commercialization of one or more of our product candidates or delay our pursuit of potential in-licenses or acquisitions. Because of the numerous risks and uncertainties associated with product development, we are unable to predict the timing or amount of increased expenses or when or if we will be able to achieve or maintain profitability. Even if we are able to generate product sales, we may not become profitable. If we fail to become profitable or are unable to sustain profitability on a continuing basis, then we may be unable to continue our operations at planned levels and be forced to reduce or terminate our operations. As of December 31, 2019, we had cash, cash equivalents and short-term investments of $188.7 million. We believe that our existing cash, cash equivalents and short-term investments will enable us to fund our operating expenses and capital expenditure requirements into the second quarter of 2021. In accordance with the requirements of Accounting Standards Update, or ASU, No. 2014-15, Disclosure of Uncertainties about an Entity’s Ability to Continue as a Going Concern (Accounting Standards Codification, or ASC, Subtopic 205-40), or ASC 205-40, we have determined that there is substantial doubt about our ability to continue as a going concern. The financial statements do not include any adjustments that might result from the outcome of this uncertainty. There is no assurance that we will be successful in obtaining additional financing on terms acceptable to us, if at all, nor is it considered probable under the accounting standards. As such, under the requirements of ASC 205-40, management may not consider the potential for future capital raises or management plans to reduce costs that are not considered probable in their assessment of our ability to meet our obligations. If we are unable to obtain funding, we may be required to delay, reduce or eliminate our product development or future commercialization efforts, or grant rights to develop and market product candidates that we would otherwise prefer to develop and market ourselves, which could adversely affect our business prospects, and we may be unable to continue operations. See “-Liquidity and Capital Resources-Funding Requirements.” Components of Our Results of Operations Revenue from Product Sales To date, we have not generated any revenue from product sales, and we do not expect to generate any revenue from the sale of products in the near future. If our development efforts for our product candidates are successful and result in regulatory approval, we may generate revenue in the future from product sales. Collaboration Revenue In 2018, we entered into the Sanofi Agreement to develop mRNA vaccines and mRNA vaccine platform development for up to five infectious disease pathogens, or the Licensed Fields. Under the terms of the Sanofi Agreement, we have granted to Sanofi exclusive, worldwide licenses under applicable patents, patent applications, know-how and materials, including those arising under the collaboration, to develop, commercialize and manufacture mRNA vaccines to prevent, treat or cure diseases, disorders or conditions in humans caused by any of three Licensed Fields. In addition, pursuant to the terms of the Sanofi Agreement and subject to certain limitations, Sanofi has the option to add up to two additional infectious disease pathogens within the granted licenses to the Licensed Fields. Under revenue recognition guidance, we account for: (i) the license we conveyed to Sanofi with respect to the Licensed Fields, (ii) the licensed know-how to be conveyed to Sanofi with respect to the Licensed Fields, (iii) our obligations to perform research and development on the Licensed Fields, (iv) our obligation to transfer licensed materials to Sanofi, (v) our obligation to manufacture and supply certain non-clinical and clinical mRNA vaccines and materials containing mRNA until we transfer such manufacturing capabilities to Sanofi and (vi) the technology and process transfer as a single performance obligation. We recognize revenue using the cost-to-cost input method, which we believe best depicts the transfer of control to the customer. Under the cost-to-cost input method, the extent of progress towards completion is measured based on the ratio of actual costs incurred to the total estimated costs expected upon satisfying the identified performance obligation. Under this method, revenue is recorded as a percentage of the estimated transaction price based on the extent of progress towards completion. Operating Expenses Research and Development Expenses Research and development expenses consist primarily of costs incurred in connection with the discovery and development of our product candidates. We expense research and development costs as incurred. These expenses include: • employee-related expenses, including salaries, related benefits and stock-based compensation expense for employees engaged in research and development functions; • expenses incurred in connection with the preclinical and clinical development of our product candidates, including under agreements with third parties, such as consultants and contract research organizations, or CROs; • the cost of manufacturing drug products for use in our preclinical studies and clinical trials, including under agreements with third parties, such as consultants and contract manufacturing organizations, or CMOs; • laboratory supplies; • facilities, depreciation and other expenses, which include direct or allocated expenses for rent and maintenance of facilities and insurance; • costs to fulfill our obligations under the Sanofi Agreement; • costs related to compliance with regulatory requirements; and • payments made under third-party licensing agreements. We recognize external development costs based on an evaluation of the progress to completion of specific tasks using information provided to us by our service providers. Nonrefundable advance payments for goods or services to be received in the future for use in research and development activities are recorded as prepaid expenses. Such amounts are recognized as an expense when the services have been performed or the goods have been delivered, or when it is no longer expected that the goods will be delivered or the services rendered. Upfront payments, milestone payments (other than those deemed contingent consideration in a business combination) and annual maintenance fees under license agreements are expensed in the period in which they are incurred. Our direct research and development expenses are tracked on a program-by-program basis and consist primarily of external costs, such as fees paid to outside consultants, CROs, CMOs and central laboratories in connection with our preclinical development, process development, manufacturing and clinical development activities. Our direct research and development expenses by program also include costs of laboratory supplies incurred for each program as well as fees incurred under license agreements. We do not allocate employee costs or facility expenses, including depreciation or other indirect costs, to specific programs because these costs are deployed across multiple programs and, as such, are not separately classified. We use internal resources primarily to conduct our research and discovery and to manage our preclinical development, process development, manufacturing and clinical development activities. The table below summarizes our direct research and development expenses incurred by program: Research and development activities are central to our business model. Product candidates in later stages of clinical development generally have higher development costs than those in earlier stages, primarily due to the increased size and duration of later-stage clinical trials. As a result, we expect that our research and development expenses will increase substantially over the next several years as we conduct our clinical trials of MRT5005 for the treatment of patients with CF; expand our manufacturing capabilities; conduct research and development activities to advance mRNA vaccines and develop an mRNA vaccine platform under the Sanofi Agreement; prepare regulatory filings for our product candidates; continue to discover and develop additional product candidates; and potentially advance product candidates from our MRT platform into later stages of clinical development. We expect to continue to devote a substantial portion of our resources to our MRT platform for the foreseeable future. In September 2019, we announced our decision to discontinue the development of MRT5201. We will not be investing any additional funds in this program and we have reallocated all resources previously dedicated to the OTC deficiency program to our other programs. The successful development and commercialization of our product candidates is highly uncertain. At this time, we cannot reasonably estimate or know the nature, timing and costs of the efforts that will be necessary to complete the preclinical and clinical development of any of our product candidates. This uncertainty is due to the numerous risks and uncertainties associated with product development and commercialization, including the uncertainty of: • the timing and progress of preclinical and clinical development activities; • the number and scope of preclinical and clinical programs we decide to pursue; • our ability to maintain our current research and development programs and to establish new ones; • establishing an appropriate safety profile with IND enabling studies; • successful patient enrollment in, and the initiation and completion of, clinical trials; • the successful completion of clinical trials with safety, tolerability and efficacy profiles that are satisfactory to the FDA or any comparable foreign regulatory authority; • the receipt of regulatory approvals from applicable regulatory authorities; • the timing, receipt and terms of any marketing approvals from applicable regulatory authorities; • our ability to establish new licensing or collaboration arrangements; • the success of our collaboration with Sanofi; • the performance of our future collaborators, if any; • establishing commercial manufacturing capabilities or making arrangements with third-party manufacturers; • development and timely delivery of commercial-grade drug formulations that can be used in our clinical trials and for commercial launch; • obtaining, maintaining, defending and enforcing patent claims and other intellectual property rights; • launching commercial sales of our product candidates, if approved, whether alone or in collaboration with others; and • maintaining a continued acceptable safety profile of the product candidates following approval. Any changes in the outcome of any of these variables with respect to the development of our product candidates in preclinical and clinical development could mean a significant change in the costs and timing associated with the development of these product candidates. For example, in September 2019, we announced our decision to discontinue the development of MRT5201. In addition, if the FDA or another regulatory authority were to delay our planned start of clinical trials or require us to conduct clinical trials or other testing beyond those that we currently expect, or if we experience significant delays in enrollment in any of our planned clinical trials, we could be required to expend significant additional financial resources and time to complete clinical development of that product candidate. We may never obtain regulatory approval for any of our product candidates. Drug commercialization will take several years and millions of dollars in development costs. General and Administrative Expenses General and administrative expenses consist primarily of salaries, related benefits and stock-based compensation expense for personnel in executive, finance and administrative functions. General and administrative expenses also include facilities, depreciation and other expenses, which include direct or allocated expenses for rent and maintenance of facilities and insurance, as well as professional fees for legal, patent, consulting, investor and public relations, accounting and audit services. We anticipate that our general and administrative expenses will increase over the next several years as we anticipate increased accounting, audit, legal, regulatory, compliance, director and officer insurance and investor and public relations costs associated with being a public company. Change in Fair Value of Contingent Consideration In connection with our acquisition of the messenger RNA therapeutic platform, or MRT Program, from Shire Human Genetic Therapies, Inc., or Shire, a subsidiary of Takeda Pharmaceutical Company Ltd., we recognized contingent consideration liabilities for future potential milestone and earnout payment obligations and, prior to the IPO, anti-dilution rights with respect to common stock issued to Shire. The contingent consideration was initially recorded at fair value on the acquisition date and is subsequently remeasured to fair value at each reporting date. Any changes in the fair value of the contingent consideration liabilities are recognized as operating income or expenses. Impairment of Intangible Asset In connection with our acquisition of the MRT Program, we recognized indefinite-lived in-process research and development, or IPR&D, which is not subject to amortization, but is tested annually for impairment or more frequently if there are indicators of impairment. Following the impairment test, if the fair value of the indefinite-lived IPR&D is less than its carrying amount, an impairment charge is recognized in the consolidated statements of operations. In September 2019, we announced our decision to discontinue the development of MRT5201, which we determined was an indicator of impairment. As a result, we retested the indefinite-lived IPR&D related to the OTC deficiency program for impairment. We determined that there was no residual value to the indefinite-lived IPR&D related to the OTC deficiency program and, as a result, recorded an impairment charge. Other Income (Expense), Net Interest Income Interest income consists of income recognized in connection with our investments in money market funds and U.S. government agency bonds. Other Income (Expense), Net Other income (expense), net consists of miscellaneous income and expense unrelated to our core operations. Income Taxes We recognized an income tax benefit of $0.5 million and $5.6 million during the years ended December 31, 2019 and 2018, respectively. The income tax benefit recognized for both years resulted from a reduction in the deferred tax liabilities recorded as part of our acquisition of the MRT Program. As of December 31, 2019, we had U.S. federal net operating loss carryforwards of $229.3 million, of which $122.1 million will, if not utilized, begin to expire in 2031. As of December 31, 2019, we had U.S. state net operating loss carryforwards of $210.6 million, which will, if not utilized, begin to expire in 2031. As of December 31, 2019, we also had U.S. federal and state research and development tax credit carryforwards of $6.5 million and $2.7 million, respectively, which will, if not utilized, begin to expire in 2032 and 2028, respectively, and orphan drug tax credit carryforwards of $13.0 million, which begin to expire in 2037. We also have state investment tax credit carryforwards of $0.3 million, which will, if not utilized, begin to expire in 2020. As of December 31, 2019, we recorded a full valuation allowance against our net deferred tax assets, except for the deferred tax asset associated with our alternative minimum tax credit carryforwards, which will be fully refundable. Results of Operations Comparison of the Years Ended December 31, 2019 and 2018 The following table summarizes our results of operations for the years ended December 31, 2019 and 2018: Collaboration Revenue Collaboration revenue was $7.8 million and $1.4 million for the years ended December 31, 2019 and 2018, respectively, which was derived from the Sanofi Agreement. The increase of $6.4 million was related to the advancement of the vaccine program during the year ended December 31, 2019 compared to the same period in 2018. Research and Development Expenses Research and development expenses were $76.4 million for the year ended December 31, 2019, compared to $58.0 million for the year ended December 31, 2018. The increase of $18.3 million was primarily due to increases in external research and development service costs resulting from costs incurred to conduct our Phase 1/2 clinical trial of MRT5005 for the treatment of patients with CF and the continued development of our MRT discovery and vaccine programs as well as an increase in personnel-related costs. Direct external expenses of our MRT5005 program increased by $11.9 million during the year ended December 31, 2019 compared to the year ended December 31, 2018 primarily due to increased raw material and manufacturing costs as well as increased costs related to our Phase 1/2 clinical trial of MRT5005 for the treatment of patients with CF. Direct external expenses of our MRT discovery program increased by $1.9 million during the year ended December 31, 2019 compared to the year ended December 31, 2018 primarily due to increased costs related to our ongoing exploratory research in the program. Direct external expenses of our MRT5201 program decreased by $4.0 million during the year ended December 31, 2019 compared to the year ended December 31, 2018. The decrease during the year ended December 31, 2019 was primarily due to reduced spending on preclinical development IND-enabling studies, partially offset by the initial costs of CROs to conduct our planned Phase 1/2 clinical trial of MRT5201 for the treatment of patients with OTC deficiency. In September 2019, we announced our decision to discontinue the development of MRT5201. We will not be investing any additional funds in this program. Direct external expenses of our vaccine program increased by $1.6 million during the year ended December 31, 2019 compared to the year ended December 31, 2018 primarily due to increased costs related to the advancement of the development programs associated with the Sanofi Agreement which became effective in July 2018. Unallocated research and development expenses increased by $6.8 million during the year ended December 31, 2019 compared to the year ended December 31, 2018. The increase of $3.9 million in personnel-related costs was primarily related to an increase in headcount during the year ended December 31, 2019 compared to the same period in 2018 as well as an increase in stock-based compensation expense, resulting from options granted during the year ended December 31, 2019. The increase of $2.9 million in other unallocated research and development expenses was due to an increase of $1.9 million in amortization expense related to the definite-lived MRT intangible asset, an increase of $1.1 million in professional fees related to manufacturing and an increase of $0.5 million in depreciation expense, partially offset by a decrease of $0.9 million in facilities costs. General and Administrative Expenses General and administrative expenses were $28.6 million for the year ended December 31, 2019, compared to $22.6 million for the year ended December 31, 2018. The increase of $6.0 million was primarily due to an increase of $4.2 million in personnel-related costs, an increase of $0.9 million in professional fees and an increase of $0.7 million in insurance costs. The increase in personnel-related costs was primarily due to an increase in stock-based compensation expense, resulting from options granted during the year ended December 31, 2019, as well as an increase in average headcount during the year ended December 31, 2019 compared to 2018. The increase in insurance costs was a result of additional insurance coverage associated with operating as a public company. The increase in professional fees was due to an increase in legal fees primarily associated with expanding and protecting our intellectual property portfolio as well as an increase in costs related to operating as a public company, partially offset by a decrease in consulting fees during the year ended December 31, 2018 for which there was no comparable expense in the same period in 2019. The decrease in depreciation expense was primarily due to the acceleration of unamortized leasehold improvements for a terminated lease in 2018. Change in Fair Value of Contingent Consideration During the years ended December 31, 2019 and 2018, we recognized operating expenses of less than $0.1 million and $25.0 million, respectively, for changes in the fair value of the contingent consideration liabilities we recorded in connection with our acquisition of the MRT Program in December 2016. The contingent consideration liabilities relate to future potential milestone and earnout payment obligations and, prior to the IPO, anti-dilution rights with respect to common stock issued to Shire. The expense recognized during the year ended December 31, 2019 was attributed primarily to an increase in the fair value of the contingent consideration liability for future earnout payments that could become due. The increase in the fair value of contingent consideration during the year ended December 31, 2019 was due to the continued progress of MRT5005, the time value of money due to the passage of time and a decrease in the discount rate, offset by a decrease due to a decision to discontinue the development of MRT5201 in September 2019, which resulted in the removal of the $23.2 million in contingent consideration liability related to this program. Impairment of Intangible Asset In September 2019, we discontinued development of MRT5201 which was an indicator of impairment, and, as a result, we retested the indefinite-lived IPR&D related to the OTC deficiency program for impairment. We determined that there was no residual value to the indefinite-lived IPR&D related to the OTC deficiency program and, as a result, during the year ended December 31, 2019, we recognized an impairment charge of $18.6 million representing the entire value of the indefinite-lived IPR&D related to the OTC deficiency program. Benefit from Income Taxes During the years ended December 31, 2019 and 2018, we recognized income tax benefits of $0.5 million and $5.6 million, respectively. The income tax benefit recognized for both years resulted from a reduction in the deferred tax liabilities recorded as part of our acquisition of the MRT Program. Liquidity and Capital Resources Since our inception, we have not generated any revenue from product sales, have generated only limited revenue from the Sanofi Agreement and have incurred significant operating losses and negative cash flows from our operations. We have not yet commercialized any of our product candidates, and we do not expect to generate revenue from sales of any product candidates for several years, if at all. See “-Funding Requirements” and Note 1 to the consolidated financial statements appearing at the end of this Annual Report on Form 10-K for a further discussion of our liquidity and the conditions and events that raise substantial doubt regarding our ability to continue as a going concern. Through December 31, 2019, we have funded our operations primarily with net cash proceeds of $189.2 million from the sale of redeemable convertible preferred stock and the sale of bridge units, which ultimately converted into shares of our common stock, the net cash proceeds of $113.2 million from our IPO, $45.0 million from the upfront payment received under the Sanofi Agreement, net cash proceeds of $44.1 million from a private placement of our common stock and net cash proceeds of $84.0 million from a public offering of our common stock. In July 2018, we closed our IPO in which we issued and sold 9,714,371 shares of common stock, including the underwriters’ over-allotment option, at a public offering price of $13.00 per share, resulting in aggregate net proceeds of $113.2 million after deducting underwriting discounts and commissions and offering expenses. On May 3, 2019, we issued and sold 5,582,940 shares of our common stock in a private placement at a price per share of $8.50, resulting in gross proceeds of $47.5 million before deducting placement agent fees of $2.8 million and other offering expenses of $0.6 million. On July 3, 2019, we filed a universal shelf registration statement on Form S-3 with the SEC, or the 2019 Shelf, to register for sale from time to time up to $250.0 million of common stock, preferred stock, debt securities, warrants and/or units in one or more offerings, which became effective on July 19, 2019 (File No. 333-232543). On September 20, 2019, we issued and sold 9,000,000 shares of our common stock through a public offering under the 2019 Shelf at a price per share of $10.00, resulting in gross proceeds of $90.0 million before deducting underwriting discounts and commissions of $5.4 million and other offering expenses of $0.6 million. On July 3, 2019, we entered into an Open Market Sale AgreementSM, or Sales Agreement, with Jefferies LLC, or Jefferies, under which we may issue and sell shares of common stock, from time to time, having an aggregate offering price of up to $50.0 million. We have not sold any shares under the Sales Agreement as of March 9, 2020. Sales of common stock through Jefferies may be made by any method that is deemed an “at the market” offering as defined in Rule 415 promulgated under the Securities Act of 1933, as amended. Jefferies has agreed to use its commercially reasonable efforts consistent with its normal trading and sales practices to sell our shares of common stock based upon our instructions. We are not obligated to make any sales of our common stock under the Sales Agreement. Any shares sold would be pursuant to the 2019 Shelf. Cash Flows The following table summarizes our sources and uses of cash for each of the periods presented: Operating Activities During the year ended December 31, 2019, operating activities used $82.2 million of cash, resulting from our net loss of $113.3 million and net cash used in changes in our operating assets and liabilities of $3.0 million, partially offset by net non-cash charges of $34.2 million. Net cash used in changes in our operating assets and liabilities consisted primarily of an $8.5 million increase in prepaid expenses and other assets, a $3.8 million increase in short-term collaboration receivables and a $1.1 million decrease in deferred revenue, partially offset by a $9.9 million increase in accounts payable. Net non-cash charges for the year ended December 31, 2019 primarily consisted of an impairment charge of $18.6 million representing the entire value of the indefinite-live IPR&D related to the OTC deficiency program resulting from our decision to discontinue the development of MRT5201 and $11.3 million in stock-based compensation expense. During the year ended December 31, 2018, operating activities used $22.1 million of cash, resulting from our net loss of $97.4 million, partially offset by net cash provided by changes in our operating assets and liabilities of $45.6 million and net non-cash charges of $29.6 million. Net cash provided by changes in our operating assets and liabilities for the year ended December 31, 2018 included a $44.4 million increase in deferred revenue resulting from the $45.0 million received under Sanofi Agreement, which became effective in July 2018. Net non-cash charges for the year ended December 31, 2018 primarily consisted of a $25.0 million increase in the change in the fair value of contingent consideration which was primarily due to the continued progress of MRT5005, including the initiation in May 2018 of our Phase 1/2 clinical trial of MRT5005 for the treatment of patients with CF, the advancement in 2018 of MRT5201 for the treatment of patients with OTC deficiency, the time value of money due to the passage of time, as well as a decrease in the discount rate. Investing Activities During the year ended December 31, 2019, net cash used in investing activities was $18.2 million, consisting of $174.3 million of purchases of short-term investments and $3.5 million of purchases of property and equipment, partially offset by $159.6 million of sales and maturities of short-term investments. During the year ended December 31, 2018, net cash used in investing activities was $85.3 million, consisting of $136.7 million of purchases of short-term investments as well as $6.6 million of purchases of property and equipment, which primarily consisted of leasehold improvements and other property and equipment related to the lease of our new headquarters in Lexington, Massachusetts, partially offset by $58.0 million of sales and maturities of short-term investments. Financing Activities During the year ended December 31, 2019, net cash provided by financing activities was $129.7 million, consisting of net cash proceeds of $44.1 million from a private placement of our common stock, net cash proceeds of $84.0 million from a public offering of our common stock and $1.5 million in proceeds from option exercises. During the year ended December 31, 2018, net cash provided by financing activities was $113.6 million, consisting of, in part, net proceeds from our IPO, inclusive of the proceeds from the over-allotment exercise, of $113.3 million after deducting underwriting discounts and commissions and offering expenses. Funding Requirements We expect our expenses to increase in connection with our ongoing activities, particularly as we continue the research and development of, continue ongoing and initiate new clinical trials of and seek marketing approval for our product candidates. In addition, we expect to incur additional costs associated with operating as a public company. Our expenses will also increase if, and as, we: • continue the clinical development of MRT5005; • leverage our programs to advance our other product candidates into preclinical and clinical development; seek regulatory approvals for any product candidates that successfully complete clinical trials; • seek to discover and develop additional product candidates; • establish a sales, marketing, medical affairs and distribution infrastructure to commercialize any product candidates for which we may obtain marketing approval and intend to commercialize on our own or jointly; • hire additional clinical, quality control and scientific personnel; • expand our manufacturing, operational, financial and management systems; • increase personnel, including personnel to support our clinical development, manufacturing and commercialization efforts and our operations as a public company; • maintain, expand and protect our intellectual property portfolio; • acquire or in-license other product candidates and technologies; and • incur additional legal, accounting and other expenses in operating as a public company. We believe that our existing cash, cash equivalents and short-term investments of $188.7 million as of December 31, 2019 will enable us to fund our operating expenses and capital expenditure requirements into the second quarter of 2021. We have based this estimate on assumptions that may prove to be wrong, and we could exhaust our available capital resources sooner than we expect. In accordance with the requirements of ASC 205-40, based on our recurring losses and cash outflows from operations since inception, expectation of continuing operating losses and cash outflows from operations for the foreseeable future and the need to raise additional capital to finance our future operations, we have concluded that there is substantial doubt about our ability to continue as a going concern. The financial statements do not include any adjustments that might result from the outcome of this uncertainty. There is no assurance that we will be successful in obtaining additional financing on terms acceptable to us, if at all, nor is it considered probable under the accounting standards. As such, under the requirements of ASC 205-40, management may not consider the potential for future capital raises or management plans to reduce costs that are not considered probable in their assessment of our ability to meet our obligations. We will need to raise additional capital or incur indebtedness to continue to fund our operations in the future. Our ability to raise additional funds will depend on financial, economic and market conditions, many of which are outside of our control, and we may be unable to raise financing when needed, or on terms favorable to us. If we are unable to raise additional funds when needed, we may be required to delay, reduce or eliminate our product development or future commercialization efforts, or grant rights to develop and market product candidates that we would otherwise prefer to develop and market ourselves, which could adversely affect our business prospects, and we may be unable to continue our operations. Because of numerous risks and uncertainties associated with research, development and commercialization of product candidates, we are unable to estimate the exact amount of our working capital requirements. Factors that may affect our planned future capital requirements and accelerate our need for additional working capital include the following: • the scope, progress, results and costs of researching and developing our product candidates, and conducting preclinical studies and clinical trials; • the costs, timing and outcome of regulatory review of our product candidates; • the costs of future activities, including product sales, medical affairs, marketing, manufacturing and distribution, for any of our product candidates for which we receive marketing approval; • the costs of manufacturing commercial-grade products and sufficient inventory to support commercial launch; • the ability to receive additional non-dilutive funding, including grants from organizations and foundations; • the revenue, if any, received from commercial sale of our products, should any of our product candidates receive marketing approval; • the cost and timing of hiring new employees to support our continued growth; • the costs of preparing, filing and prosecuting patent applications, maintaining and enforcing our intellectual property rights and defending intellectual property-related claims; • the ability to establish and maintain collaborations on favorable terms, if at all; • the extent to which we acquire or in-license other product candidates and technologies; • the timing, receipt and amount of sales of, or milestone payments related to or royalties on, our current or future product candidates, if any; and • our ability to continue as a going concern. A change in the outcome of any of these or other variables with respect to the development of any of our product candidates could significantly change the costs and timing associated with the development of that product candidate. Further, our operating plans may change in the future, and we may need additional funds to meet operational needs and capital requirements associated with such operating plans. Until such time, if ever, as we can generate substantial product revenue, we expect to finance our cash needs through a combination of public or private equity offerings, debt financings, collaborations, strategic partnerships or marketing, distribution or licensing arrangements with third parties and grants from organizations and foundations. To the extent that we raise additional capital through the sale of equity or convertible debt securities, the ownership interests of our common stockholders may be materially diluted, and the terms of such securities could include liquidation or other preferences that could adversely affect the rights of our common stockholders. Debt financing and preferred equity financing, if available, may involve agreements that include restrictive covenants that limit our ability to take specified actions, such as incurring additional debt, making capital expenditures or declaring dividends. In addition, debt financing would result in increased fixed payment obligations. If we raise funds through collaborations, strategic partnerships or marketing, distribution or licensing arrangements with third parties, we may have to relinquish valuable rights to our technologies, future revenue streams, research programs or product candidates or grant licenses on terms that may not be favorable to us. Contractual Obligations and Commitments The following table summarizes our contractual obligations as of December 31, 2019 and the effects that such obligations are expected to have on our liquidity and cash flows in future periods: (1) Reflects minimum payments due under our operating lease for office and laboratory space, which expires April 2028, and our operating lease for communications equipment, which expires March 2023. (2) Reflects minimum purchase commitments under a master supply agreement expiring in December 2024 with Roche Diagnostics Corporation, which we engaged to manufacture drug product materials. (3) Reflects sponsored research commitments under our research agreement with MIT, which expires December 2022. (4) Reflects the annual license maintenance fees payable under our license agreement with MIT. Amounts in the table represent reflect such fees payable through 2025, but we will be obligated to make such payments until the license agreement is terminated. In addition, under various licensing and related agreements to which we are a party, we may be required to make milestone and earnout payments and to pay royalties and other amounts to third parties. We have not included any such contingent payment obligations in the table above as the amount, timing and likelihood of such payments are not known. Such contingent payment obligations are described below. Under the Shire Agreement, as amended, we are obligated to make milestone payments to Shire of up to $60.0 million in the aggregate upon the occurrence of specified commercial milestones, including upon the first commercial sale of an MRT Product for the treatment of CF and upon the achievement of a specified level of annual net sales with respect to an MRT Product. We are also obligated to make additional milestone payments of $10.0 million for each non-CF MRT Product upon the first commercial sale of a non-CF MRT Product; provided that such milestone payments will only be due once for any two non-CF MRT Products that contain the same MRT compounds or once per non-CF MRT Product that is a vaccine developed under our collaboration with Sanofi. Under the Shire Agreement, we are also obligated to pay a quarterly earnout payment of a mid-single-digit percentage of net sales of each MRT Product. The earnout period, which is determined on a product-by-product and country-by-country basis, will begin on the date of the first commercial sale of such MRT Product in such country and will end on the later of (1) 10 years after such first commercial sale and (2) the expiration of the last valid claim of the patent rights acquired from Shire or derived from patent rights or know-how acquired from Shire covering such MRT Product in such country. We and Shire entered into an amendment to the asset purchase agreement on June 7, 2018 to align certain terms of the asset purchase agreement with the Sanofi Agreement, which we entered into with Sanofi on June 8, 2018. Under our license agreement with MIT, we are obligated to make milestone payments to MIT aggregating up to $1.375 million upon the achievement of specified clinical and regulatory milestones with respect to each licensed product and $1.250 million upon our first commercial sale of each licensed product, and to pay royalties of a low single-digit percentage to MIT based on our, and any of our affiliates’ and sublicensees’, net sales of licensed products. The royalties are payable on a product-by-product and country-by-country basis, and may be reduced in specified circumstances. In addition, we are obligated to pay MIT a low double-digit percentage of the portion of income from sublicensees that we ascribe to the MIT-licensed patents, excluding royalties on net sales and research support payments. Pursuant to such provision, we paid $0.7 million to MIT as its share of sublicense income with respect to the upfront payment received under the Sanofi Agreement. The amounts that we may owe to MIT will depend upon the relative value of the patents we licensed from MIT and sublicensed to Sanofi as compared to the other rights that we licensed to Sanofi. The determination of the relative value of such rights is subject to a process described in our license agreement with MIT. Under the Sanofi Agreement, we and Sanofi have agreed to collaborate to perform certain research and development activities to advance mRNA vaccines and mRNA vaccine platform development during a three-year research term, which may be extended by mutual agreement. Under the Sanofi Agreement, if we commercialize any product covered by a Sanofi patent right, we will be required to pay to Sanofi a royalty of a low single-digit percentage. The amount, timing and likelihood of such payments are not known. We have entered into contracts in the normal course of business with CROs, CMOs and other third parties for preclinical research studies and testing, clinical trials and manufacturing services. These contracts do not contain any minimum purchase commitments and are cancelable by us upon prior notice and, as a result, are not included in the table of contractual obligations and commitments above. Payments due upon cancellation consist only of payments for services provided and expenses incurred, including non-cancelable obligations of our service providers, up to the date of cancellation. In September 2019, we entered into a suite retention and development agreement with Albany Molecular Research, Inc., or AMRI, under which a series of cleanroom suites, or the Suites, will be built at AMRI’s manufacturing facility for our exclusive use. Under this agreement, we agreed to provide $6.0 million to finance the costs of the build-out, or Build-Out Costs. In the event the Build-Out Costs exceed $6.0 million, we and AMRI will share the overage equally, up to $11.0 million. We currently anticipate the Build-Out Costs to be in the range of $15.0 million to $20.0 million. We will be responsible for any Build-Out Costs exceeding $11.0 million. Beginning with the month following the build-out completion, we will pay monthly fees of $1.0 million for five years, which are subject to a 3% increase on January 1 of each calendar year following the first anniversary of the build-out completion, and we have the right to extend the lease for an additional three year term. As of December 31, 2019, we have determined that we do not have control, as defined in ASU No. 2016 02, Leases (Topic 842), or ASC 842, of the Suites and as such, this lease was not included in the right-of-use asset or operating lease liabilities on our consolidated balance sheet. Critical Accounting Policies and Significant Judgments and Estimates Our consolidated financial statements are prepared in accordance with generally accepted accounting principles in the United States. The preparation of our consolidated financial statements and related disclosures requires us 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 base our estimates on historical experience, known trends and events and various other factors that we believe are reasonable under the circumstances, the results of which form the basis for making judgments about the carrying values of assets and liabilities that are not readily apparent from other sources. We evaluate our estimates and assumptions on an ongoing basis. Our actual results may differ from these estimates under different assumptions or conditions. While our significant accounting policies are described in more detail in Note 2 to our consolidated financial statements appearing at the end of this Annual Report on Form 10-K, we believe that the following accounting policies are those most critical to the judgments and estimates used in the preparation of our consolidated financial statements. Accrued Research and Development Expenses As part of the process of preparing our consolidated financial statements, we are required to estimate our accrued research and development expenses. This process involves reviewing open contracts and purchase orders, communicating with our personnel to identify services that have been performed on our behalf and estimating the level of service performed and the associated cost incurred for the service when we have not yet been invoiced or otherwise notified of actual costs. The majority of our service providers invoice us in arrears for services performed, on a pre-determined schedule or when contractual milestones are met; however, some require advance payments. We make estimates of our accrued expenses as of each balance sheet date in the consolidated financial statements based on facts and circumstances known to us at that time. We periodically confirm the accuracy of these estimates with the service providers and make adjustments, if necessary. Examples of estimated accrued research and development expenses include fees paid to: • vendors in connection with preclinical development activities; • CROs and investigative sites in connection with preclinical studies and clinical trials; and • CMOs in connection with the production of preclinical and clinical trial materials. We base our expenses related to external research and development services on our estimates of the services received and efforts expended pursuant to quotes and contracts with multiple CMOs and CROs that supply, conduct and manage preclinical studies and clinical trials on our behalf. The financial terms of these agreements are subject to negotiation, vary from contract to contract and may result in uneven payment flows. There may be instances in which payments made to our vendors will exceed the level of services provided and result in a prepayment of the expense. Payments under some of these contracts depend on factors such as the successful enrollment of patients and the completion of clinical trial milestones. In accruing service fees, we estimate the time period over which services will be performed and the level of effort to be expended in each period. If the actual timing of the performance of services or the level of effort varies from the estimate, we adjust the accrual or the amount of prepaid expenses accordingly. Although we do not expect our estimates to be materially different from amounts actually incurred, our understanding of the status and timing of services performed relative to the actual status and timing of services performed may vary and may result in reporting amounts that are too high or too low in any particular period. To date, there have not been any material adjustments to our prior estimates of accrued research and development expenses. Revenue Recognition The terms of our collaboration agreements may include consideration such as non-refundable license fees, funding of research and development services, payments due upon the achievement of clinical and preclinical performance-based development milestones, regulatory milestones, manufacturing services, sales-based milestones and royalties on product sales. We recognize revenue under ASC 606, Revenue from Contracts with Customers, which applies to all contracts with customers, except for contracts that are within the scope of other standards, such as leases, insurance, collaboration arrangements and financial instruments. ASC 606 provides a five-step framework whereby revenue is recognized when control of promised goods or services is transferred to a customer at an amount that reflects the consideration to which the entity expects to be entitled in exchange for those goods or services. To determine revenue recognition for arrangements that we determine are within the scope of the new revenue standard, we perform the following five steps: (i) identify the promised goods or services in the contract; (ii) determine whether the promised goods or services are performance obligations including whether they are distinct in the context of the contract; (iii) measure the transaction price, including the constraint on variable consideration; (iv) allocate the transaction price to the performance obligations; and (v) recognize revenue when (or as) we satisfy each performance obligation. We only apply the five-step model to contracts when collectability of the consideration to which we are entitled in exchange for the goods or services we transfer to the customer is determined to be probable. At contract inception, once the contract is determined to be within the scope of ASC 606, we assess whether the goods or services promised within each contract are distinct and, therefore, represent a separate performance obligation. Goods and services that are determined not to be distinct are combined with other promised goods and services until a distinct bundle is identified. We then allocate the transaction price (the amount of consideration we expect to be entitled to from a customer in exchange for the promised goods or services) to each performance obligation and recognize the associated revenue when (or as) each performance obligation is satisfied. Our estimate of the transaction price for each contract includes all variable consideration to which we expect to be entitled. We recognize the transaction price allocated to upfront license payments as revenue upon delivery of the license to the customer and resulting ability of the customer to use and benefit from the license, if the license is determined to be distinct from the other performance obligations identified in the contract. If the license is considered to not be distinct from other performance obligations, we utilize judgment to assess the nature of the combined performance obligation to determine whether the combined performance obligation is satisfied (i) at a point in time, but only for licenses determined to be distinct from other performance obligations in the contract, or (ii) over time; and, if over time, the appropriate method of measuring progress for purposes of recognizing revenue from license payments. We evaluate the measure of progress each reporting period and, if necessary, adjust the measure of performance and related revenue recognition. For each collaboration that includes development milestone payments, we evaluate whether it is probable that the consideration associated with each milestone will not be subject to a significant reversal in the cumulative amount of revenue recognized. Amounts that meet this threshold are included in the transaction price using the most likely amount method, whereas amounts that do not meet this threshold are considered constrained and excluded from the transaction price until they meet this threshold. Milestones tied to regulatory approval, and therefore not within our control, are considered constrained until such approval is received. Upfront and ongoing development milestones per our collaboration agreements are not subject to refund if the development activities are not successful. At the end of each subsequent reporting period, we re-evaluate the probability of a significant reversal of the cumulative revenue recognized for the milestones, and, if necessary, adjust the estimate of the overall transaction price. Any such adjustments are recorded on a cumulative catch-up basis, which would affect revenues from collaborators in the period of adjustment. We exclude sales-based milestone payments and royalties from the transaction price until the sale occurs (or, if later, until the underlying performance obligation to which some or all of the royalty has been allocated has been satisfied or partially satisfied), because the license to our intellectual property is deemed to be the predominant item to which the royalties relate as it is the primary driver of value. ASC 606 requires us to allocate the arrangement consideration on a relative standalone selling price basis for each performance obligation after determining the transaction price of the contract and identifying the performance obligations to which that amount should be allocated. The relative standalone selling price is defined in ASC 606 as the price at which an entity would sell a promised good or service separately to a customer. If other observable transactions in which we have sold the same performance obligation separately are not available, we are required to estimate the standalone selling price of each performance obligation. Key assumptions to determine the standalone selling price may include forecasted revenues, development timelines, reimbursement rates for personnel costs, discount rates and probabilities of technical and regulatory success. Whenever we determine that a contract should be accounted for as a combined performance obligation we will utilize the cost-to-cost input method. Revenue will be recognized over time using the cost-to-cost input method, based on the total estimated costs to fulfill the obligations. We will recognize revenue as services are being delivered. Significant management judgment is required in determining the level of effort required under an arrangement and the period over which we are expected to complete our performance obligations under an arrangement. We evaluate our collaborative agreements for proper classification in the consolidated statements of operations based on the nature of the underlying activity. Transactions between collaborators recorded in our consolidated statements of operations are recorded on either a gross or net basis, depending on the characteristics of the collaborative relationship. For revenue generating arrangements where we, as a vendor, provide consideration to a licensor or collaborator, as a customer, we apply the accounting standard that governs such transactions. This standard addresses the accounting for revenue arrangements where both the vendor and the customer make cash payments to each other for services and/or products. A payment to a customer is presumed to be a reduction of the transaction price unless we receive an identifiable benefit for the payment and we can reasonably estimate the fair value of the benefit received. Payments to a customer that are deemed a reduction of the transaction price are recorded first as a reduction of revenue, to the extent of both cumulative revenue recorded to date and probable future revenues, which include any unamortized deferred revenue balances, under all arrangements with such customer, and then as an expense. Payments that are not deemed to be a reduction of the transaction price are recorded as an expense. Consideration that does not meet the requirements to satisfy the above revenue recognition criteria is a contract liability and is recorded as deferred revenue in the consolidated balance sheets. Although we follow detailed guidelines in measuring revenue, certain judgments affect the application of our revenue policy. For example, in connection with the Sanofi Agreement, we have recorded short-term and long-term deferred revenue on our consolidated balance sheets based on our best estimate of when such revenue will be recognized. Short-term deferred revenue consists of amounts that are expected to be recognized as revenue in the next 12 months. Amounts that we expect will not be recognized within the next 12 months are classified as long-term deferred revenue. The estimate of deferred revenue also reflects management’s estimate of the periods of our involvement in certain of our collaborations. Our performance obligations under these collaborations consist of participation on steering committees and the performance of other research and development services. In certain instances, the timing of satisfying these obligations can be difficult to estimate. Accordingly, our estimates may change in the future. Such changes to estimates would result in a change in revenue recognition amounts. If these estimates and judgments change over the course of these agreements, it may affect the timing and amount of revenue that we will recognize and record in future periods. Under ASC 606, we will recognize revenue and record a receivable when we fulfill our performance obligations under the Sanofi Agreement. When no further performance obligation is required to be satisfied, we will recognize revenue for the portion satisfied and record a receivable. Amounts are recorded as short-term collaboration receivables when our right to consideration is unconditional. A contract liability is recognized when a customer prepays consideration or owes prepayment to an entity according to a contract. We do not assess whether a contract has a significant financing component if the expectation at contract inception is that the period between payment by the customer and the transfer of the promised goods or services to the customer will be one year or less. We expense incremental costs of obtaining a contract as and when incurred if the expected amortization period of the asset that we would have recognized is one year or less or the amount is immaterial. Valuation of Contingent Consideration Contingent consideration reflected on our consolidated balance sheets consists of liabilities for potential milestone and earnout payment obligations and through the closing of our IPO, anti-dilution rights recorded in connection with our acquisition of the MRT Program in December 2016. Contingent consideration is initially recognized at fair value at the acquisition date and is subsequently remeasured to fair value at each reporting date, with changes recorded in our consolidated statements of operations. Significant judgment is required in estimating fair value. Our estimates of fair value are based upon assumptions we believed to be reasonable, but which are inherently uncertain and, as a result, actual results may differ materially from estimates. The fair value of the contingent consideration related to the potential future milestone and earnout payments was estimated by us on the acquisition date and is estimated by us at each reporting date based, in part, on the results of a third-party valuation. The third-party valuation is prepared using a discounted cash flow analysis based on various assumptions, including the probability of achieving specified events, discount rates and the period of time until the earnout payments are payable and the conditions triggering the milestone payments are met. The fair value of the contingent consideration related to the anti-dilution rights was estimated by us on the acquisition date and was estimated by us at each reporting date based, in part, on the results of a third-party valuation. The third-party valuation was prepared using a probability-weighted expected return method, or PWERM, which considers as inputs the probability of occurrence of events that would trigger the issuance of additional shares, the expected timing of such events, the expected value of the contingently issuable equity upon the occurrence of a triggering event and a risk-adjusted discount rate. As a result of our IPO, we fully satisfied our obligation to issue shares of common stock to Shire under the Shire Agreement. Impairment of In-Process Research and Development IPR&D reflected on our consolidated balance sheets consists of indefinite- and definite-lived intangible assets recorded in connection with our acquisition of the MRT Program in December 2016. Indefinite-lived IPR&D is not subject to amortization, but is tested annually for impairment or more frequently if there are indicators of impairment. We test our indefinite-lived IPR&D annually for impairment on October 1st. In testing indefinite-lived IPR&D for impairment, we have the option to first assess qualitative factors to determine whether the existence of events or circumstances would indicate that it is more likely than not that its fair value is less than its carrying amount, or we can perform a quantitative impairment analysis to determine the fair value of the indefinite-lived IPR&D without performing a qualitative assessment. Qualitative factors that we consider include significant underperformance of the business in relation to expectations, significant negative industry or economic trends and significant changes or planned changes in the use of the assets. If we choose to first assess qualitative factors and we determine that it is more likely than not that the fair value of the indefinite-lived IPR&D is less than its carrying amount, we would then determine the fair value of the indefinite-lived IPR&D. Under either approach, if the fair value of the indefinite-lived IPR&D is less than its carrying amount, an impairment charge would be recognized for the difference between the fair value and the carrying amount in the consolidated statements of operations. Significant judgment is required in testing IPR&D for impairment, and changes in estimates and assumptions could materially affect the determination of whether impairment exists and, if so, the amount of that impairment. In September 2019, we discontinued development of MRT5201, which was an indicator of impairment, and, as a result, we retested the indefinite-lived IPR&D related to the OTC deficiency program for impairment. We will not be investing any additional funds in this program and have reallocated all resources previously dedicated to the OTC deficiency program to other programs within the company. We determined that there was no residual value to the indefinite-lived IPR&D related to the OTC deficiency program and, as a result, we recorded an impairment charge of $18.6 million during the year ended December 31, 2019, representing the entire value of the indefinite-lived IPR&D related to the OTC deficiency program. During the year ended December 31, 2018, we did not recognize any impairment charges related to our definite-lived IPR&D. Impairment of Goodwill Goodwill reflected on our consolidated balance sheets consists of an intangible asset recorded in connection with our acquisition of the MRT Program in December 2016. Goodwill is not subject to amortization, but is tested annually for impairment or more frequently if there are indicators of impairment. We test our goodwill annually for impairment on October 1st. We have determined that there is a single reporting unit for purposes of testing goodwill for impairment. We have the option to first assess qualitative factors to determine whether the existence of events or circumstances would indicate that it is more likely than not that the fair value of the reporting unit was less than its carrying amount, or we can perform a two-step quantitative impairment analysis without performing a qualitative assessment. Examples of such events or circumstances considered in our qualitative assessment include, but are not limited to, a significant adverse change in legal or business climate, an adverse regulatory action or unanticipated competition. If we choose to first assess qualitative factors and we determine that it is more likely than not that the fair value of the reporting unit is less than its carrying amount, we would then perform a two-step quantitative impairment test. The two-step test starts with comparing the fair value of the reporting unit to the carrying amount of the reporting unit, including goodwill. If the fair value of the reporting unit exceeds the carrying amount, no impairment loss is recognized. However, if the fair value of the reporting unit is less than the carrying value, we must perform the second step of the impairment test to determine if goodwill is impaired. If we determine that goodwill is impaired, the carrying value of the goodwill is written down to its fair value and an impairment charge is recognized in the consolidated statements of operations. Significant judgment is required in testing goodwill for impairment, and changes in estimates and assumptions could materially affect the determination of whether impairment exists and, if so, the amount of that impairment. During the years ended December 31, 2019 and 2018, we did not recognize any impairment charges related to goodwill. Stock-Based Compensation We measure stock-based awards granted to employees, directors and, effective January 1, 2019, non-employee consultants based on their fair value on the date of the grant and recognize compensation expense for those awards over the requisite service period, which is generally the vesting period of the respective award. For stock-based awards with service-based vesting conditions, we recognize compensation expense using the straight-line method. For stock-based awards with both performance-based and service-based vesting conditions, we recognize compensation expense using the graded-vesting method over the requisite service period, commencing when achievement of the performance condition becomes probable. We recognize adjustments to compensation expense for forfeitures as they occur. The fair value of each stock option grant is estimated on the date of grant using the Black-Scholes option-pricing model, which requires inputs based on certain subjective assumptions, including the expected stock price volatility, the expected term of the option, the risk-free interest rate for a period that approximates the expected term of the option, and our expected dividend yield. The fair value of each restricted common stock award is estimated on the date of grant based on the fair value of our common stock on that same date. Through December 31, 2018, for stock-based awards granted to non-employee consultants, we recognized compensation expense over the period during which services were rendered by such non-employee consultants until completed. At the end of each financial reporting period prior to completion of the service, the fair value of these awards was reimbursed using the then-current fair value of our common stock and updated assumption inputs in the Black-Scholes option-pricing model. Recently Adopted Accounting Policies On January 1, 2019, we adopted ASC 842. Under ASC 842, most leases are required to be recognized on the balance sheet as a right-of-use asset and a lease liability. The standard has been implemented using the cumulative-effect adjustment on the effective date of the standard, with comparative periods presented in accordance with the previous guidance. We have also elected to utilize the permitted practical expedients, which allowed us to not reassess previous accounting conclusions around whether arrangements are or contain leases, and carried forward both the historical classification of leases and the treatment of initial direct costs. ASC 842 requires us to make significant assumptions and judgments including, but not limited to, the determination of whether a contract contains a lease, the allocation of consideration in a contract between lease and non-lease components and the determination of the discount rate for the lease. Our assessment of leases under ASC 842 is based upon assumptions we believed to be reasonable, but which are inherently uncertain, and changes in these assumptions could materially affect the amounts recognized as a right-of-use asset and lease liability on the balance sheet, and, as a result, actual results may differ materially from estimates. The adoption of this standard did not materially impact our consolidated net earnings and had no impact on cash flows. Emerging Growth Company Status The Jumpstart Our Business Startups Act of 2012, or the JOBS Act, permits an “emerging growth company” such as us to take advantage of an extended transition period to comply with new or revised accounting standards applicable to public companies until those standards would otherwise apply to private companies. We have irrevocably elected to “opt out” of this provision and, as a result, we will comply with new or revised accounting standards when they are required to be adopted by public companies that are not emerging growth companies. Off-Balance Sheet Arrangements We did not have during the periods presented, and we do not currently have, any off-balance sheet arrangements, as defined in the rules and regulations of the SEC. Recently Issued Accounting Pronouncements A description of recently issued accounting pronouncements that may potentially impact our financial position and results of operations is disclosed in Note 2 to our consolidated financial statements appearing at the end of this Annual Report on Form 10-K.

<s>[INST] Overview We are a clinicalstage messenger RNA, or mRNA, therapeutics company developing a new class of potentially transformative medicines to treat diseases caused by protein or gene dysfunction. Using our proprietary mRNA therapeutic platform, or MRT platform, we create mRNA that encodes functional proteins. Our mRNA is designed to be delivered to the target cell where the cell’s own machinery recognizes it and translates it, restoring or augmenting protein function to treat or prevent disease. We believe that the mRNA design, delivery and manufacturing capabilities of our MRT platform provide us with the most advanced platform for developing product candidates that deliver mRNA encoding functional proteins for therapeutic uses. We believe that our MRT platform is broadly applicable across multiple diseases in which the production of a desirable protein can have a therapeutic effect, with the potential to transform lifethreatening illnesses into manageable chronic conditions. We are primarily focused on applying our MRT platform to treat pulmonary diseases caused by insufficient protein production or where production of proteins can modify disease. We also believe our technology is applicable to a broad range of diseases, including diseases that affect the liver. Additionally, our MRT platform may be applied to produce various classes of treatments, such as therapeutic antibodies or vaccines in areas such as infectious disease and oncology. We are developing MRT5005 for the treatment of cystic fibrosis, or CF. We believe MRT5005 is the first clinicalstage mRNA product candidate designed to deliver mRNA encoding fully functional cystic fibrosis transmembrane conductance regulator, or CFTR, protein to the lung. We have designed MRT5005 to be inhaled via a handheld nebulizer and to be administered in a onceweekly dose. Once the inhaled MRT5005 has entered the epithelial cells lining the patient’s lungs, our therapeutic mRNA uses the cells’ own machinery for translation and expression of fully functional CFTR protein, thereby restoring this essential ion channel, which we believe will address the pathology of CF directly. The U.S. Food and Drug Administration, or FDA, has granted both orphan drug and fast track designation for MRT5005 for the treatment of CF. We are conducting a Phase 1/2 clinical trial to evaluate the safety and tolerability of MRT5005. Percent predicted forced expiratory volume in one second, or ppFEV1, which is a welldefined and accepted endpoint measuring lung function, is also being measured at predefined timepoints throughout the trial. In April 2019, we completed dosing of patients in the singleascending dose, or SAD, portion of the Phase 1/2 clinical trial and in July 2019, we reported interim data from the SAD portion of the clinical trial through onemonth follow up post dosing. MRT5005 was generally welltolerated at low and middose levels with no serious adverse events reported at any dose level. Marked increases in ppFEV1 were observed after a single dose of MRT5005, primarily at the middose level. Based on the analysis of the interim results, we have amended the clinical trial protocol to include one additional SAD dose group and two additional dose groups in the ongoing multipleascending dose, or MAD, portion of this trial. We began dosing patients in the MAD portion of this trial in early 2019. We expect to report data from the additional SAD dose group and the MAD portion of the clinical trial in the third quarter of 2020. We are leveraging our lung delivery platform and focusing our preclinical research efforts on identifying lead product candidates for a nextgeneration CF program, as well as beyond CF in additional pulmonary diseases with unmet medical need. Building upon the MRT5005 program’s success to date, we are exploring innovation in the MRT platform including novel lipid nanoparticles, protein engineering approaches and manufacturing process enhancements to identify nextgeneration CF candidates that can support expansion of our pipeline opportunities. Beyond CF, we have discovery efforts underway to identify lead product candidates in additional pulmonary diseases, including primary [/INST] Positive. </s>

Inspire Medical Systems, Inc.

2019-02-26

2018-12-31

Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations. The following discussion and analysis of our financial condition and results of operations should be read in conjunction with our financial statements and the related notes to those statements included elsewhere in this Annual Report on Form 10-K. In addition to historical financial information, the following discussion and analysis contains forward-looking statements that involve risks, uncertainties and assumptions. Some of the numbers included herein have been rounded for the convenience of presentation. Our actual results may differ materially from those anticipated in these forward-looking statements as a result of many factors, including those discussed under Part I. "Item 1A. Risk Factors’’ and elsewhere in this Annual Report on Form 10-K. Overview We are a medical technology company focused on the development and commercialization of innovative and minimally invasive solutions for patients with obstructive sleep apnea. Our proprietary Inspire system is the first and only FDA-approved neurostimulation technology that provides a safe and effective treatment for moderate to severe obstructive sleep apnea. We have developed a novel, closed-loop solution that continuously monitors a patient’s breathing and delivers mild hypoglossal nerve stimulation to maintain an open airway. Inspire therapy is indicated for patients with moderate to severe obstructive sleep apnea who do not have significant central sleep apnea and do not have a complete concentric collapse of the airway at the soft palate level. In addition, patients in the United States ("U.S.") must have been confirmed to fail or be unable to tolerate positive airway pressure treatments, such as CPAP, and be 22 years of age or older, though there are no similar requirements for patients in Europe. We sell our Inspire system to hospitals and ASCs in the U.S. and in select countries in Europe through a direct sales organization. Our direct sales force engages in sales efforts and promotional activities focused on ENT physicians and sleep centers. In addition, we highlight our compelling clinical data and value proposition to increase awareness and adoption amongst referring physicians. We build upon this top-down approach with strong direct-to-patient marketing initiatives to create awareness of the benefits of our Inspire system and drive demand through patient empowerment. This outreach helps to educate thousands of patients on our Inspire therapy and frequently results in patient leads. We increased the number of employees in our sales, marketing and reimbursement organizations from 40 as of December 31, 2015 to 129 as of December 31, 2018. Although our sales and marketing efforts are directed at patients and physicians because they are the primary users of our technology, we consider the hospitals and ASCs where the procedure is performed to be our customers, as they are the purchasing agents of our Inspire system. Our customers are reimbursed the cost required to treat each patient through various third-party payors, such as commercial payors and government agencies. Our Inspire system is currently reimbursed primarily on a per-patient prior authorization basis for patients covered by commercial payors, on a medical necessity basis for most patients covered by Medicare, and under U.S. government contract for patients who are treated by the Veterans Health Administration. To date, approximately 330 commercial payors have prior authorized for patients’ treatment with our Inspire therapy. In July 2018, Aetna Inc., one of the leading health plans in the U.S., began providing coverage for our Inspire therapy, and in January 2019, Blue Cross Blue Shield Association's (“BCBSA”) Evidence Street, which performs healthcare technology assessments for the 36 BCBSA insurers, issued a positive assessment of Inspire therapy to its members. We have currently secured positive coverage policies with 18 U.S. commercial payors. In June 2018, Japan’s Ministry of Health, Labour and Welfare approved our Inspire therapy to treat moderate to severe OSA, and we are currently seeking reimbursement coverage in Japan. For the year ended December 31, 2018, 87.7% of our revenue was derived in the U.S. and 12.3% was derived in Europe. No single customer accounted for more than 10% of our revenue. We rely on third-party suppliers to manufacture our Inspire system and its components. Many of these suppliers are currently single source suppliers. We seek to maintain higher levels of inventory to protect ourselves from supply interruptions, and, as a result, we are subject to the risk of inventory obsolescence and expiration, which could lead to inventory impairment charges. In the U.S., our products are shipped directly to our customers on a purchase order basis, primarily by a third-party vendor with a facility in Tennessee. We ship our physician programmers and some Inspire systems from our facility in Minnesota. Warehousing and shipping operations for our European customers are handled by a third-party vendor with facilities located in the Netherlands. Customers do not have the right to return non-defective product, nor do we place product on consignment. Our sales representatives do not maintain trunk stock. Since our inception in 2007, we have financed our operations primarily through sales of our Inspire system, private placements of our convertible preferred securities, amounts borrowed under our credit facility, the initial public offering of our common stock that closed in May 2018 (our "IPO") and the offering of our common stock that closed in December 2018 (our "follow-on offering"). We have devoted significant resources to research and development activities related to our Inspire system, including clinical and regulatory initiatives to obtain marketing approval, and sales and marketing activities. For the year ended December 31, 2018, we generated revenue of $50.6 million with a gross margin of 80.1% and a net loss of $21.8 million compared to revenue of $28.6 million with a gross margin of 78.9% and a net loss of $17.5 million for the year ended December 31, 2017 and revenue of $16.4 million with a gross margin of 76.2% and a net loss of $18.5 million for the year ended December 31, 2016. Our accumulated deficit as of December 31, 2018 was $146.9 million. We have invested heavily in product development. Our research and development activities have been centered on driving continuous improvements to our Inspire therapy. We have also made significant investments in clinical studies to demonstrate the safety and efficacy of our Inspire therapy and to support regulatory submissions. We intend to make significant investments building our sales and marketing organization by increasing the number of U.S. sales representatives and continuing our direct-to-patient marketing efforts in existing and new markets throughout the U.S. and in Europe. We also intend to continue to make investments in research and development efforts to develop our next generation Inspire systems and support our future regulatory submissions for expanded indications and for new markets such as Europe and Japan. Because of these and other factors, we expect to continue to incur net losses for the next several years and we expect to require substantial additional funding, which may include future equity and debt financings. On May 7, 2018, we completed our IPO by issuing 7,762,500 shares of common stock, at a public offering price of $16.00 per share, for net proceeds of approximately $112.0 million after deducting underwriting discounts and commissions and offering expenses payable by us. On December 11, 2018, we completed the follow-on offering that included our offer and sale of 1,875,000 shares of common stock and the selling stockholders' offer and sale of 1,000,000 shares of common stock, at a public offering price of $40.00 per share. We received net proceeds of approximately $69.8 million after deducting underwriting discounts and commissions and offering expenses. We received no proceeds from the sale of our common stock by the selling shareholders. Components of Our Results of Operations Revenue We derive primarily all of our revenue from the sale of our Inspire system to hospitals and ASCs in the U.S. and select countries in Europe. Recent revenue growth has been driven by, and we expect continued growth as a result of, increased patient and physician awareness of the Inspire system, additional sales representatives and an increase in approvals of prior authorization submissions. Any reversal in these recent trends, however, could have a negative impact on our future revenue. In addition, we have expanded our sales and marketing organization to help us drive and support revenue growth and intend to continue this expansion. Moreover, we expect that our revenue growth will be positively impacted by, and to the extent we obtain, additional positive coverage policies. Our revenue has fluctuated, and we expect our revenue to continue to fluctuate, from quarter to quarter due to a variety of factors. For example, we have historically experienced seasonality in our first and fourth quarters. Cost of Goods Sold and Gross Margin Cost of goods sold consists primarily of acquisition costs of the components of the Inspire system, overhead costs, scrap and inventory obsolescence, as well as distribution-related expenses such as logistics and shipping costs, net of costs charged to customers. The overhead costs include the cost of material procurement and operations supervision and management personnel. We expect overhead costs as a percentage of revenue to continue to decrease as our sales volume increases. We expect cost of goods sold to increase in absolute dollars primarily as, and to the extent, our revenue grows. We calculate gross margin as gross profit divided by revenue. Our gross margin has been and we expect it will continue to be affected by a variety of factors, including manufacturing costs, the average selling price of our Inspire system, the implementation of cost-reduction strategies, inventory obsolescence costs, which generally occur when new generations of our Inspire system are introduced, and to a lesser extent the sales mix between the U.S. and Europe as our average selling price in the U.S. tends to be higher than in Europe. Our gross margin may increase over the long term to the extent our production volumes increase and we receive discounts on the costs charged by our contract manufacturers, thereby reducing our per unit costs. However, our gross margin may fluctuate from quarter to quarter due to seasonality. Research and Development Expenses Research and development expenses consist primarily of product development, engineering, clinical studies to develop and support our products, regulatory expenses, testing, consulting services and other costs associated with the next generation versions of the Inspire system. These expenses include employee compensation (including stock-based compensation), supplies, materials, consulting, and travel expenses related to research and development programs. Additionally, these expenses include clinical trial management and monitoring, payments to clinical investigators, data management and travel expenses for our various clinical trials. We expect research and development expenses to increase in the future as we develop next generation versions of our Inspire system and continue to expand our clinical studies to secure positive coverage policies from private commercial payors in the U.S. and enter into new markets such as Europe, Japan and Australia. We expect research and development expenses as a percentage of revenue to vary over time depending on the level and timing of initiating new product development efforts and new clinical development activities. Selling, General and Administrative Expenses Selling, general and administrative expenses consist primarily of compensation for personnel, including base salaries, stock-based compensation and commissions related to our sales organization, finance, information technology, and human resource functions, as well as spending related to marketing, sales operations and training and reimbursement personnel. Other selling, general and administrative expenses include training physicians, travel expenses, advertising, direct-to-patient promotional programs, conferences, trade shows and consulting services, professional services fees, audit fees, insurance costs and general corporate expenses, including facilities-related expenses. We expect selling general and administrative expenses to continue to increase as we expand our commercial infrastructure to both drive and support our planned growth in revenue and as we increase our headcount and expand administrative personnel to support our growth and operations as a public company including finance personnel and information technology services. Additionally, we anticipate increased expenses related to audit, legal, and tax-related services associated with maintaining compliance with exchange listing and SEC requirements, director and officer insurance premiums and investor relations costs associated with being a public company. We also expect to see an increase in our stock-based compensation expense with the establishment of a new equity plan in connection with our IPO and related grants either in the form of restricted stock or options. Other Expense, Net Other expense, net consists primarily of interest expense payable under our credit facility. Other items include interest income and fair value adjustments related to convertible preferred stock warrants, which were accounted for as a liability and marked-to-market at each reporting period. Immediately prior to the closing of our IPO, our outstanding convertible preferred stock warrants automatically converted into warrants to purchase shares of our common stock. Results of Operations Year Ended December 31, 2018 Compared to Year Ended December 31, 2017 Revenue Revenue increased $22.0 million, or 77.1%, to $50.6 million for the year ended December 31, 2018 compared to the year ended December 31, 2017. The increase was attributable to an increase in sales of our Inspire system of $20.1 million in the U.S. and an increase of $1.9 million in Europe, primarily in Germany. Revenue information by region is summarized as follows: Revenue generated in the U.S. was $44.4 million for the year ended December 31, 2018, an increase of $20.1 million or 82.7% over the year ended December 31, 2017. Revenue growth in the U.S. was primarily due to increased market penetration in existing territories, the expansion of our U.S. sales representatives into new territories, increased physician and patient awareness of our Inspire system, and a greater number of prior authorization approvals. Additionally, $1.0 million of the increase in revenue was attributable to an increase in our average selling price with the introduction of the fourth generation Inspire system in the U.S. in July 2017. Revenue generated in Europe was $6.2 million in the year ended December 31, 2018, an increase of $1.9 million or 45.4% over the year ended December 31, 2017. Revenue growth in Europe was primarily due to increased market penetration in existing territories and increased physician and patient awareness of our Inspire system. Additionally, $0.5 million of the increase in revenue was attributable to an increase in our average selling price and, to a lesser extent, changes in foreign currency rates. Cost of Goods Sold and Gross Margin Cost of goods sold increased $4.1 million, or 67.1%, to $10.1 million for the year ended December 31, 2018 compared to $6.0 million for the year ended December 31, 2017. The increase was primarily due to increased purchases of manufactured products due to higher sales volume of our Inspire system. Gross margin was 80.1% for the year ended December 31, 2018 compared to 78.9% for the year ended December 31, 2017. The lower gross margin for the year ended December 31, 2017 was primarily due to higher cost of goods sold resulting from an excess inventory charge of $0.5 million for the anticipated introduction of the fourth generation Inspire system in the U.S. in July 2017. Research and Development Expenses Research and development expenses increased $1.2 million, or 19.3%, to $7.4 million for the year ended December 31, 2018 compared to $6.2 million for the year ended December 31, 2017. This change was primarily due to an increase of $1.1 million of compensation and employee-related expenses, mainly as a result of increased headcount, and $0.1 million for ongoing research and development costs. Selling, General and Administrative Expenses Selling, general and administrative expenses increased $21.1 million, or 65.4%, to $53.5 million for the year ended December 31, 2018 compared to $32.4 million for the year ended December 31, 2017. The primary driver of this increase was an increase of $14.8 million due to compensation, travel and other employee-related expenses, mainly as a result of increased headcount, $1.0 million of which related to our reimbursement organization. In addition, selling, general and administrative expenses increased $2.0 million related to legal fees, financial audit fees, and insurance costs, which increased primarily as a result of becoming a public company, as well as out-sourced information technology services and facilities costs. Other drivers included an increase of $2.5 million of direct-to-patient marketing programs, trade show and conference expenses and an increase of $0.2 million due to increased physician training costs. Other Expense, Net Other expense, net was steady at $1.5 million for the years ended December 31, 2018 and 2017. In fiscal 2018, an increase of $1.7 million of interest income related to our higher cash, cash equivalents and short-term investments balances was offset by an increase in interest expense of $0.8 million related to additional borrowings under our credit facility, the fair value adjustment of $0.6 million of our previously outstanding convertible preferred stock warrants, and $0.2 million related to the final payment fee under our credit facility. Year Ended December 31, 2017 Compared to Year Ended December 31, 2016 Revenue Revenue increased $12.1 million, or 73.9%, to $28.6 million in fiscal year 2017 compared to $16.4 million in fiscal year 2016. The increase was attributable to an increase in sales of our Inspire system of $10.5 million in the U.S. and an increase of $1.6 million in Europe, primarily in Germany. Revenue information by region is summarized as follows: Revenue generated in the U.S. was $24.3 million in fiscal year 2017, an increase of $10.5 million or 76.2% over fiscal year 2016. Revenue growth in the U.S. was primarily due to increased market penetration in existing territories, the expansion of our sales representatives into new territories, increased physician and patient awareness of our Inspire system, increased prior authorization approvals, and an increase in our average selling price. Revenue generated in Europe was $4.3 million in fiscal year 2017, an increase of $1.6 million or 62.0% over fiscal year 2016. Revenue growth in Europe was primarily due to increased market penetration in existing territories and increased physician and patient awareness of our Inspire system. Cost of Goods Sold and Gross Margin Cost of goods sold increased $2.1 million, or 54.1%, to $6.0 million in fiscal year 2017 compared to $3.9 million in fiscal year 2016. The increase was primarily due to increased costs to purchase manufactured products due to higher sales volume of our Inspire system. Gross margin increased to 78.9% in fiscal year 2017 compared to 76.2% in fiscal year 2016. The increase in gross margin was primarily due to the growth in revenue, which enabled us to spread the fixed portion of our operations costs, including distribution-related expenses and management salaries, over more units. Research and Development Expenses Research and development expenses decreased $0.9 million, or 12.6%, to $6.2 million in fiscal year 2017 compared to $7.1 million in fiscal year 2016. As a percentage of revenue, research and development expenses decreased to 21.7% in fiscal year 2017 compared to 43.2% in fiscal year 2016. The decrease in research and development expenses was primarily attributable to a decrease in product development costs and consulting costs of $1.4 million relating to the completion of the fourth generation of our Inspire system in fiscal year 2016, partially offset by higher research study costs of $0.2 million and an increase of $0.3 million in regulatory expenses due to the commencement of regulatory activities in Japan during 2017. Selling, General and Administrative Expenses Selling, general and administrative expenses increased $9.7 million, or 42.6%, to $32.4 million in fiscal year 2017 compared to $22.7 million in fiscal year 2016. The primary driver of the increase was compensation, travel and other employee-related expenses of $3.9 million and $1.1 million for our U.S. and European sales and marketing organizations, respectively, primarily as a result of increased headcount. Other drivers included an increase of $2.3 million of direct-to-patient marketing programs, trade show and conference expenses, an increase of $0.7 million of expenses related to increased headcount in our reimbursement organization, and an increase of $0.4 million due to increased physician training costs. Also contributing to the increase was an additional $0.7 million related to legal fees, financial audit fees, insurance costs, out-sourced information technology services and facilities costs, and $0.3 million due to compensation, travel and other employee-related expenses for administrative personnel. Other Expense, Net Other expense, net increased $0.2 million, or 18.2%, to $1.5 million in fiscal year 2017 compared to $1.3 million in fiscal year 2016. The increase in other expense, net was due to an increase in interest expense of $0.5 million related to additional borrowings under our credit facility and the fair value adjustment of $0.1 million of our outstanding convertible preferred stock warrants, which were accounted for as a liability and marked-to-market at each reporting period. This increase was partially offset by $0.1 million due to foreign currency exchange and by $0.1 million of interest income with our higher cash, cash equivalents and short-term investments balances compared to 2016. Liquidity and Capital Resources As of December 31, 2018, we had cash, cash equivalents and short-term investments of $188.2 million and an accumulated deficit of $146.9 million, compared to cash, cash equivalents and short-term investments of $16.1 million and an accumulated deficit of $125.1 million as of December 31, 2017. As of December 31, 2018, we had $24.5 million of outstanding borrowings under our credit facility. No borrowings remain available under this credit facility. On May 7, 2018, we completed our IPO by issuing 7,762,500 shares of common stock, at a public offering price of $16.00 per share, for net proceeds of approximately $112.0 million after deducting underwriting discounts and commissions and offering expenses payable by us. On December 11, 2018, we completed the follow-on offering that included our offer and sale of 1,875,000 shares of common stock and the selling stockholders' offer and sale of 1,000,000 shares of common stock, at a public offering price of $40.00 per share. We received net proceeds of approximately $69.8 million after deducting underwriting discounts and commissions and offering expenses. We received no proceeds from the sale of our common stock by the selling shareholders. Our sources of capital have historically come from private placements of our convertible preferred securities, sales of our Inspire system, borrowings under credit facilities and registered offerings of our common stock. As of December 31, 2018, we had raised a total of $119.1 million in net proceeds from private placements of our convertible preferred securities and $181.8 million from registered equity offerings. We believe that our existing cash resources will be sufficient to meet our capital requirements and fund our operations for at least the next 12 months. We may also seek liquidity through additional securities offerings or through borrowings under a new credit facility. Cash Flows The following table presents a summary of our cash flow for the periods indicated: Operating Activities The net cash used in operating activities was $18.7 million for 2018 and consisted primarily of a net loss of $21.8 million, an increase in net operating assets of $0.9 million and non-cash charges of $2.3 million. Net operating assets consisted primarily of accrued expenses, accounts payable, accounts receivable, and prepaid expenses and other assets to support the growth of our operations. Non-cash charges consisted primarily of stock-based compensation, the change in fair value of preferred stock warrants, accretion of debt discount, and depreciation, offset by the non-cash income related to the accretion of the investment discount. The net cash used in operating activities was $15.8 million in 2017 and consisted primarily of a net loss of $17.5 million, a decrease in net operating assets of $0.8 million and non-cash charges of $0.9 million. Net operating assets consisted primarily of accounts receivable and inventory to support the growth of our operations and accrued compensation as annual bonuses were paid. Non-cash charges consisted primarily of depreciation and stock-based compensation. The net cash used in operating activities was $17.9 million in 2016 and consisted primarily of a net loss of $18.5 million, a decrease in net operating assets of $0.3 million and non-cash charges of $0.3 million. Net operating assets consisted primarily of accounts receivable to support the growth of our operations and accrued compensation as annual bonuses were paid. Non-cash charges consisted primarily of depreciation and stock-based compensation. Investing Activities Net cash used in investing activities for 2018 was $83.4 million and consisted primarily of purchases of short-term investments of $115.5 million, offset by proceeds from sales or maturities of short-term investments of $32.3 million. Net cash used in investing activities was $7.6 million in 2017 and consisted of $7.2 million of investments in short-term marketable securities and $0.4 million of purchases of property and equipment. Net cash used in investing activities in 2016 was $0.3 million and consisted of purchases of property and equipment. Financing Activities Net cash provided by financing activities was $190.4 million for 2018 and consisted primarily of $181.8 million of net proceeds from public offerings of our common stock and borrowings of $8.0 million under our credit facility. Net cash provided by financing activities was $25.7 million in 2017 and consisted primarily of $25.0 million of net proceeds from the issuance of Series F convertible preferred stock, borrowings of $1.0 million under our credit facility less $0.5 million of expenses and $0.2 million in proceeds from the exercise of stock options. Net cash provided by financing activities was $12.8 million in 2016 and consisted primarily of $12.3 million of net proceeds from the issuance of Series F convertible preferred stock, $0.3 million from the purchase of preferred shares under preferred stock warrants and $0.2 million in proceeds from the exercise of stock options. Indebtedness In August 2015, we entered into a loan and security agreement with Oxford Finance LLC ("Oxford Finance"), as lender and collateral agent. The loan and security agreement initially provided for a term A loan facility in the amount of $15.5 million, which was fully funded on the closing date, and a term B loan facility in an amount of at least $3.5 million but no more than $10.0 million, to be available in the future subject to our achievement of certain revenue milestones. We refer to our term A loan facility and our term loan B facility together as our credit facility. In February 2017, we amended the loan and security agreement to, among other things, increase borrowings under the term A loan facility by $1.0 million, increase the minimum amount of the term B loan facility to $5.0 million and reduce the maximum amount of the term B loan facility to $9.0 million. On February 7, 2018, we borrowed $8.0 million under the term B loan facility. The credit facility is secured by substantially all of our personal property other than our intellectual property. Outstanding borrowings under the credit facility bear interest at an annual rate equal to the greater of (i) 7.95% and (ii) the sum of (a) the 30-day U.S. LIBOR rate on the last business day of the month that immediately precedes the month in which such interest will accrue, plus (b) 6.90%. We are required to make monthly payments of interest only through March 1, 2019, or the interest-only period; provided that the interest-only period will be extended to March 1, 2020 if we have revenue, measured on a trailing 12-month basis as of December 31, 2018, of at least $25.0 million, which was met, and, therefore, the interest-only period is extended to March 1, 2020. Following the interest-only period, we will be required to make monthly payments of interest and principal in 24 consecutive monthly installments. Outstanding borrowings under the credit facility mature on February 1, 2022. On the maturity date, in addition to our regular monthly payments of principal and accrued interest, we will be required to make a payment of 5.0% (or 5.5% if the interest-only period has been extended to March 1, 2020) of the total amount borrowed under the credit facility, which we refer to as the Final Payment, unless we have not already made such payment in connection with an acceleration or prepayment of borrowings under the credit facility. Because the interest-only period has been extended, the Final Payment fee will be 5.5%. Borrowings under the term A loan facility are prepayable at our option in whole, but not in part, together with all accrued and unpaid interest thereon and, if not previously made, the Final Payment, subject to a prepayment fee of 1.5% if such borrowings are prepaid prior to February 24, 2019 and 1.00% if such borrowings are prepaid on or after February 24, 2019. The Final Payment is being accrued over the life of the credit facility and will be due at the earlier of maturity or prepayment. Borrowings under the term B loan facility are prepayable at our option in whole, but not in part, together with all accrued and unpaid interest thereon and, if not previously made, the Final Payment, subject to a prepayment fee of 2.5% if the such borrowings are prepaid prior to February 7, 2019, 1.5% if such borrowings are prepaid on or after February 7, 2019 but prior to February 7, 2020 and 1.00% if such borrowings are on or after February 7, 2020. We are also required to prepay the amounts outstanding under the credit facility upon the occurrence of certain customary events of default, as well as the occurrence of certain material adverse events. The credit facility also includes certain customary affirmative and negative covenants, but does not include any financial covenants. We were in compliance with all covenants under the credit facility as of December 31, 2018. In August 2015, we issued to Oxford Finance warrants to purchase 12,404 and 17,176 shares, respectively, of our Series E convertible preferred stock, having an exercise price of $2.62 per share. In February 2017 and February 2018, we issued warrants to Oxford Finance to purchase 29,197 and 233,577 shares, respectively, of our Series F convertible preferred stock, having an exercise price of $1.37 per share. Each of the warrants described above has a term of 10 years. Upon the closing of the IPO, the warrants to purchase 630,372 shares of preferred stock at a weighted average exercise price of $1.46 per share became exercisable to purchase 100,558 shares of common stock at a weighted average exercise price of $9.38 per share. Warrants to purchase 93,963 shares of common stock were exercised during 2018, resulting in 6,595 warrants outstanding at December 31, 2018 with a weighted average exercise price of $15.16 per share as of such date. Off-Balance Sheet Arrangements We do not have any off-balance sheet arrangements, as defined by applicable regulations of the SEC, that are reasonably likely to have a current or future material effect on our financial condition, results of operations, liquidity, capital expenditures or capital resources. Contractual Obligations and Commitments Our contractual obligations and commitments as of December 31, 2018 are summarized in the table below: 1.The total amount outstanding under the credit facility was $24.5 million at December 31, 2018. All amounts borrowed under the credit facility are interest-only through March 1, 2020, after which payments of interest and principal will be payable in 24 consecutive monthly installments. Variable interest is assumed at December 31, 2018 rates. Under the terms of the credit facility, a final payment fee of 5.5% is due at the earlier of maturity or prepayment. This amount is not included in the table above. 2.We currently sublease approximately 44,000 square feet of office space for our corporate headquarters in Golden Valley, Minnesota, under an operating lease which expires November 30, 2020. We also lease approximately 9,300 square feet for our previous headquarters in Maple Grove, Minnesota under a lease that expires in March 2019. Critical Accounting Policies and Estimates The preparation of the financial statements in conformity with accounting principles generally accepted in the U.S. requires management to make estimates and assumptions that affect the amounts reported in the audited financial statements and accompanying notes included elsewhere in this Annual Report on Form 10-K. We believe that such estimates have been based on reasonable and supportable assumptions and the resulting estimates are reasonable for use in the preparation of the audited financial statements. Actual results could differ from these estimates. Significant areas requiring management estimates or judgments include the following key financial areas: Revenue Recognition We recognize revenue when persuasive evidence of an arrangement exists, product shipment has occurred, or there are no further obligations yet to be performed, pricing is fixed or determinable, and collection is reasonably assured. We make reasonable assumptions regarding the future collectability of amounts receivable from customers to determine whether the revenue recognition criteria have been met. Taxes assessed by a governmental authority that are directly imposed on revenue-producing transactions between a seller and a customer are not recorded as revenue. In general, our standard terms and conditions of sale do not allow for product returns. Sales returns have been limited to damaged product and have not been material. We expense shipping and handling costs as incurred and include them in the cost of goods sold. In those cases where shipping and handling costs are billed to customers, we classify the amounts billed as a component of cost of goods sold. Common Stock Valuation and Stock-Based Compensation We maintain an equity incentive plan to provide long-term incentives for employees, consultants, and members of the board of directors. The plan allows for the issuance of non-statutory and incentive stock options to employees and non-statutory stock options to consultants and directors. We recognize equity-based compensation expense for awards of equity instruments to employees and directors based on the grant date fair value of those awards in accordance with Financial Accounting Standards Board ("FASB") Accounting Standards Codification ("ASC") Topic 718, Stock Compensation ("ASC 718"). ASC 718 requires all equity-based compensation awards to employees and directors, including grants of restricted shares and stock options, to be recognized as expense in the statements of operations and comprehensive loss based on their grant date fair values. We estimate the fair value of stock options using the Black-Scholes option pricing model. We have not granted any restricted shares. We have not granted any share-based awards to our consultants. The Black-Scholes option pricing model requires the input of certain subjective assumptions, including (i) the expected share price volatility, (ii) the expected term of the award, (iii) the risk-free interest rate and (iv) the expected dividend yield. Due to the lack of a public market for the trading of our common stock and a lack of company-specific historical and implied volatility data, we have based our estimate of expected volatility on the historical volatility of a group of similar companies that are publicly traded. The historical volatility is calculated based on a period of time commensurate with the expected term assumption. The group of representative companies have characteristics similar to us, including stage of product development and focus on the life science industry. We use the simplified method, which is the average of the final vesting tranche date and the contractual term, to calculate the expected term for options granted to employees and directors as we do not have sufficient historical exercise data to provide a reasonable basis upon which to estimate the expected term. The risk-free interest rate is based on a Treasury instrument whose term is consistent with the expected term of the stock options. We use an assumed dividend yield of zero as we have never paid dividends and have no current plans to pay any dividends on our common stock. We expense the fair value of our equity-based compensation awards granted to employees and directors on a straight-line basis over the associated service period, which is generally the period in which the related services are received. We account for award forfeitures as they occur. Inventories Inventories are valued at the lower of cost or net realizable value, computed on a first-in, first out basis. We estimate the recoverability of our inventory by reference to internal estimates of future demands and product life cycles, including expiration of inventory prior to sale. We regularly review inventory quantities on-hand for excess and obsolete inventory and, when circumstances indicate, incur charges to write down inventories to their net realizable value. Our review of inventory for excess and obsolete quantities is based primarily on the estimated forecast of future product demand, product life cycles, and introduction of new products. The reserve for excess and obsolete inventory was $0.8 million and $0.5 million as of December 31, 2018 and 2017, respectively. Income Taxes We account for income taxes using the liability method. Under this method, deferred tax assets and liabilities are determined based on the differences between the financial reporting and tax bases of assets and liabilities and are measured using the enacted tax rates that will be in effect when the differences are expected to reverse. Valuation allowances against deferred tax assets are established, when necessary, to reduce deferred tax assets to the amounts expected to be realized. As we have historically incurred operating losses, we have recorded a full valuation allowance against its net deferred tax assets, and there is no provision for income taxes. Our policy is to record interest and penalties expense related to uncertain tax positions as other expense in the statements of operations and comprehensive loss. Recent Accounting Pronouncements A discussion of recent accounting pronouncements is included in Note 2 to our financial statements contained in this Annual Report on Form 10-K. JOBS Act As a company with less than $1.07 billion in revenue during our last fiscal year, we qualify as an "emerging growth company," as defined in the JOBS Act. An emerging growth company may take advantage of reduced reporting requirements that are otherwise applicable to public companies. These provisions include: •being permitted to present only two years of audited financial statements and only two years of related Management's Discussion and Analysis of Financial Condition and Results of Operations in this Annual Report on Form 10-K; •not being required to comply with the auditor attestation requirements of Section 404 of the Sarbanes-Oxley Act; •reduced disclosure obligations regarding executive compensation in this Annual Report on Form 10-K and in our periodic reports, proxy statements and registration statements; and •exemptions from the requirements of holding a nonbinding advisory vote on executive compensation and stockholder approval of any golden parachute payments not previously approved. We may take advantage of these provisions until December 31, 2023. However, if certain events occur prior to the end of such date, including if we become a "large accelerated filer," our annual gross revenue exceeds $1.07 billion or we issue more than $1.0 billion of non-convertible debt in any three-year period, we will cease to be an emerging growth company prior to December 31, 2023. We have elected to take advantage of certain of the reduced disclosure obligations in this registration statement and may elect to take advantage of other reduced reporting requirements in future filings. As a result, the information that we provide to our stockholders may be different from what you might receive from other public reporting companies in which you hold equity interests. In addition, under the JOBS Act, emerging growth companies can delay adopting new or revised accounting standards until such time as those standards apply to private companies. We have elected to avail ourselves of this exemption and, as a result, our financial statements may not be comparable to the financial statements of issuers who are required to comply with the effective dates for new or revised accounting standards that are applicable to public companies. Section 107 of the JOBS Act provides that we can elect to opt out of the extended transition period at any time, which election is irrevocable.

<s>[INST] Overview We are a medical technology company focused on the development and commercialization of innovative and minimally invasive solutions for patients with obstructive sleep apnea. Our proprietary Inspire system is the first and only FDAapproved neurostimulation technology that provides a safe and effective treatment for moderate to severe obstructive sleep apnea. We have developed a novel, closedloop solution that continuously monitors a patient’s breathing and delivers mild hypoglossal nerve stimulation to maintain an open airway. Inspire therapy is indicated for patients with moderate to severe obstructive sleep apnea who do not have significant central sleep apnea and do not have a complete concentric collapse of the airway at the soft palate level. In addition, patients in the United States ("U.S.") must have been confirmed to fail or be unable to tolerate positive airway pressure treatments, such as CPAP, and be 22 years of age or older, though there are no similar requirements for patients in Europe. We sell our Inspire system to hospitals and ASCs in the U.S. and in select countries in Europe through a direct sales organization. Our direct sales force engages in sales efforts and promotional activities focused on ENT physicians and sleep centers. In addition, we highlight our compelling clinical data and value proposition to increase awareness and adoption amongst referring physicians. We build upon this topdown approach with strong directtopatient marketing initiatives to create awareness of the benefits of our Inspire system and drive demand through patient empowerment. This outreach helps to educate thousands of patients on our Inspire therapy and frequently results in patient leads. We increased the number of employees in our sales, marketing and reimbursement organizations from 40 as of December 31, 2015 to 129 as of December 31, 2018. Although our sales and marketing efforts are directed at patients and physicians because they are the primary users of our technology, we consider the hospitals and ASCs where the procedure is performed to be our customers, as they are the purchasing agents of our Inspire system. Our customers are reimbursed the cost required to treat each patient through various thirdparty payors, such as commercial payors and government agencies. Our Inspire system is currently reimbursed primarily on a perpatient prior authorization basis for patients covered by commercial payors, on a medical necessity basis for most patients covered by Medicare, and under U.S. government contract for patients who are treated by the Veterans Health Administration. To date, approximately 330 commercial payors have prior authorized for patients’ treatment with our Inspire therapy. In July 2018, Aetna Inc., one of the leading health plans in the U.S., began providing coverage for our Inspire therapy, and in January 2019, Blue Cross Blue Shield Association's (“BCBSA”) Evidence Street, which performs healthcare technology assessments for the 36 BCBSA insurers, issued a positive assessment of Inspire therapy to its members. We have currently secured positive coverage policies with 18 U.S. commercial payors. In June 2018, Japan’s Ministry of Health, Labour and Welfare approved our Inspire therapy to treat moderate to severe OSA, and we are currently seeking reimbursement coverage in Japan. For the year ended December 31, 2018, 87.7% of our revenue was derived in the U.S. and 12.3% was derived in Europe. No single customer accounted for more than 10% of our revenue. We rely on thirdparty suppliers to manufacture our Inspire system and its components. Many of these suppliers are currently single source suppliers. We seek to maintain higher levels of inventory to protect ourselves from supply interruptions, and, as a result, we are subject to the risk of inventory obsolescence and expiration, which could lead to inventory impairment charges. In the U.S., our products are shipped directly to our customers on a purchase order basis, primarily by a thirdparty vendor with a facility in Tennessee. We ship our physician programmers and some Inspire systems from our facility in Minnesota. Warehousing and shipping operations for our European customers are handled by a thirdparty vendor with facilities located in the Netherlands. Customers do not have the right to return nondef [/INST] Positive. </s>

Inspire Medical Systems, Inc.

2020-02-25

2019-12-31

Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations. The following discussion and analysis of our financial condition and results of operations should be read in conjunction with our financial statements and the related notes to those statements included elsewhere in this Annual Report on Form 10-K. In addition to historical financial information, the following discussion and analysis contains forward-looking statements that involve risks, uncertainties, and assumptions. Some of the numbers included herein have been rounded for the convenience of presentation. Our actual results may differ materially from those anticipated in these forward-looking statements as a result of many factors, including those discussed under Part I. "Item 1A. Risk Factors’’ and elsewhere in this Annual Report on Form 10-K. Overview We are a medical technology company focused on the development and commercialization of innovative and minimally invasive solutions for patients with OSA. Our proprietary Inspire system is the first and only FDA-approved neurostimulation technology that provides a safe and effective treatment for moderate to severe OSA. We have developed a novel, closed-loop solution that continuously monitors a patient’s breathing and delivers mild hypoglossal nerve stimulation to maintain an open airway. Inspire therapy is indicated for patients with moderate to severe OSA who do not have significant central sleep apnea and do not have a complete concentric collapse of the airway at the soft palate level. In addition, patients in the U.S. must have been confirmed to fail or be unable to tolerate positive airway pressure treatments, such as CPAP, and be 22 years of age or older, though there are no similar requirements for patients in Europe. We sell our Inspire system to hospitals and ASCs in the U.S. and in select countries in Europe through a direct sales organization. Our direct sales force engages in sales efforts and promotional activities focused on ENT physicians and sleep centers. In addition, we highlight our compelling clinical data and value proposition to increase awareness and adoption amongst referring physicians. We build upon this top-down approach with strong direct-to-patient marketing initiatives to create awareness of the benefits of our Inspire system and drive demand through patient empowerment. This outreach helps to educate thousands of patients on our Inspire therapy and frequently results in patient leads. We increased the number of employees in our sales, marketing, and reimbursement organizations from 40 as of December 31, 2015 to 186 as of December 31, 2019. Although our sales and marketing efforts are directed at patients and physicians because they are the primary users of our technology, we consider the hospitals and ASCs where the procedure is performed to be our customers, as they are the purchasing agents of our Inspire system. Our customers are reimbursed the cost required to treat each patient through various third-party payors, such as commercial payors and government agencies. Our Inspire system is currently reimbursed primarily on a per-patient prior authorization basis for patients covered by commercial payors, on a case-by-case basis for patients covered by Medicare, and under U.S. government contract for patients who are treated by the Veterans Health Administration. To date, more than 430 commercial payors have prior authorized for patients’ treatment with our Inspire therapy. We have currently secured positive coverage policies with 52 U.S. commercial payors, including most large national commercial insurers. In June 2018, Japan’s Ministry of Health, Labour and Welfare approved our Inspire therapy to treat moderate to severe OSA, and we are currently seeking reimbursement coverage in Japan. For the year ended December 31, 2019, 89.8% of our revenue was derived in the U.S. and 10.2% was derived in Europe. No single customer accounted for more than 10% of our revenue. We rely on third-party suppliers to manufacture our Inspire system and its components. Many of these suppliers are currently single source suppliers. We seek to maintain higher levels of inventory to protect ourselves from supply interruptions, and, as a result, we are subject to the risk of inventory obsolescence and expiration, which could lead to inventory impairment charges. In the U.S., our products are shipped directly to our customers on a purchase order basis, primarily by a third-party vendor with a facility in Tennessee, although we do ship some products from our facility in Minnesota. Warehousing and shipping operations for our European customers are handled by a third-party vendor with facilities located in the Netherlands. Customers do not have the right to return non-defective product, nor do we place product on consignment. Our sales representatives do not maintain trunk stock. Since our inception in 2007, we have financed our operations primarily through sales of our Inspire system, private placements of our convertible preferred securities, amounts borrowed under our credit facility, the initial public offering of our common stock that closed in May 2018 (our "IPO"), and the offering of our common stock that closed in December 2018 (our "follow-on offering"). We have devoted significant resources to research and development activities related to our Inspire system, including clinical and regulatory initiatives to obtain marketing approval, and sales and marketing activities. For the year ended December 31, 2019, we generated revenue of $82.1 million with a gross margin of 83.4% and a net loss of $33.2 million compared to revenue of $50.6 million with a gross margin of 80.1% and a net loss of $21.8 million for the year ended December 31, 2018, and revenue of $28.6 million with a gross margin of 78.9% and a net loss of $17.5 million for the year ended December 31, 2017. Our accumulated deficit as of December 31, 2019 was $180.2 million. We have invested heavily in product development. Our research and development activities have been centered on driving continuous improvements to our Inspire therapy. We have also made significant investments in clinical studies to demonstrate the safety and efficacy of our Inspire therapy and to support regulatory submissions. We intend to make significant investments building our sales and marketing organization by increasing the number of U.S. sales representatives and continuing our direct-to-patient marketing efforts in existing and new markets throughout the U.S. and in Europe. We also intend to continue to make investments in research and development efforts to develop our next generation Inspire systems and support our future regulatory submissions for expanded indications and for new markets such as Europe, Japan, and Australia. Because of these and other factors, we expect to continue to incur net losses for the next several years and we expect to require substantial additional funding, which may include future equity and debt financings. On May 7, 2018, we completed our IPO by issuing 7,762,500 shares of common stock, at a public offering price of $16.00 per share, for net proceeds of approximately $112.0 million after deducting underwriting discounts and commissions and offering expenses payable by us. On December 11, 2018, we completed the follow-on offering that included our offer and sale of 1,875,000 shares of common stock and the selling stockholders' offer and sale of 1,000,000 shares of common stock, at a public offering price of $40.00 per share. We received net proceeds of approximately $69.8 million after deducting underwriting discounts and commissions and offering expenses. We received no proceeds from the sale of our common stock by the selling shareholders. Components of Our Results of Operations Revenue We derive primarily all of our revenue from the sale of our Inspire system to hospitals and ambulatory service centers in the U.S. and select countries in Europe. Recent revenue growth has been driven by, and we expect continued growth as a result of, increased patient and physician awareness of the Inspire system, additional sales representatives, an increase in approvals of prior authorization submissions, and additional positive coverage policies. Any reversal in these recent trends, however, could have a negative impact on our future revenue. In addition, we have expanded our sales and marketing organization to help us drive and support revenue growth and intend to continue this expansion. Moreover, we expect that our revenue growth will be positively impacted by, and to the extent we obtain, additional positive coverage policies. Our revenue has fluctuated, and we expect our revenue to continue to fluctuate, from quarter to quarter due to a variety of factors. For example, we have historically experienced seasonality in our first and fourth quarters. Cost of Goods Sold and Gross Margin Cost of goods sold consists primarily of acquisition costs for the components of the Inspire system, overhead costs, scrap, and inventory obsolescence, as well as distribution-related expenses such as logistics and shipping costs, net of costs charged to customers. The overhead costs include the cost of material procurement, depreciation expense for production equipment, warranty replacement costs, and operations supervision and management personnel, including employee compensation, stock-based compensation, supplies, and travel. We expect overhead costs as a percentage of revenue to continue to decrease as our sales volume increases. We expect cost of goods sold to increase in absolute dollars primarily as, and to the extent, our revenue grows. We calculate gross margin as gross profit divided by revenue. Our gross margin has been and we expect it will continue to be affected by a variety of factors, including manufacturing costs, the average selling price of our Inspire system, the implementation of cost-reduction strategies, inventory obsolescence costs, which generally occur when new generations of our Inspire system are introduced, and to a lesser extent the sales mix between the U.S. and Europe as our average selling price in the U.S. tends to be higher than in Europe. Our gross margin may increase over the long term to the extent our production volumes increase and we receive discounts on the costs charged by our contract manufacturers, thereby reducing our per unit costs. However, our gross margin may fluctuate from quarter to quarter due to seasonality. Research and Development Expenses Research and development expenses consist primarily of product development, engineering, clinical studies to develop and support our products, regulatory expenses, testing, consulting services and other costs associated with the next generation versions of the Inspire system. These expenses include employee compensation, including stock-based compensation, supplies, materials, consulting, and travel expenses related to research and development programs. Additionally, these expenses include clinical trial management, payments to clinical investigators, data management and travel expenses for our various clinical trials. We expect research and development expenses to increase in the future as we develop next generation versions of our Inspire system and continue to expand our clinical studies to secure positive coverage policies from private commercial payors in the U.S. and enter into new markets including additional European countries, Japan, and Australia. We expect research and development expenses as a percentage of revenue to vary over time depending on the level and timing of initiating new product development efforts and new clinical development activities. Selling, General and Administrative Expenses Selling, general and administrative expenses consist primarily of compensation for personnel, including base salaries, stock-based compensation expense and commissions related to our sales organization, finance, information technology, and human resource functions, as well as spending related to marketing, sales operations, and training and reimbursement personnel. Other selling, general and administrative expenses include training physicians, travel expenses, advertising, direct-to-patient promotional programs, conferences, trade shows and consulting services, professional services fees, audit fees, insurance costs and general corporate expenses, including facilities-related expenses. We expect selling, general and administrative expenses to continue to increase as we expand our commercial infrastructure to both drive and support our planned growth in revenue and as we increase our headcount and expand administrative personnel to support our growth and operations as a public company including finance personnel and information technology services. Additionally, we anticipate increased expenses related to audit, legal, and tax-related services associated with maintaining compliance with exchange listing and SEC requirements, director and officer insurance premiums and investor relations costs associated with being a public company. We also expect to see an increase in our stock-based compensation expense with grants of restricted stock or options and shares of our common stock purchased pursuant to our employee stock purchase plan. Other (Income) Expense, Net Other (income) expense, net consists primarily of interest expense payable under our credit facility and interest income. Other items include fair value adjustments related to convertible preferred stock warrants, which were accounted for as a liability and marked-to-market at each reporting period. Immediately prior to the closing of our IPO, our outstanding convertible preferred stock warrants automatically converted into warrants to purchase shares of our common stock. Results of Operations Year Ended December 31, 2019 Compared to Year Ended December 31, 2018 Revenue Revenue increased $31.5 million, or 62.2%, to $82.1 million for the year ended December 31, 2019 compared to the year ended December 31, 2018. The increase was attributable to an increase in sales of our Inspire system of $29.3 million in the U.S. and an increase of $2.2 million in Europe, primarily in Germany. Revenue information by region is summarized as follows: Revenue generated in the U.S. was $73.7 million for the year ended December 31, 2019, an increase of $29.3 million or 66.0% over the year ended December 31, 2018. Revenue growth in the U.S. was due to increased market penetration in existing territories, the expansion into new territories, increased physician and patient awareness of our Inspire system, a greater number of prior authorization approvals, additional positive coverage policies and, to a lesser extent, an increase in our average selling price as a result of the introduction of the new sensing lead on the Inspire system to the U.S. market in February 2019. Revenue generated in Europe was $8.4 million in the year ended December 31, 2019, an increase of $2.2 million or 35.0% over the year ended December 31, 2018. Revenue growth in Europe was primarily due to increased market penetration in existing territories, the expansion into new territories, and increased physician and patient awareness of our Inspire system. Cost of Goods Sold and Gross Margin Cost of goods sold increased $3.5 million, or 35.7%, to $13.6 million for the year ended December 31, 2019 compared to $10.1 million for the year ended December 31, 2018. The increase was primarily due to increased purchases of manufactured products due to higher sales volume of our Inspire system. Gross margin was 83.4% for the year ended December 31, 2019 compared to 80.1% for the year ended December 31, 2018. Gross margin for the year ended December 31, 2019 was higher primarily due to the introduction of the new sensing lead on the Inspire system in the U.S. in February 2019 which has a higher gross margin than the previous sensor, as well as manufacturing efficiencies. Research and Development Expenses Research and development expenses increased $5.4 million, or 73.8%, to $12.8 million for the year ended December 31, 2019 compared to $7.4 million for the year ended December 31, 2018. This change was primarily due to an increase of $3.4 million for ongoing research and development costs, including initial development of the next generation Inspire therapy system and $2.0 million of compensation and employee-related expenses, mainly as a result of increased headcount. Selling, General and Administrative Expenses Selling, general and administrative expenses increased $37.0 million, or 69.0%, to $90.5 million for the year ended December 31, 2019 compared to $53.5 million for the year ended December 31, 2018. The primary driver of this increase was an increase of $22.5 million in compensation, including salaries, commissions, and stock-based compensation, travel and other employee-related expenses, mainly as a result of increased headcount. In addition, selling, general and administrative expenses increased by $3.9 million due to legal fees, financial audit fees, insurance costs, and other corporate costs which increased primarily as a result of being a public company during the entire year ended December 31, 2019 compared to being a public company during only part of the same prior year period, as well as out-sourced information technology services and facilities costs. Other drivers included an increase of $9.0 million of marketing, primarily consisting of direct-to-patient initiatives, and an increase of $1.6 million of regulatory and reimbursement costs, which increased primarily due to market access consulting services used to obtain positive coverage policies. Other (Income) Expense, Net Other (income) expense, net changed by $3.2 million, or 216.8%, to $1.7 million of income for the year ended December 31, 2019 compared to $1.5 million of expense for the year ended December 31, 2018. Interest income increased $1.9 million due to our higher cash, cash equivalents and investments balances. Interest expense decreased $1.2 million, primarily due to the lack of the $0.6 million fair value adjustment taken during the year ended December 31, 2018 on our previously outstanding convertible preferred stock warrants. Year Ended December 31, 2018 Compared to Year Ended December 31, 2017 For a discussion of our results of operations for the year ended December 31, 2017, including a year-to-year comparison between 2018 and 2017, refer to Part II, Item 7, "Management's Discussion and Analysis of Financial Condition and Results of Operations" in our Annual Report Form 10-K for the year ended December 31, 2018. Liquidity and Capital Resources As of December 31, 2019, we had cash, cash equivalents and investments of $155.7 million and an accumulated deficit of $180.2 million, compared to cash, cash equivalents and investments of $188.2 million and an accumulated deficit of $146.9 million as of December 31, 2018. As of December 31, 2019, we had $24.5 million of outstanding borrowings under our credit facility. No borrowings remain available under this credit facility. On May 7, 2018, we completed our IPO by issuing 7,762,500 shares of common stock, at a public offering price of $16.00 per share, for net proceeds of approximately $112.0 million after deducting underwriting discounts and commissions and offering expenses payable by us. On December 11, 2018, we completed the follow-on offering that included our offer and sale of 1,875,000 shares of common stock and the selling stockholders' offer and sale of 1,000,000 shares of common stock, at a public offering price of $40.00 per share. We received net proceeds of approximately $69.8 million after deducting underwriting discounts and commissions and offering expenses. We received no proceeds from the sale of our common stock by the selling shareholders. Our sources of capital have historically been from private placements of our convertible preferred securities, sales of our Inspire system, borrowings under credit facilities and registered offerings of our common stock. As of December 31, 2019, we had raised a total of $119.1 million in net proceeds from private placements of our convertible preferred securities and $181.8 million from registered equity offerings. We believe that our existing cash resources will be sufficient to meet our capital requirements and fund our operations for at least the next 12 months. We may also seek liquidity through additional securities offerings or through borrowings under a new credit facility. Cash Flows The following table presents a summary of our cash flow for the periods indicated: Operating Activities Net cash used in operating activities was $32.8 million for 2019 and consisted of a net loss of $33.2 million, an increase in net operating assets of $6.6 million, and non-cash charges of $7.0 million. The non-cash charges consisted of stock-based compensation, accretion of the debt discount, non-cash lease expense, stock issued for services rendered, and depreciation and amortization, offset by the non-cash income related to the accretion of the investment discount, and other, net. Operating assets, which includes accounts receivable, inventories, and prepaid expenses and other current assets, increased generally due to increased revenues year-over-year. Operating liabilities, which includes accrued expenses and accounts payable, increased generally due to our increased business volume year-over-year and the costs to support the growth of our operations, including compensation and personnel-related costs. Net cash used in operating activities was $18.7 million for 2018 and consisted of a net loss of $21.8 million, an increase in net operating assets of $0.9 million and non-cash charges of $2.3 million. Net operating assets consisted primarily of accrued expenses, accounts payable, accounts receivable, and prepaid expenses and other assets to support the growth of our operations. Non-cash charges consisted primarily of stock-based compensation, the change in fair value of preferred stock warrants, accretion of debt discount, and depreciation, offset by the non-cash income related to the accretion of the investment discount. Net cash used in operating activities was $15.8 million in 2017 and consisted of a net loss of $17.5 million, a decrease in net operating assets of $0.8 million and non-cash charges of $0.9 million. Net operating assets consisted primarily of accounts receivable and inventory to support the growth of our operations and accrued compensation as annual bonuses were paid. Non-cash charges consisted primarily of depreciation and stock-based compensation. Investing Activities Net cash used in investing activities for 2019 was $43.6 million and consisted primarily of purchases of investments of $178.1 million, partially offset by proceeds from sales or maturities of investments of $137.3 million. Purchases of property and equipment were $2.7 million. Net cash used in investing activities for 2018 was $83.4 million and consisted primarily of purchases of investments of $115.5 million, offset by proceeds from sales or maturities of investments of $32.3 million. Purchases of property and equipment were $0.2 million. Net cash used in investing activities for 2017 was $7.6 million and consisted primarily of purchases of investments of $9.0 million, offset by proceeds from sales or maturities of investments of $1.8 million. Purchases of property and equipment were $0.4 million. Financing Activities Net cash provided by financing activities was $2.0 million for 2019 and consisted of $1.4 million in proceeds from the issuance of common stock from the employee stock purchase plan and $1.1 million in proceeds from the exercise of stock options and warrants, partially offset by a $0.5 million final payment fee due upon the amendment of our credit facility. Net cash provided by financing activities was $190.4 million for 2018 and consisted primarily of $181.8 million of net proceeds from public offerings of our common stock and borrowings of $8.0 million under our credit facility. Net cash provided by financing activities was $25.7 million in 2017 and consisted primarily of $25.0 million of net proceeds from the issuance of Series F convertible preferred stock, borrowings of $1.0 million under our credit facility less $0.5 million of expenses and $0.2 million in proceeds from the exercise of stock options. Indebtedness In August 2015, we entered into a loan and security agreement with Oxford Finance LLC ("Oxford Finance"), as lender and collateral agent. The loan and security agreement initially provided for a term A loan facility in the amount of $15.5 million, which was fully funded on the closing date, and a term B loan facility in an amount of at least $3.5 million but no more than $10.0 million, to be available in the future subject to our achievement of certain revenue milestones. We refer to our term A loan facility and our term loan B facility together as our credit facility. In February 2017, we amended the loan and security agreement to, among other things, increase borrowings under the term A loan facility by $1.0 million, increase the minimum amount of the term B loan facility to $5.0 million and reduce the maximum amount of the term B loan facility to $9.0 million. In February 2018, we borrowed $8.0 million under the term B loan facility. In March 2019, we amended the loan and security agreement. Following such amendment, outstanding borrowings under the credit facility bear interest at an annual rate equal to the sum of (i) the greater of (A) the 30 day U.S. LIBOR rate reported in The Wall Street Journal on the last business day of the month that immediately precedes the month in which the interest will accrue or (B) 2.50%, plus (ii) 5.10%; provided, however, under no circumstances will the basic rate be less than 7.60%. We are required to make monthly payments of interest only through April 1, 2022. Following the interest-only period, we will be required to make monthly payments of interest and principal in 24 consecutive monthly installments. Outstanding borrowings under the credit facility mature on March 1, 2024. On the maturity date, in addition to our regular monthly payments of principal and accrued interest, we will be required to make a payment of 3.50% of the total amount borrowed under the credit facility, which we refer to as the Final Payment, unless we have already made such payment in connection with an acceleration or prepayment of borrowings under the credit facility. Borrowings under the facility are pre-payable at our option in whole, but not in part, together with all accrued and unpaid interest thereon and, if not previously made, the Final Payment, subject to a prepayment fee of 3.0% if such borrowings are prepaid prior to March 27, 2020, 2.0% if such borrowings are prepaid on or after March 27, 2020 but prior to March 27, 2021 and 1.0% if such borrowings are on or after March 27, 2021 and prior to maturity. We are also required to prepay the amounts outstanding under the credit facility upon the occurrence of certain customary events of default, as well as the occurrence of certain material adverse events. The credit facility also includes certain customary affirmative and negative covenants, but does not include any financial covenants. The credit facility is secured by substantially all of our personal property other than our intellectual property. We were in compliance with all covenants under the credit facility as of December 31, 2019. In August 2015, we issued to Oxford Finance warrants to purchase 12,404 and 17,176 shares of our Series E convertible preferred stock, having an exercise price of $2.62 per share. In February 2017 and February 2018, we issued warrants to Oxford Finance to purchase 29,197 and 233,577 shares, respectively, of our Series F convertible preferred stock, having an exercise price of $1.37 per share. Each of the warrants described above has a term of 10 years. Upon the closing of the IPO, the warrants to purchase 630,372 shares of preferred stock at a weighted average exercise price of $1.46 per share became exercisable to purchase 100,558 shares of common stock at a weighted average exercise price of $9.38 per share. Warrants to purchase 93,963 shares of common stock were exercised during 2018, and the warrants to purchase 6,595 shares of common stock were exercised during 2019. No warrants remain outstanding at December 31, 2019. Off-Balance Sheet Arrangements We do not have any off-balance sheet arrangements, as defined by applicable regulations of the SEC, that are reasonably likely to have a current or future material effect on our financial condition, results of operations, liquidity, capital expenditures or capital resources. Contractual Obligations and Commitments Our contractual obligations and commitments as of December 31, 2019 are summarized in the table below: (1) Represents principal payments only. See Note 5 to our audited financial statements for more information. (2) Variable interest is assumed at December 31, 2019 rates. Under the terms of the credit facility, a final payment fee of 3.50% is due at the earlier of maturity or prepayment. This amount is not included in the table above. (3) Real estate obligation represents the legally binding minimum lease payments for a lease signed but not yet commenced. See Note 4 to our audited financial statements for more information. Critical Accounting Policies and Estimates The preparation of the financial statements in conformity with accounting principles generally accepted in the U.S. requires management to make estimates and assumptions that affect the amounts reported in the audited financial statements and accompanying notes included elsewhere in this Annual Report on Form 10-K. We believe that such estimates have been based on reasonable and supportable assumptions and the resulting estimates are reasonable for use in the preparation of the audited financial statements. Actual results could differ from these estimates. Significant areas requiring management estimates or judgments include the following key financial areas: Revenue Recognition We recognize revenue in accordance with Accounting Standards Codification ("ASC") Topic 606, Revenue from Contracts with Customers ("ASC 606"), which we adopted effective January 1, 2019 using the modified retrospective approach. The adoption of ASC 606 did not have a material impact on the amount and timing of revenue recognized in our financial statements. Revenues from product sales are recognized when the customer obtains control of the product, which occurs at a point in time, either upon shipment of the product or receipt of the product, depending on shipment terms. Our standard shipping terms are free on board shipping point, unless the customer requests that control and title to the inventory transfer upon delivery. In those cases where shipping and handling costs are billed to customers, we classify the amounts billed as a component of cost of goods sold. Revenue is measured as the amount of consideration we expect to receive, adjusted for any applicable estimates of variable consideration and other factors affecting the transaction price, which is based on the invoiced price, in exchange for transferring products. All revenue is recognized when we satisfy our performance obligations under the contract. The majority of our contracts have a single performance obligation and are short term in nature. Sales taxes and value added taxes in foreign jurisdictions that are collected from customers and remitted to governmental authorities are accounted for on a net basis and therefore are excluded from net sales. Shipping and handling costs associated with outbound freight after control over a product has transferred to a customer are accounted for as a fulfillment cost and are included in cost of goods sold. Variable consideration related to certain customer sales incentives is estimated based on the amounts expected to be paid based on the agreement with the customer using probability assessments. We offer customers a limited right of return for our product in case of non-conformity or performance issues. We estimate the amount of our product sales that may be returned by our customers based on historical sales and returns. As our historical product returns to date have been immaterial, we have not recorded a reduction in revenue related to variable consideration for product returns. Stock-Based Compensation We maintain an equity incentive plan to provide long-term incentives for eligible employees, consultants, and members of the board of directors. The plan allows for the issuance of non-statutory and incentive stock options to employees and non-statutory stock options to consultants and directors. We also offer an employee stock purchase plan which allows participating employees to purchase shares of our common stock at a discount through payroll deductions. We recognize equity-based compensation expense for awards of equity instruments to employees and directors based on the grant date fair value of those awards in accordance with ASC Topic 718, Stock Compensation ("ASC 718"). ASC 718 requires all equity-based compensation awards to employees and directors, including grants of restricted shares and stock options, to be recognized as expense in the statements of operations and comprehensive loss based on their grant date fair values. We estimate the fair value of stock options using the Black-Scholes option pricing model. The fair value of each purchase under the employee stock purchase plan is estimated at the beginning of the offering period using the Black-Scholes option pricing model. We have not granted any restricted shares. We have not granted any stock-based awards to our consultants. The Black-Scholes option pricing model requires the input of certain subjective assumptions, including (i) the expected share price volatility, (ii) the expected term of the award, (iii) the risk-free interest rate and (iv) the expected dividend yield. Due to the lack of a public market for the trading of our common stock and a lack of company-specific historical and implied volatility data, we have based our estimate of expected volatility on the historical volatility of a group of similar companies that are publicly traded. The historical volatility is calculated based on a period of time commensurate with the expected term assumption. The group of representative companies have characteristics similar to us, including stage of product development and focus on the life science industry. We use the simplified method, which is the average of the final vesting tranche date and the contractual term, to calculate the expected term for options granted to employees and directors as we do not have sufficient historical exercise data to provide a reasonable basis upon which to estimate the expected term. The risk-free interest rate is based on a U.S. government Treasury instrument whose term is consistent with the expected term of the stock options. We use an assumed dividend yield of zero as we have never paid dividends and have no current plans to pay any dividends on our common stock. We expense the fair value of our equity-based compensation awards granted to employees and directors on a straight-line basis over the associated service period, which is generally the period in which the related services are received. We account for award forfeitures as they occur. Inventories Inventories are valued at the lower of cost or net realizable value, computed on a first-in, first out basis. We estimate the recoverability of our inventory by reference to internal estimates of future demands and product life cycles, including expiration of inventory prior to sale. We regularly review inventory quantities on-hand for excess and obsolete inventory and, when circumstances indicate, incur charges to write down inventories to their net realizable value. The determination of a reserve for excess and obsolete inventory involves management exercising judgment to determine the required reserve, considering future demand, product life cycles, introduction of new products and current market conditions. The reserve for excess and obsolete inventory was less than $0.1 million and $0.8 million as of December 31, 2019 and 2018, respectively. Income Taxes We account for income taxes using the liability method. Under this method, deferred tax assets and liabilities are determined based on the differences between the financial reporting and tax bases of assets and liabilities and are measured using the enacted tax rates that will be in effect when the differences are expected to reverse. Valuation allowances against deferred tax assets are established, when necessary, to reduce deferred tax assets to the amounts expected to be realized. As we have historically incurred operating losses, we have recorded a full valuation allowance against our net deferred tax assets, and there is no provision for income taxes other than the accrual for uncertain tax benefits recorded during the year ended December 31, 2019. Our policy is to record interest and penalties expense related to uncertain tax positions as other expense in the statements of operations and comprehensive loss. Recent Accounting Pronouncements A discussion of recent accounting pronouncements is included in Note 2 to our financial statements contained in this Annual Report on Form 10-K. JOBS Act Prior to December 31, 2019, we were an “emerging growth company” as defined by the JOBS Act. The JOBS Act provides that an emerging growth company can take advantage of the extended transition period for complying with new or revised accounting standards. This allows an emerging growth company to delay the adoption of certain accounting standards until those standards would otherwise apply to private companies. We elected to avail ourselves of this exemption prior to December 31, 2019, and as a result, our financial statements prior to that date may not have been comparable to the financial statements of issuers who are required to comply with the effective dates for new or revised accounting standards that are applicable to public companies. Subject to certain conditions, as an emerging growth company we also were able to rely on certain of the exemptions and reduced reporting requirements of the JOBS Act, including without limitation, from providing an auditor's attestation report on our system of internal control over financial reporting pursuant to Section 404(b) of the Sarbanes-Oxley Act of 2002 and from complying with any requirement that may be adopted by the Public Company Accounting Oversight Board regarding mandatory audit firm rotation or a supplement to the auditor's report providing additional information about the audit and the financial statements, known as the auditor discussion and analysis. Because we no longer qualify as an emerging growth company, we are no longer able to take advantage of the extended transition period for the adoption of certain accounting standards or of the reduced disclosure and other benefits available to emerging growth companies, including our exemption from providing our auditor’s attestation on our system of internal control over financial reporting, which is included in this Annual Report on Form 10-K.

<s>[INST] Overview We are a medical technology company focused on the development and commercialization of innovative and minimally invasive solutions for patients with OSA. Our proprietary Inspire system is the first and only FDAapproved neurostimulation technology that provides a safe and effective treatment for moderate to severe OSA. We have developed a novel, closedloop solution that continuously monitors a patient’s breathing and delivers mild hypoglossal nerve stimulation to maintain an open airway. Inspire therapy is indicated for patients with moderate to severe OSA who do not have significant central sleep apnea and do not have a complete concentric collapse of the airway at the soft palate level. In addition, patients in the U.S. must have been confirmed to fail or be unable to tolerate positive airway pressure treatments, such as CPAP, and be 22 years of age or older, though there are no similar requirements for patients in Europe. We sell our Inspire system to hospitals and ASCs in the U.S. and in select countries in Europe through a direct sales organization. Our direct sales force engages in sales efforts and promotional activities focused on ENT physicians and sleep centers. In addition, we highlight our compelling clinical data and value proposition to increase awareness and adoption amongst referring physicians. We build upon this topdown approach with strong directtopatient marketing initiatives to create awareness of the benefits of our Inspire system and drive demand through patient empowerment. This outreach helps to educate thousands of patients on our Inspire therapy and frequently results in patient leads. We increased the number of employees in our sales, marketing, and reimbursement organizations from 40 as of December 31, 2015 to 186 as of December 31, 2019. Although our sales and marketing efforts are directed at patients and physicians because they are the primary users of our technology, we consider the hospitals and ASCs where the procedure is performed to be our customers, as they are the purchasing agents of our Inspire system. Our customers are reimbursed the cost required to treat each patient through various thirdparty payors, such as commercial payors and government agencies. Our Inspire system is currently reimbursed primarily on a perpatient prior authorization basis for patients covered by commercial payors, on a casebycase basis for patients covered by Medicare, and under U.S. government contract for patients who are treated by the Veterans Health Administration. To date, more than 430 commercial payors have prior authorized for patients’ treatment with our Inspire therapy. We have currently secured positive coverage policies with 52 U.S. commercial payors, including most large national commercial insurers. In June 2018, Japan’s Ministry of Health, Labour and Welfare approved our Inspire therapy to treat moderate to severe OSA, and we are currently seeking reimbursement coverage in Japan. For the year ended December 31, 2019, 89.8% of our revenue was derived in the U.S. and 10.2% was derived in Europe. No single customer accounted for more than 10% of our revenue. We rely on thirdparty suppliers to manufacture our Inspire system and its components. Many of these suppliers are currently single source suppliers. We seek to maintain higher levels of inventory to protect ourselves from supply interruptions, and, as a result, we are subject to the risk of inventory obsolescence and expiration, which could lead to inventory impairment charges. In the U.S., our products are shipped directly to our customers on a purchase order basis, primarily by a thirdparty vendor with a facility in Tennessee, although we do ship some products from our facility in Minnesota. Warehousing and shipping operations for our European customers are handled by a thirdparty vendor with facilities located in the Netherlands. Customers do not have the right to return nondefective product, nor do we place product on consignment. Our sales representatives do not maintain trunk stock. Since our inception in 2007, we have financed our operations primarily through sales of our Inspire system, private placements of our convertible preferred securities, amounts borrowed under our credit facility, the initial public offering of our common stock that closed in May 2018 (our "IPO"), and the offering of our common stock that closed in December 2 [/INST] Positive. </s>

PENSARE ACQUISITION Corp

2018-06-28

2018-03-31

Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations We are a blank check company incorporated on April 7, 2016 in Delaware for the purpose of entering into a merger, share exchange, asset acquisition, stock purchase, recapitalization, reorganization or other similar business combination with one or more target businesses that we have not yet identified. The registration statements for the Company’s initial public offering were declared effective on July 27, 2017. On August 1, 2017, the Company consummated the initial public offering of 27,000,000 units at $10.00 per unit, generating gross proceeds of $270,000,000. Simultaneously with the closing of the initial public offering, the Company consummated the sale of private warrants at a price of $1.00 per warrant in a private placement to the sponsor, MasTec and EBC, generating gross proceeds of $9,500,000. Following the closing of the initial public offering on August 1, 2017, an amount of $270,000,000 ($10.00 per unit) from the net proceeds of the sale of the units in the initial public offering and the private warrants was placed in the Trust Account and will be invested in U.S. government securities, within the meaning set forth Section 2(a)(16) of the Investment Company Act, with a maturity of 180 days or less or in any open-ended investment company that holds itself out as a money market fund selected by the Company meeting the conditions of paragraphs (d)(2), (d)(3) and (d)(4) of Rule 2a-7 of the Investment Company Act, as determined by the Company, until the earlier of: (i) the completion of a business combination and (ii) the distribution of the Trust Account, as described below, except that interest earned on the Trust Account can be released to pay the Company’s income tax obligations. On August 4, 2017, the underwriters exercised their over-allotment option in full resulting in an additional 4,050,000 units being issued for $40,500,000, less the underwriters’ discount of $1,012,500, netting $39,487,500 which was deposited into the Trust Account. In connection with the underwriters’ exercise of their over-allotment option in full, the Company also consummated the sale of an additional 1,012,500 private warrants at $1.00 per warrant, generating total gross proceeds of $1,012,500 less the advance payment of $600,000 towards this transaction resulting in another $412,500 being deposited into the Trust Account bringing the balance in the Trust Account on August 4, 2017 to $310,500,000. Transaction costs amounted to $8,646,303, consisting of $7,762,500 of underwriting fees, and $883,803 of other costs. In addition, as of March 31, 2018, $ 482,676 of cash was held outside of the Trust Account, available for working capital purposes. Our efforts to identify a prospective target business will not be limited to a particular industry or geographic region although we intend to focus on businesses in the wireless telecommunications industry in the United States. We intend to utilize cash derived from the proceeds of our initial public offering of securities and the private placement of our warrants, our securities, debt or a combination of cash, securities and debt, in effecting a business combination. The issuance of additional shares of common stock or warrants in a business combination: ● may significantly reduce the equity interest of our stockholders; ● could cause a change of control if a substantial number of shares of our Common Stock are issued, which may affect, among other things, our ability to use our net operating loss carryforwards, if any, and could result in the resignation or removal of our present officers and directors; ● may subordinate the rights of holders of shares of common stock if we issue shares of preferred stock with rights senior to those afforded to our shares of common stock; ● may have the effect of delaying or preventing a change of control by diluting the stock ownership or voting rights of a person seeking to obtain control of us; and ● may adversely affect prevailing market prices for our securities. Similarly, if we issue debt securities, it could result in: ● default and foreclosure on our assets if our cash flows after a business combination are insufficient to pay our debt obligations; ● acceleration of our obligations to repay the indebtedness even if we make all principal and interest payments when due if we breach certain covenants that require the maintenance of certain financial ratios or reserves without a waiver or renegotiation of such covenants; ● our immediate payment of all principal and accrued interest, if any, if the debt security is payable on demand; and/or ● our inability to obtain necessary additional financing if the debt security contains covenants restricting our ability to obtain such financing while the debt security is outstanding. We expect to incur significant costs in the pursuit of our acquisition plans. We cannot assure you that our plans to complete a business combination will be successful. We have until February 1, 2019 to consummate an initial business combination. If we are unable to consummate an initial business combination within such time period, we will, as promptly as reasonably possible but not more than ten business days thereafter, redeem 100% of the outstanding public shares, at a per-share price, payable in cash, equal to the aggregate amount then on deposit in the trust account established in connection with the initial public offering (the “Trust Account”), including any interest earned on the funds held in the Trust Account net of interest that may be used by us to pay our franchise and income taxes payable, divided by the number of then outstanding public shares, which redemption will completely extinguish public stockholders’ rights as stockholders (including the right to receive further liquidation distributions, if any), subject to applicable law and as further described herein, and then seek to dissolve and liquidate. We expect the pro rata redemption price to be approximately $10.00 per share of common stock (regardless of whether or not the underwriters exercise their over-allotment option), without taking into account any interest earned on such funds. However, we cannot assure you that we will in fact be able to distribute such amounts as a result of claims of creditors which may take priority over the claims of our public stockholders. Results of Operations We have neither engaged in any operations nor generated any revenues to date. All activity from inception to March 31, 2018 were organizational activities and those necessary to consummate the initial public offering, described below, and identifying a target company for a business combination. We do not expect to generate any operating revenues until after the completion of our business combination. We generate non-operating income in the form of interest income on cash and marketable securities. There have been no significant changes in our financial position and no material adverse change has occurred since the date of our audited financial statements included in our registration statement for the initial public offering. We expect to incur increased expenses as a result of being a public company (for legal, financial reporting, accounting and auditing compliance), as well as due diligence expenses. For the year ended March 31, 2018, we had net loss of $2,520,045, which consists of interest income on marketable securities held in the Trust Account of $1,603,251, plus other interest income of $51 offset by operating costs and taxes of $4,123,347. For the period from April 7, 2016 (inception) through March 31, 2017, we had net loss of $59,193. Liquidity and Capital Resources As of March 31, 2018, we had cash of $482,676 and cash and marketable securities held in Trust Account available to pay taxes of $183,998. Until the consummation of the initial public offering, the Company’s only source of liquidity was an initial purchase of common stock by the sponsor and certain of our officers and directors and loans from the sponsor pursuant to the terms of a promissory note. On August 1, 2017, we consummated the initial public offering of 27,000,000 units, at a price of $10.00 per unit, generating gross proceeds of $270,000,000. Simultaneously with the closing of the initial public offering, we consummated the sale of 9,500,000 private warrants at a price of $1.00 per private warrant, generating total proceeds of $9,500,000. On August 4, 2017, the underwriters exercised their over-allotment option in full resulting in an additional 4,050,000 units being issued for $40,500,000, less the underwriter’s discount of $1,012,500, netting $39,487,500. In connection with the underwriters’ exercise of their over-allotment option in full, the Company consummated the sale of an additional 1,012,500 private warrants at $1.00 per warrant, generating total gross proceeds of $1,012,500. In order to fund working capital deficiencies or finance transaction costs in connection with an intended business combination, the sponsor, our officers and our directors or their affiliates may, but are not obligated to, loan us funds. From time to time or at any time, in whatever amount they deem reasonable in their sole discretion. Each loan is evidenced by a promissory note. The notes would be paid upon consummation of a business combination, without interest, or, at the lender’s discretion, up to $1,500,000 of such loans may be converted into warrants at a price of $1.00 per warrant. Such warrants would be identical to the private warrants. Following the initial public offering and the exercise of the over-allotment option, a total of $310,500,000 was placed in the Trust Account and we had $2,327,118 of cash held outside the Trust Account, after payment of all costs related to the initial public offering and the exercise of the over-allotment option, and available for working capital purposes. We incurred $8,646,303 in initial public offering related costs, including $7,762,500 of underwriting fees and $883,803 of initial public offering costs. As of March 31, 2018, we had cash and marketable securities held in the Trust Account of $312,103,251 (including $1,603,251 of interest income) consisting of cash and U.S. treasury bills with a maturity of 180 days or less. A portion of the interest income of $183,998 has been recorded as a current asset and may be available to us to pay taxes. For the year ended March 31, 2018, cash used in operating activities amounted to $1,332,905 resulting from net loss of $2,520,045, interest earned on cash and marketable securities held in Trust Account of $1,603,251, depreciation of $1,525 and changes in our operating assets and liabilities of $2,788,866. For the period from April 7, 2016 (inception) through March 31, 2017, cash used in operating activities amounted to $56,798 resulting from net loss of $(59,193), and changes in our operating assets and liabilities of $2,395. We intend to use substantially all of the net proceeds of the initial public offering, including funds held in the Trust Account, to acquire a target business and to pay our expenses related thereto. To the extent that our capital stock or debt is used, in whole or in part, as consideration to complete our business combination, the remaining proceeds held in the Trust Account will be used as working capital to finance the operation of the target business or businesses, make other acquisitions and pursue our growth strategies. We intend to use the funds held outside the Trust Account primarily to identify and evaluate target businesses, perform business due diligence on prospective target businesses, travel to and from the offices, plants or similar locations of prospective target businesses, and structure, negotiate and complete a business combination. In order to finance transaction costs in connection with a business combination, our sponsor or certain of our officers and directors may, but are not obligated to, loan us funds as may be required. If we complete a business combination, we would repay such loaned amounts out of the proceeds of the Trust Account released to us. In the event that a business combination does not close, we may use a portion of the working capital held outside the Trust Account to repay such loaned amounts but in no event will proceeds from our Trust Account be used to repay such amounts. We believe we have raised sufficient additional funds, when taken together with funds that may be made available to us by our sponsor, officers, directors and their affiliates through loans, to meet the expenditures required for operating our business. However, if our estimate of the costs of identifying a target business, undertaking in-depth due diligence and negotiating a business combination are less than the actual amounts necessary to do so, we may have insufficient funds available to operate our business prior to our business combination. Moreover, we may need to obtain additional financing either to complete our business combination or because we become obligated to redeem a significant number of our common stock upon completion of our business combination, in which case we may issue additional securities or incur debt in connection with such business combination. Subject to compliance with applicable securities laws, we would only complete such financing simultaneously with the completion of our business combination. If we are unable to complete our business combination because we do not have sufficient funds available to us, we will be forced to cease operations and liquidate the Trust Account. In addition, following our business combination, if cash on hand is insufficient, we may need to obtain additional financing in order to meet our obligations. On June 8, 2018 the Sponsor advanced the Company one million dollars ($1,000,000) for working capital purposes. The Working Capital Loan was evidenced by a $1,000,000 promissory note, which shall be payable without interest upon consummation of a Business Combination or, at the holder’s discretion, the note may be converted into warrants (“Warrants”) at a conversion price of $1.00 per Warrant. Each Warrant will contain terms identical to those of the warrants issued in the private placement, entitling the holder thereof to purchase one share of common stock, par value $0.001, at an exercise price of $11.50 per share as more fully described in the prospectus for the IPO dated July 27, 2017. In addition, the Company holds a Commitment Letter from its Chief Executive Officer and managing member of the sponsor, whereby the managing member of the sponsor commits to funding any working capital shortfalls through the earlier of an initial business combination or the Company’s liquidation. The loans would be issued as required and each loan would be evidenced by a promissory note, up to an aggregate of Seven Hundred and Fifty Thousand Dollars ($750,000). The loans will be non-interest bearing, unsecured and payable upon the consummation of the Company’s initial business combination or at the holder’s discretion, convertible into warrants of the Company at a price of $1.00 per warrant. If the Company does not complete a business combination, any such loans will be forgiven. As of March 31, 2018, the Company had no promissory notes outstanding. Liquidation Until we consummate a business combination, we will be using the funds not held in the Trust Account for identifying and evaluation prospective acquisition candidates, performing due diligence on prospective target businesses, paying for travel expenditures, selecting target businesses to acquire, and structuring, negotiating and consummating a business combination. We may need to raise additional capital through loans or additional investments from our sponsor, stockholders, officers, directors, or third parties. Our officers, directors and sponsor may, but are not obligated to, loan us funds, from time to time, in whatever amount they deem reasonable in their sole discretion, to meet our working capital needs. If we are unable to raise additional capital, we may be required to take additional measures to conserve liquidity, which could include, but not necessarily be limited to curtailing operations, suspending the pursuit of a potential transaction, and reducing overhead expenses. We cannot provide any assurance that new financing will be available to us on commercially acceptable terms, if at all. Even if we can obtain sufficient financing or raise additional capital, we only have until February 1, 2019 (18 months from the closing of our initial public offering) to consummate a business combination. There is no assurance that we will be able to do so prior to February 1, 2019. If we do not complete a business combination by February 1, 2019 (18 months from the closing of our initial public offering), we will (i) cease all operations except for the purpose of winding up, (ii) as promptly as reasonably possible but not more than ten business days thereafter, redeem 100% of the outstanding public shares, at a per-share price, payable in cash, equal to the aggregate amount then on deposit in the trust account, including any interest earned on the funds held in the Trust Account not previously released to us, divided by the number of then outstanding public shares, which redemption will completely extinguish public stockholders’ rights as stockholders (including the right to receive further liquidation distributions, if any), subject to applicable law, and (iii) as promptly as reasonably possible following such redemption, subject to the approval of our remaining stockholders and our board of directors, dissolve and liquidate, subject (in the case of (ii) and (iii) above) to our obligations under Delaware law to provide for claims of creditors and the requirements of other applicable law. We cannot assure you that we will have funds sufficient to pay or provide for all creditors’ claims. The holders of the founder shares will not participate in any redemption distribution with respect to their founder shares. Holders of warrants will receive no proceeds in connection with the redemption or liquidation. In the event of liquidation, it is possible that the per share value of the residual assets remaining available for distribution (including Trust Account assets) will be less than the initial public offering price per unit in the initial public offering. Off-Balance Sheet Arrangements; Contractual Obligations As of March 31, 2018, we did not have any off-balance sheet arrangements as defined in Item 303(a)(4)(ii) of Regulation S-K and did not have any long-term debt, capital lease obligations, operating lease obligations or purchase obligations other than a monthly fee of $20,000 payable to our sponsor for office space, utilities, secretarial and administrative services, effective as of July 27, 2017, the effective date of the registration statement for our initial public offering. We have not guaranteed any debt or commitments of other entities or entered into any options on non-financial assets. Critical Accounting Policies Management’s discussion and analysis of our results of operations and liquidity and capital resources are based on our financial information. We describe our significant accounting policies in Note 3-Summary of Significant Accounting Policies, of the Notes to Financial Statements included in this report. Our financial statements have been prepared in accordance with U.S. GAAP. In the opinion of management, all adjustments (consisting of normal recurring adjustments) have been made that are necessary to present fairly the financial position, the results of its operations and its cash flows. Certain of our accounting policies require that management apply significant judgments in defining the appropriate assumptions integral to financial estimates. On an ongoing basis, management reviews the accounting policies, assumptions, estimates and judgments to ensure that our financial statements are presented fairly and in accordance with U.S. GAAP. Judgments are based on historical experience, terms of existing contracts, industry trends and information available from outside sources, as appropriate. However, by their nature, judgments are subject to an inherent degree of uncertainty, and, therefore, actual results could differ from our estimates. Under our amended and restated certificate of incorporation, all of the public shares may be converted into cash in connection with our liquidation or a tender offer or stockholder approval in connection with an initial business combination. In accordance with FASB ASC 480, “Distinguishing Liabilities from Equity”, redemption provisions not solely within the control of our Company require the security to be classified outside of permanent equity. Ordinary liquidation events, which involve the conversion and liquidation of all of the entity’s equity instruments, are excluded from the provisions of FASB ASC 480. Although we did not specify a maximum conversion threshold, our charter provides that in no event will we convert the public shares in an amount that would cause its net tangible assets (stockholders’ equity) to be less than $5,000,001. We recognize changes in conversion value immediately as they occur and will adjust the carrying value of the security to equal the conversion value at the end of each reporting period. Increases or decreases in the carrying amount of convertible common stock shall be affected by charges against additional paid-in capital in accordance with ASC 480. Accordingly, at March 31, 2018 and March 31, 2017, 30,420,187 and 0 public shares were classified outside of permanent equity at their conversion value, respectively.

<s>[INST] The registration statements for the Company’s initial public offering were declared effective on July 27, 2017. On August 1, 2017, the Company consummated the initial public offering of 27,000,000 units at $10.00 per unit, generating gross proceeds of $270,000,000. Simultaneously with the closing of the initial public offering, the Company consummated the sale of private warrants at a price of $1.00 per warrant in a private placement to the sponsor, MasTec and EBC, generating gross proceeds of $9,500,000. Following the closing of the initial public offering on August 1, 2017, an amount of $270,000,000 ($10.00 per unit) from the net proceeds of the sale of the units in the initial public offering and the private warrants was placed in the Trust Account and will be invested in U.S. government securities, within the meaning set forth Section 2(a)(16) of the Investment Company Act, with a maturity of 180 days or less or in any openended investment company that holds itself out as a money market fund selected by the Company meeting the conditions of paragraphs (d)(2), (d)(3) and (d)(4) of Rule 2a7 of the Investment Company Act, as determined by the Company, until the earlier of: (i) the completion of a business combination and (ii) the distribution of the Trust Account, as described below, except that interest earned on the Trust Account can be released to pay the Company’s income tax obligations. On August 4, 2017, the underwriters exercised their overallotment option in full resulting in an additional 4,050,000 units being issued for $40,500,000, less the underwriters’ discount of $1,012,500, netting $39,487,500 which was deposited into the Trust Account. In connection with the underwriters’ exercise of their overallotment option in full, the Company also consummated the sale of an additional 1,012,500 private warrants at $1.00 per warrant, generating total gross proceeds of $1,012,500 less the advance payment of $600,000 towards this transaction resulting in another $412,500 being deposited into the Trust Account bringing the balance in the Trust Account on August 4, 2017 to $310,500,000. Transaction costs amounted to $8,646,303, consisting of $7,762,500 of underwriting fees, and $883,803 of other costs. In addition, as of March 31, 2018, $ 482,676 of cash was held outside of the Trust Account, available for working capital purposes. Our efforts to identify a prospective target business will not be limited to a particular industry or geographic region although we intend to focus on businesses in the wireless telecommunications industry in the United States. We intend to utilize cash derived from the proceeds of our initial public offering of securities and the private placement of our warrants, our securities, debt or a combination of cash, securities and debt, in effecting a business combination. The issuance of additional shares of common stock or warrants in a business combination: may significantly reduce the equity interest of our stockholders; could cause a change of control if a substantial number of shares of our Common Stock are issued, which may affect, among other things, our ability to use our net operating loss carryforwards, if any, and could result in the resignation or removal of our present officers and directors; may subordinate the rights of holders of shares of common stock if we issue shares of preferred stock with rights senior to those afforded to our shares of common stock; may have the effect of delaying or preventing a change of control by diluting the stock ownership or voting rights of a person seeking to obtain control of us; and may adversely affect prevailing market prices for our securities. Similarly, if we issue debt se [/INST] Negative. </s>

PENSARE ACQUISITION Corp

2019-06-14

2019-03-31

Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations We are a blank check company incorporated on April 7, 2016 in Delaware for the purpose of entering into a merger, share exchange, asset acquisition, stock purchase, recapitalization, reorganization or other similar business combination with one or more target businesses that we have not yet identified. The registration statements for the Company’s initial public offering were declared effective on July 27, 2017. On August 1, 2017, the Company consummated the initial public offering of 27,000,000 units at $10.00 per unit, generating gross proceeds of $270,000,000. Simultaneously with the closing of the initial public offering, the Company consummated the sale of private warrants at a price of $1.00 per warrant in a private placement to the sponsor, MasTec and EBC, generating gross proceeds of $9,500,000. Following the closing of the initial public offering on August 1, 2017, an amount of $270,000,000 ($10.00 per unit) from the net proceeds of the sale of the units in the initial public offering and the private warrants was placed in the Trust Account and will be invested in U.S. government securities, within the meaning set forth Section 2(a)(16) of the Investment Company Act, with a maturity of 180 days or less or in any open-ended investment company that holds itself out as a money market fund selected by the Company meeting the conditions of paragraphs (d)(2), (d)(3) and (d)(4) of Rule 2a-7 of the Investment Company Act, as determined by the Company, until the earlier of: (i) the completion of a business combination and (ii) the distribution of the Trust Account, as described below, except that interest earned on the Trust Account can be released to pay the Company’s income tax obligations. On August 4, 2017, the underwriters exercised their over-allotment option in full resulting in an additional 4,050,000 units being issued for $40,500,000, less the underwriters’ discount of $1,012,500, netting $39,487,500 which was deposited into the Trust Account. In connection with the underwriters’ exercise of their over-allotment option in full, the Company also consummated the sale of an additional 1,012,500 private warrants at $1.00 per warrant, generating total gross proceeds of $1,012,500 less the advance payment on August 1, 2017 of $600,000 towards this transaction resulting in another $412,500 being deposited into the Trust Account bringing the balance in the Trust Account on August 4, 2017 to $310,500,000. Transaction costs amounted to $8,646,303, consisting of $7,762,500 of underwriting fees, and $883,803 of other costs. In addition, as of March 31, 2019, $135,265 of cash was held outside of the Trust Account, available for working capital purposes. Our efforts to identify a prospective target business will not be limited to a particular industry or geographic region although we intend to focus on businesses in the wireless telecommunications industry in the United States. We intend to utilize cash derived from the proceeds of our initial public offering of securities and the private placement of our warrants, our securities, debt or a combination of cash, securities and debt, in effecting a business combination. The issuance of additional shares of common stock or warrants in a business combination: ● may significantly reduce the equity interest of our stockholders; ● could cause a change of control if a substantial number of shares of our Common Stock are issued, which may affect, among other things, our ability to use our net operating loss carryforwards, if any, and could result in the resignation or removal of our present officers and directors; ● may subordinate the rights of holders of shares of common stock if we issue shares of preferred stock with rights senior to those afforded to our shares of common stock; ● may have the effect of delaying or preventing a change of control by diluting the stock ownership or voting rights of a person seeking to obtain control of us; and ● may adversely affect prevailing market prices for our securities. Similarly, if we issue debt securities, it could result in: ● default and foreclosure on our assets if our cash flows after a business combination are insufficient to pay our debt obligations; ● acceleration of our obligations to repay the indebtedness even if we make all principal and interest payments when due if we breach certain covenants that require the maintenance of certain financial ratios or reserves without a waiver or renegotiation of such covenants; ● our immediate payment of all principal and accrued interest, if any, if the debt security is payable on demand; and /or ● our inability to obtain necessary additional financing if the debt security contains covenants restricting our ability to obtain such financing while the debt security is outstanding. We expect to incur significant costs in the pursuit of our acquisition plans. We cannot assure you that our plans to complete a business combination will be successful. We have until August 1, 2019 to consummate an initial business combination. If we are unable to consummate an initial business combination within such time period, we will, as promptly as reasonably possible but not more than ten business days thereafter, redeem 100% of the outstanding public shares, at a per-share price, payable in cash, equal to the aggregate amount then on deposit in the trust account established in connection with the initial public offering (the “Trust Account”), including any interest earned on the funds held in the Trust Account net of interest that may be used by us to pay our franchise and income taxes payable, divided by the number of then outstanding public shares, which redemption will completely extinguish public stockholders’ rights as stockholders (including the right to receive further liquidation distributions, if any), subject to applicable law and as further described herein, and then seek to dissolve and liquidate. We expect the pro rata redemption price to be approximately $10.00 per share of common stock (regardless of whether or not the underwriters exercise their over-allotment option), without taking into account any interest earned on such funds. However, we cannot assure you that we will in fact be able to distribute such amounts as a result of claims of creditors which may take priority over the claims of our public stockholders. As previously disclosed in our current report on Form 8-K filed with the SEC on February 1, 2019, we entered into the Agreement on January 31, 2019 with TPx and Merger Sub relating to the proposed business combination between the Company and TPx. On May 20, 2019, we mutually agreed with TPx to terminate the Agreement pursuant to a Termination of Business Combination Agreement dated as of May 20, 2019, effective as of such date. As a result of the termination of the Agreement, effective as of May 20, 2019, the Agreement is of no further force or effect, and no party to the Agreement shall have any liability under the Agreement except as otherwise expressly set forth in the Agreement. We intend to continue to pursue a business combination. On January 28, 2019, at the Special Meeting in lieu of the 2019 Annual Meeting of the Company’s Stockholders, our stockholders approved an amendment to our amended and restated certificate of incorporation to extend the date by which the Company has to consummate a business combination for an additional three months, from February 1, 2019 to May 1, 2019. The amendment was approved with 26,352,896 votes cast in favor of the amendment, 122,986 votes cast against the amendment and 323,175 abstentions. In connection with the special meeting and the resulting amendment to our amended and restated certificate of incorporation, 2,796,290 shares of our common stock were redeemed from funds available in the trust account established in connection with the Company’s initial public offering (the “Trust Account”), for a redemption amount of approximately $10.18 per share. On April 22, 2019, we announced that our sponsor, had agreed to contribute to us as a loan $0.033 for each share of our common stock issued in our initial public offering that was not redeemed in connection with the stockholder vote to approve an amendment to our amended and restated certificate of incorporation to extend the date by which we have to consummate a business combination for an additional three months, from May 1, 2019 to August 1, 2019. On April 29, 2019, at the Special Meeting of the Company’s Stockholders, our stockholders approved an amendment to our amended and restated certificate of incorporation to extend the date by which the Company has to consummate a business combination for an additional three months, from May 1, 2019 to August 1, 2019. The amendment was approved with 26,163,835 votes cast in favor of the amendment, 2,020,001 votes cast against the amendment and 422,075 abstentions. In connection with the special meeting and the resulting amendment to our amended and restated certificate of incorporation, 3,831,985 shares of our common stock were redeemed from funds available in the Trust Account, for a redemption amount of approximately $10.33 per share. On May 31, 2019, we announced that our sponsor will reduce its contributions to the Trust Account. Our sponsor will continue to pay to the Trust Account $0.033 per public share that has not been redeemed per month, but the total monthly payment will be no greater than $200,000. If more than 6,060,606 public shares remain outstanding after redemptions in connection with this adjustment, then the amount paid per share will be reduced proportionately. In connection with this announcement, we offered our public stockholders the right to redeem their shares of our common stock for their pro rata portion of the funds available in the Trust Account. Our stockholders have until 5:00 p.m., eastern time, on June 14, 2019 to elect to redeem their public shares. Results of Operations We have neither engaged in any operations nor generated any revenues to date. All activity from inception to March 31, 2019 were organizational activities and those necessary to consummate the initial public offering, described below, and identifying a target company for a business combination. We do not expect to generate any operating revenues until after the completion of our business combination. We generate non-operating income in the form of interest income on cash and marketable securities. There have been no significant changes in our financial position and no material adverse change has occurred since the date of our audited financial statements included in our registration statement for the initial public offering. We expect to incur increased expenses as a result of being a public company (for legal, financial reporting, accounting and auditing compliance), as well as due diligence expenses. For the year ended March 31, 2019, we had net income of $989,799, which consists of interest income on marketable securities held in the Trust Account of $5,281,923, offset by operating costs and taxes of $4,292,124. For the year ended March 31, 2018, we had net loss of $2,520,045, which consists of interest income on marketable securities held in the Trust Account of $1,603,251, plus other interest income of $51 offset by operating costs and taxes of $4,123,347. For the period from April 7, 2016 (inception) through March 31, 2017, we had net loss of ($59,193). Liquidity and Capital Resources As of March 31, 2019, we had cash of $135,265 and cash and marketable securities held in Trust Account available to pay taxes of $62,725. Until the consummation of the initial public offering, the Company’s only source of liquidity was an initial purchase of common stock by the sponsor and certain of our officers and directors and loans from the sponsor pursuant to the terms of a promissory note. On August 1, 2017, we consummated the initial public offering of 27,000,000 units, at a price of $10.00 per unit, generating gross proceeds of $270,000,000. Simultaneously with the closing of the initial public offering, we consummated the sale of 9,500,000 private warrants at a price of $1.00 per private warrant, generating total proceeds of $9,500,000. On August 4, 2017, the underwriters exercised their over-allotment option in full resulting in an additional 4,050,000 units being issued for $40,500,000, less the underwriter’s discount of $1,012,500, netting $39,487,500. In connection with the underwriters’ exercise of their over-allotment option in full, the Company consummated the sale of an additional 1,012,500 private warrants at $1.00 per warrant, generating total gross proceeds of $1,012,500. In order to fund working capital deficiencies or finance transaction costs in connection with an intended business combination, the sponsor, our officers and our directors or their affiliates may, but are not obligated to, loan us funds. From time to time or at any time, in whatever amount they deem reasonable in their sole discretion. Each loan is evidenced by a promissory note. The notes would be paid upon consummation of a business combination, without interest, or, at the lender’s discretion, up to $1,500,000 of such loans may be converted into warrants at a price of $1.00 per warrant. Such warrants would be identical to the private warrants. Following the initial public offering and the exercise of the over-allotment option, a total of $310,500,000 was placed in the Trust Account and we had $2,327,118 of cash held outside the Trust Account, after payment of all costs related to the initial public offering and the exercise of the over-allotment option, and available for working capital purposes. We incurred $8,646,303 in initial public offering related costs, including $7,762,500 of underwriting fees and $883,803 of initial public offering costs. As of March 31, 2019, we had cash and marketable securities held in the Trust Account of $290,454,757 (including $6,885,174 of interest income) consisting of cash and U.S. treasury bills with a maturity of 180 days or less. A portion of the interest income of $62,725 has been recorded as a current asset and may be available to us to pay taxes. As of March 31, 2018, we had cash and marketable securities held in the Trust Account of $312,103,251 (including $1,603,251 interest income) consisting of cash and U.S. treasury bills with a maturity of 180 days or less. A portion of interest income of $183,998 has been recorded as a current asset and may be available to us to pay taxes. For the year ended March 31, 2019, cash used in operating activities amounted to $2,041,313 resulting from net income of $989,799, interest earned on cash and marketable securities held in Trust Account of $5,281,923, depreciation of $3,659, deferred income taxes of $216,000, and changes in our operating assets and liabilities of $2,463,152. For the year ended March 31, 2018, cash used in operating activities amounted to $1,332,905 resulting from net loss of $2,520,045, interest earned on cash and marketable securities held in Trust Account of $1,603,251, depreciation of $1,525 and changes in our operating assets and liabilities of $2,788,866. We intend to use substantially all of the net proceeds of the initial public offering, including funds held in the Trust Account, to acquire a target business and to pay our expenses related thereto. To the extent that our capital stock or debt is used, in whole or in part, as consideration to complete our business combination, the remaining proceeds held in the Trust Account will be used as working capital to finance the operation of the target business or businesses, make other acquisitions and pursue our growth strategies. We intend to use the funds held outside the Trust Account primarily to identify and evaluate target businesses, perform business due diligence on prospective target businesses, travel to and from the offices, plants or similar locations of prospective target businesses, and structure, negotiate and complete a business combination. In order to finance transaction costs in connection with a business combination, our sponsor or certain of our officers and directors may, but are not obligated to, loan us funds as may be required. If we complete a business combination, we would repay such loaned amounts out of the proceeds of the Trust Account released to us. In the event that a business combination does not close, we may use a portion of the working capital held outside the Trust Account to repay such loaned amounts but in no event will proceeds from our Trust Account be used to repay such amounts. We believe we have raised sufficient additional funds, when taken together with funds that may be made available to us by our sponsor, officers, directors and their affiliates through loans, to meet the expenditures required for operating our business. However, if our estimate of the costs of identifying a target business, undertaking in-depth due diligence and negotiating a business combination are less than the actual amounts necessary to do so, we may have insufficient funds available to operate our business prior to our business combination. Moreover, we may need to obtain additional financing either to complete our business combination or because we become obligated to redeem a significant number of our common stock upon completion of our business combination, in which case we may issue additional securities or incur debt in connection with such business combination. Subject to compliance with applicable securities laws, we would only complete such financing simultaneously with the completion of our business combination. If we are unable to complete our business combination because we do not have sufficient funds available to us, we will be forced to cease operations and liquidate the Trust Account. In addition, following our business combination, if cash on hand is insufficient, we may need to obtain additional financing in order to meet our obligations. On June 8, 2018, our sponsor loaned the Company $1,000,000 for working capital purposes. On February 11, 2019, our sponsor advanced the Company an additional $317,628 for working capital purposes. On April 10, 2019 and May 9, 2019, our sponsor advanced the Company $150,000 and $250,000, respectively, for working capital purposes. These working capital loans are evidenced by a promissory note, which is payable without interest upon consummation of a business combination or, at the holder’s discretion, up to $1,500,000 of the notes may be converted into warrants of the Company at a conversion price of $1.00 per warrant. Each warrant will contain terms identical to those of the warrants issued in the private placement, entitling the holder thereof to purchase one share of common stock, par value $0.001, at an exercise price of $11.50 per share as more fully described in the prospectus for the IPO dated July 27, 2017. On February 1, 2019, the Company signed a promissory note agreeing to repay up to $2,797,117 of advances to be made by the Company’s sponsor to cover contribution payments due to the Trust Account. As of April 11, 2019, the full amount was advanced under that note. In addition, two of the Company’s service providers had agreed to defer the payment of fees owed to them until the consummation of a business combination, which amounted to $4,814,028 as of March 31, 2019. Such fees are included in accounts payable and accrued expenses in the accompanying balance sheet at March 31, 2019. On May 9, 2019, the Company signed a promissory note agreeing to repay $805,916 for an advance made by the Company’s sponsor as an additional contribution payment to the Trust Account. Based on the foregoing, the Company believes it will have sufficient cash to meet its needs for the next months (through August 1, 2019) following the date from when the financial statements are issued. In addition, the Company holds a Commitment Letter from its Chief Executive Officer and managing member of the sponsor, whereby the managing member of the sponsor commits to funding any working capital shortfalls through the earlier of an initial business combination or the Company’s liquidation. The loans would be issued as required and each loan would be evidenced by a promissory note, up to an aggregate of $750,000. The loans will be non-interest bearing, unsecured and payable upon the consummation of the Company’s initial business combination or at the holder’s discretion, convertible into warrants of the Company at a price of $1.00 per warrant. If the Company does not complete a business combination, any such loans will be forgiven. On January 16, 2019, the Company announced that its sponsor had agreed to contribute to the Company as a loan $0.033 for each public share that was not redeemed in connection with the stockholder vote to approve an amendment to the Company’s amended and restated certificate of incorporation to extend the date by which the Company has to consummate a business combination for an additional three months, from February 1, 2019 to May 1, 2019, for each calendar month (commencing on February 2, 2019 and on the second day of each subsequent month), or portion thereof, that is needed by the Company to complete a Business Combination from February 2, 2019 until May 1, 2019. On February 1, 2019, the Company signed a promissory note agreeing to pay up to $2,797,117 of advances to be made by the Company’s sponsor to cover contribution payments due to the Trust Account. On April 29, 2019, the Company held a special meeting of stockholders at which time the stockholders of the Company approved an amendment to the Company’s amended and restated certificate of incorporation to extend the date by which the Company has to consummate a business combination for an additional three months, from May 1, 2019 to August 1, 2019. On April 22, 2019, the Company announced that its sponsor, had agreed to contribute as a loan, $0.033 for each share of common stock issued in the initial public offering that was not redeemed in connection with the stockholder vote to approve an amendment to the Company’s amended and restated certificate of incorporation to extend the date by which they have to consummate a business combination for an additional three months, from May 1, 2019 to August 1, 2019. The contribution was deposited in the trust account established in connection with the Company’s initial public offering. On May 9, 2019, the Company signed a promissory note agreeing to repay $805,916 to the sponsor for its contribution. On May 31, 2019, the Company announced that the sponsor will reduce its contributions to the Trust Account. The sponsor will continue to pay to the Trust Account $0.033 per public share that has not been redeemed per month, but the total monthly payment will be no greater than $200,000. If more than 6,060,606 public shares remain outstanding after redemptions in connection with this adjustment, then the amount paid per share will be reduced proportionately. In connection with this announcement, the Company offered the public stockholders the right to redeem their shares of common stock for their pro rata portion of the funds available in the Trust Account. Liquidation and Going Concern Until we consummate a business combination, we will be using the funds not held in the Trust Account for identifying and evaluation prospective acquisition candidates, performing due diligence on prospective target businesses, paying for travel expenditures, selecting target businesses to acquire, and structuring, negotiating and consummating a business combination. We may need to raise additional capital through loans or additional investments from our sponsor, stockholders, officers, directors, or third parties. Our officers, directors and sponsor may, but are not obligated to, loan us funds, from time to time, in whatever amount they deem reasonable in their sole discretion, to meet our working capital needs. If we are unable to raise additional capital, we may be required to take additional measures to conserve liquidity, which could include, but not necessarily be limited to curtailing operations, suspending the pursuit of a potential transaction, and reducing overhead expenses. We cannot provide any assurance that new financing will be available to us on commercially acceptable terms, if at all. Even if we can obtain sufficient financing or raise additional capital, we only have until August 1, 2019 to consummate a business combination. There is no assurance that we will be able to do so prior to August 1, 2019. If we do not complete a business combination by August 1, 2019, we will (i) cease all operations except for the purpose of winding up, (ii) as promptly as reasonably possible but not more than ten business days thereafter, redeem 100% of the outstanding public shares, at a per-share price, payable in cash, equal to the aggregate amount then on deposit in the trust account, including any interest earned on the funds held in the Trust Account not previously released to us, divided by the number of then outstanding public shares, which redemption will completely extinguish public stockholders’ rights as stockholders (including the right to receive further liquidation distributions, if any), subject to applicable law, and (iii) as promptly as reasonably possible following such redemption, subject to the approval of our remaining stockholders and our board of directors, dissolve and liquidate, subject (in the case of (ii) and (iii) above) to our obligations under Delaware law to provide for claims of creditors and the requirements of other applicable law. We cannot assure you that we will have funds sufficient to pay or provide for all creditors’ claims. The holders of the founder shares will not participate in any redemption distribution with respect to their founder shares. Holders of warrants will receive no proceeds in connection with the redemption or liquidation. In the event of liquidation, it is possible that the per share value of the residual assets remaining available for distribution (including Trust Account assets) will be less than the initial public offering price per unit in the initial public offering. Off-Balance Sheet Arrangements; Contractual Obligations As of March 31, 2019, we did not have any off-balance sheet arrangements as defined in Item 303(a)(4)(ii) of Regulation S-K and did not have any long-term debt, capital lease obligations, operating lease obligations or purchase obligations other than a monthly fee of $20,000 payable to our sponsor for office space, utilities, secretarial and administrative services, effective as of July 27, 2017, the effective date of the registration statement for our initial public offering. We have not guaranteed any debt or commitments of other entities or entered into any options on non-financial assets. Critical Accounting Policies Management’s discussion and analysis of our results of operations and liquidity and capital resources are based on our financial information. We describe our significant accounting policies in Note 3-Summary of Significant Accounting Policies, of the Notes to Financial Statements included in this report. Our financial statements have been prepared in accordance with U.S. GAAP. In the opinion of management, all adjustments (consisting of normal recurring adjustments) have been made that are necessary to present fairly the financial position, the results of its operations and its cash flows. Certain of our accounting policies require that management apply significant judgments in defining the appropriate assumptions integral to financial estimates. On an ongoing basis, management reviews the accounting policies, assumptions, estimates and judgments to ensure that our financial statements are presented fairly and in accordance with U.S. GAAP. Judgments are based on historical experience, terms of existing contracts, industry trends and information available from outside sources, as appropriate. However, by their nature, judgments are subject to an inherent degree of uncertainty, and, therefore, actual results could differ from our estimates. Under our amended and restated certificate of incorporation, all of the public shares may be converted into cash in connection with our liquidation or a tender offer or stockholder approval in connection with an initial business combination. In accordance with FASB ASC 480, “Distinguishing Liabilities from Equity”, redemption provisions not solely within the control of our Company require the security to be classified outside of permanent equity. Ordinary liquidation events, which involve the conversion and liquidation of all of the entity’s equity instruments, are excluded from the provisions of FASB ASC 480. Although we did not specify a maximum conversion threshold, our charter provides that in no event will we convert the public shares in an amount that would cause its net tangible assets (stockholders’ equity) to be less than $5,000,001. We recognize changes in conversion value immediately as they occur and will adjust the carrying value of the security to equal the conversion value at the end of each reporting period. Increases or decreases in the carrying amount of convertible common stock shall be affected by charges against additional paid-in capital in accordance with ASC 480. Accordingly, at March 31, 2019 and March 31, 2018, 26,982,942 and 30,342,514 public shares were classified outside of permanent equity at their conversion value, respectively. Ordinary shares subject to possible redemption We account for our ordinary shares subject to possible conversion in accordance with the guidance in Accounting Standards Codification (“ASC”) Topic 480 “Distinguishing Liabilities from Equity.” Ordinary shares subject to mandatory redemption are classified as a liability instrument and are measured at fair value. Conditionally redeemable ordinary shares (including ordinary shares that feature redemption rights that are either within the control of the holder or subject to redemption upon the occurrence of uncertain events note solely within our control) are classified as temporary equity. At all other times, ordinary shares are classified as shareholders’ equity. Our ordinary shares feature certain redemption rights that are considered to be outside of our control and subject to occurrence of uncertain future events. Accordingly, the ordinary shares subject to possible redemption are presented at redemption value as temporary equity, outside the shareholders’ equity section of our balance sheet. Recent accounting pronouncements Management does not believe that any recently issued, but not yet effective, accounting pronouncements, if currently adopted, would have a material effect on our consolidated financial statements.

<s>[INST] The registration statements for the Company’s initial public offering were declared effective on July 27, 2017. On August 1, 2017, the Company consummated the initial public offering of 27,000,000 units at $10.00 per unit, generating gross proceeds of $270,000,000. Simultaneously with the closing of the initial public offering, the Company consummated the sale of private warrants at a price of $1.00 per warrant in a private placement to the sponsor, MasTec and EBC, generating gross proceeds of $9,500,000. Following the closing of the initial public offering on August 1, 2017, an amount of $270,000,000 ($10.00 per unit) from the net proceeds of the sale of the units in the initial public offering and the private warrants was placed in the Trust Account and will be invested in U.S. government securities, within the meaning set forth Section 2(a)(16) of the Investment Company Act, with a maturity of 180 days or less or in any openended investment company that holds itself out as a money market fund selected by the Company meeting the conditions of paragraphs (d)(2), (d)(3) and (d)(4) of Rule 2a7 of the Investment Company Act, as determined by the Company, until the earlier of: (i) the completion of a business combination and (ii) the distribution of the Trust Account, as described below, except that interest earned on the Trust Account can be released to pay the Company’s income tax obligations. On August 4, 2017, the underwriters exercised their overallotment option in full resulting in an additional 4,050,000 units being issued for $40,500,000, less the underwriters’ discount of $1,012,500, netting $39,487,500 which was deposited into the Trust Account. In connection with the underwriters’ exercise of their overallotment option in full, the Company also consummated the sale of an additional 1,012,500 private warrants at $1.00 per warrant, generating total gross proceeds of $1,012,500 less the advance payment on August 1, 2017 of $600,000 towards this transaction resulting in another $412,500 being deposited into the Trust Account bringing the balance in the Trust Account on August 4, 2017 to $310,500,000. Transaction costs amounted to $8,646,303, consisting of $7,762,500 of underwriting fees, and $883,803 of other costs. In addition, as of March 31, 2019, $135,265 of cash was held outside of the Trust Account, available for working capital purposes. Our efforts to identify a prospective target business will not be limited to a particular industry or geographic region although we intend to focus on businesses in the wireless telecommunications industry in the United States. We intend to utilize cash derived from the proceeds of our initial public offering of securities and the private placement of our warrants, our securities, debt or a combination of cash, securities and debt, in effecting a business combination. The issuance of additional shares of common stock or warrants in a business combination: may significantly reduce the equity interest of our stockholders; could cause a change of control if a substantial number of shares of our Common Stock are issued, which may affect, among other things, our ability to use our net operating loss carryforwards, if any, and could result in the resignation or removal of our present officers and directors; may subordinate the rights of holders of shares of common stock if we issue shares of preferred stock with rights senior to those afforded to our shares of common stock; may have the effect of delaying or preventing a change of control by diluting the stock ownership or voting rights of a person seeking to obtain control of us; and may adversely affect prevailing market prices for our securities. Sim [/INST] Positive. </s>

First Choice Bancorp

2019-03-25

2018-12-31

ITEM 7. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS The purpose of this management's discussion and analysis of financial condition and results of operations ("MD&A") is to focus on information about our consolidated financial condition at December 31, 2018 and 2017, and our consolidated results of operations for the two years ended December 31, 2018. Our consolidated financial statements and the supplemental financial data appearing elsewhere in this Annual Report should be read in conjunction with this discussion and analysis. Overview First Choice Bancorp, a California corporation, was organized on September 1, 2017 to serve as the holding company for its wholly owned subsidiary, First Choice Bank (the "Bank"), a California state chartered commercial bank. On December 21, 2017, the Bank received requisite shareholder and regulatory approval necessary for the Bank to reorganize into the holding company form of ownership pursuant to which First Choice Bank became a wholly-owned subsidiary of First Choice Bancorp. When we refer to "Bancorp" or the "holding company", we are referring First Choice Bancorp, the parent company, on a stand-alone basis. When we refer to "we," "us," "our," or the "Company", we are referring to First Choice Bancorp and Bank collectively. We are regulated as a bank holding company by the Board of Governors of the Federal Reserve System (“Federal Reserve”) and the Bank is regulated by the California Department of Business Oversight ("DBO") and the Federal Reserve. The Bank was incorporated under the laws of the State of California in March 2005, is licensed by the DBO, and commenced banking operations in August 2005, as a California state-chartered commercial bank headquartered in Cerritos, Los Angeles County, California. On October 1, 2018, the Bank satisfied the requirements of the Federal Reserve Bank and became a state member bank of the Federal Reserve System and purchased the required stock of the Federal Reserve Bank. Accordingly, the Bank is subject to periodic examination and supervision by the DBO and the Federal Reserve as the Bank's primary regulators. In addition, the Bank's deposits are insured under the Federal Deposit Insurance Act by the Federal Deposit Insurance Corporation ("FDIC") and as a result FDIC also has examination authority over the Bank. Recent Developments Common Stock registered with Nasdaq Capital Market and added to the Russell 3000® Index and the Russell 2000® Index We registered and issued outstanding shares of common stock with the Nasdaq Capital Market and on May 1, 2018, our shares commenced trading under our existing ticker symbol “FCBP”. The Company was added to the Russell 3000® Index and the Russell 2000® Index when Russell investments reconstituted its comprehensive set of U.S. and global equity indexes after the market closed on June 22, 2018. Merger with Pacific Commerce Bancorp We completed the previously announced acquisition of Pacific Commerce Bancorp ("PCB") on July 31, 2018 following receipt of all necessary regulatory and shareholder approvals. We had entered into an Agreement and Plan of Reorganization and Merger, dated February 23, 2018 (the "Merger Agreement"), by which PCB would be merged with and into First Choice Bancorp, and PCB’s bank subsidiary, Pacific Commerce Bank, would be merged with and into First Choice Bancorp’s bank subsidiary, First Choice Bank (collectively, the “Merger”). The Merger was an all stock transaction valued at approximately $133.3 million, or $13.69 per share, based on a closing price of our common stock of $28.70 as of July 31, 2018. At the effective time of the Merger, each share of PCB common stock was converted into the right to receive 0.47689 shares (referred to as the "final exchange ratio") of Company common stock, with cash paid in lieu of any fractional shares. The final exchange ratio of the stock-to-stock transaction was higher than the ratio of 0.46531 announced at the time of the acquisition, as the ratio was subject to certain adjustments as previously described in the joint proxy statement. The higher exchange ratio was primarily due to adjustments resulting from an increase in PCB’s capital from the exercise of stock options, lower than budgeted transaction costs and higher than projected net income during the first six months of 2018. In the aggregate, we issued 4,386,816 shares of our common stock in exchange for all of the outstanding shares of PCB common stock. In addition, we issued 420,393, in the aggregate, in replacement vested stock options with a fair value of $7.4 million to PCB directors, officers and employees. The PCB directors, officers and employees that did not continue to work with us had the option to receive either a rollover stock option or cash equal to the value of their PCB stock option, and after such elections were made, 278,096 rollover stock options were issued and exercisable into shares of our common stock, and no cash was issued. For the remaining PCB directors, officers and employees that continued to work with us, their stock options were converted into rollover stock options exercisable into 142,297 shares of our common stock. PCB was headquartered in Los Angeles, California, with $544.7 million in total assets, $414.9 million in gross loans and $474.8 million in total deposits as of July 31, 2018. Pacific Commerce Bank had six full-service branches in Los Angeles and San Diego Counties, including its operating division, ProAmérica Bank, in Downtown Los Angeles. The Merger provides us with the opportunity to further serve our existing customers and to expand our footprint in Southern California to the Mexican border. We retained the brand name ProAmérica. The acquisition has been accounted for using the acquisition method of accounting and, accordingly, the operating results of PCB have been included in the consolidated financial statements from August 1, 2018. Refer to Note 2 - Business Combination to the Consolidated Financial Statements included in Item 8 - Financial Statements and Supplementary Data, of this Annual Report. Member of Federal Reserve On October 1, 2018, First Choice Bank became a member and a stockholder of the Federal Reserve Bank and purchased $6.7 million of Federal Reserve Bank stock. Stock Repurchase Plan On December 3, 2018, we announced an authorized stock repurchase plan, providing for the repurchase of up to 1.2 million shares of the Company’s outstanding common stock, or approximately 10% of its then outstanding shares, which we refer to as the "repurchase plan". We repurchased 36,283 shares of Company common stock at an average price of $21.82 during 2018 and 1,163,717 shares of Company common stock remained available for repurchase under the repurchase plan at December 31, 2018. The repurchase plan permits shares to be repurchased in open market or private transactions, through block trades, and pursuant to any trading plan that may be adopted in accordance with Rules 10b5-1 and 10b-18 of the SEC. The repurchase plan may be suspended, terminated or modified at any time for any reason, including market conditions, the cost of repurchasing shares, the availability of tentative investment opportunities, liquidity, and other factors deemed appropriate. These factors may also affect the timing and amount of share repurchases. The repurchase plan does not obligate the Company to purchase any particular number of shares. Financial Highlights Financial Performance • Net income increased $7.8 million to $15.1 million or $1.64 per diluted share for 2018 compared to $7.4 million or $1.02 per diluted share for 2017. The increase in net income was driven mostly by the PCB acquisition which was completed on July 31, 2018. The after-tax merger, integration and public company registration expenses of $4.0 million reduced diluted earnings per share by $0.44 for 2018. Net income for 2017 included an income tax write-down adjustment of $1.8 million, related to the decline in value of the net deferred tax assets to reflect the reduction in the federal corporate tax rate as a result of the Tax Cuts and Jobs Act ("Tax Act") that was enacted into law on December 22, 2017; this write-down reduced diluted earnings per share by $0.25 for 2017. • Return on average assets and return on average equity was 1.28% and 9.09% for 2018 compared to 0.83% and 6.96% for 2017. The after-tax merger, integration and public company registration expenses lowered the return on average assets and return on average equity by 34 basis points and 242 basis points for 2018. The income tax write down adjustment lowered the return on average assets and return on average equity by 21 basis points and 172 basis points for 2017. Return on average tangible equity was 11.38% for 2018 compared to 6.96% for 2017. The after-tax merger, integration and public company registration expenses lowered the return on average tangible equity by 303 basis points for 2018. Refer to - Non-GAAP Financial Measures section in this MD&A. • Net interest margin increased 96 basis points to 4.93% for 2018 from 3.97% for 2017. The 2018 net interest margin benefited from higher market rates on new loan production and loan repricing, higher accelerated accretion of net discounts due to early loan payoffs, and additional scheduled accretion income from the net purchase accounting discounts on acquired PCB loans. The accelerated discount accretion due to early payoffs and prepayment penalties expanded the net interest margin by 14 basis points for 2018. The scheduled accretion income from the net purchase accounting discounts on the acquired loans also contributed 16 basis points to the 2018 net interest margin. • The average cost of funds was 86 basis points for 2018 compared to 78 basis points for 2017. The higher cost of funds was attributed to an overall increase in market rates, partially offset by the more favorable mix of deposits added in the PCB acquisition. Average noninterest-bearing deposits represented 35.9% of average total deposits for 2018 compared to 26.5% for 2017. • Our operating efficiency ratio was 61.1% in 2018 compared with 59.6% in 2017. Excluding the impact of the merger, integration and public company registration costs incurred in 2018, our operating efficiency ratio was 52.0% in 2018 compared with 59.6% in 2017. Refer to - Non-GAAP Financial Measures section in this MD&A. • Total consolidated assets increased $718.7 million to $1.62 billion at December 31, 2018 from $903.8 million at December 31, 2017. The increase is due primarily to the PCB acquisition, which added $536.5 million total assets, including $399.8 million in loans and $73.4 million of goodwill at the date of acquisition. Total loans held for investment increased $509.3 million to $1.25 billion at December 31, 2018 from $741.7 million at December 31, 2017 due to organic growth of $109.4 million and the loans acquired in the PCB acquisition. Average loans during 2018 increased $245.6 million, or 33.2%, compared to 2017. • Total consolidated liabilities increased $576.3 million to $1.37 billion at December 31, 2018 from $798.1 million at December 31, 2017. The increase is due to the PCB acquisition, which added $476.6 million total liabilities, including $474.9 million in deposits at the date of acquisition. Total deposits increased $479.7 million to $1.25 billion at December 31, 2018 from $772.7 million at December 31, 2017 due mostly to the deposits acquired in the PCB acquisition. Noninterest-bearing demand deposits totaled $546.7 million, or 43.8% of total deposits at December 31, 2018, compared to $235.6 million, or 30.4% of total deposits at December 31, 2017. Total borrowings increased $93.1 million to $113.4 million at December 31, 2018 compared to $20.4 million at December 31, 2017. The increase in borrowings was a result of loan portfolio growth. • Total consolidated equity increased $142.4 million to $248.1 million at December 31, 2018 from $105.7 million at December 31, 2017. The increase is due primarily to the all-stock purchase consideration of $133.3 million for the PCB acquisition. Credit Quality • Non-performing assets decreased to $1.7 million, or 0.11% of total assets, at December 31, 2018 from $1.8 million, or 0.19% of total assets, at December 31, 2017. Non-performing loans were $1.7 million, or 0.14% of loans held for investment, at December 31, 2018; this compares to $1.8 million, or 0.24% of loans held for investment, at December 31, 2017. Capital & Growth Strategy • We build, preserve and manage our capital to be ‘well-capitalized’ as defined in the regulations, to support strategic organic and acquired balance sheet growth, to provide returns to our shareholders in the form of dividends and share repurchases, and to manage balance sheet risk generally. The Company and the Bank remain well-capitalized with favorable capital ratios. At December 31, 2018, the Bank had a total risk-based capital ratio of 14.18% and a Tier 1 common to risk weighted assets ratio of 13.26%; this compares to a total risk-based capital ratio of 14.72% and a Tier 1 common to risk weighted assets ratio of 13.46% at December 31, 2017. • At December 31, 2018, our tangible book value per share was $14.33 compared to $14.56 at December 31, 2017. Refer to - Non-GAAP Financial Measures section in this MD&A for additional information. • During 2018 we increased shareholders' equity $142.4 million due to net income of $15.1 million, the issuance of approximately 4.4 million shares of Company common stock with a value of $133.3 million to acquire PCB, and the exercise of rollover stock options and vesting of restricted stock of $2.7 million, offset by cash dividends of $7.6 million and Company common stock repurchases of $1.1 million. • The holding company also maintains a $25.0 million secured line of credit to provide cash flow flexibility in support of our capital management and growth initiatives. This secured line of credit was increased from $10 million to $25.0 million during 2018 to reflect the Company’s larger size after the PCB acquisition. We had $8.5 million of the senior secured notes outstanding at December 31, 2018. Primary Factors We Use to Evaluate Our Business As a financial institution, we manage and evaluate various aspects of both our consolidated results of operations and our consolidated financial condition. We evaluate the comparative levels and trends of the line items in our consolidated balance sheets and consolidated income statements and various financial ratios that are commonly used in our industry. We analyze these financial trends and ratios against our own historical performance, our budgeted performance and the financial condition and performance of comparable financial institutions in our region. Segment Information We provide a broad range of financial services to individuals and companies through our branch network. Those services include a wide range of deposit and lending products for businesses and individuals. While our chief decision makers monitor the revenue streams of our various product and service offerings, we manage our operations and review our financial performance on a company-wide basis. Accordingly, we consider all of our operations to be aggregated into one reportable operating segment. Impact of Acquisition on Earnings The comparability of our financial information is affected by the acquisition of PCB. We completed the acquisition on July 31, 2018. This acquisition has been accounted for using the acquisition method of accounting and, accordingly, PCB’s operating results have been included in the consolidated financial statements for periods beginning after July 31, 2018. Results of Operations In addition to net income, the primary factors we use to evaluate and manage our results of operations include net interest income, noninterest income and noninterest expense. Net Interest Income Net interest income represents interest income less interest expense. We generate interest income from interest and fees (net of costs amortized over the expected life of the loans) plus the accretion of net discounts received on interest-earning assets, including loans and investment securities and dividends on restricted stock investments. We incur interest expense from interest paid on interest-bearing liabilities, including interest-bearing deposits and borrowings. Net interest income has been the most significant contributor to our revenues and net income. To evaluate net interest income, we measure and monitor: (a) yields and accretable net discount on our loans and other interest-earning assets; (b) the costs of our deposits and other funding sources; and (c) our net interest margin. Net interest margin is calculated as the annualized net interest income divided by average interest-earning assets. Because noninterest-bearing sources of funds, such as noninterest-bearing deposits and shareholders’ equity, also fund interest-earning assets, net interest margin includes the benefit of these noninterest-bearing sources. Changes in market interest rates, the slope of the yield curve, and interest we earn on interest-earning assets or pay on interest-bearing liabilities, as well as the volume and types of interest-earning assets, interest-bearing and noninterest-bearing liabilities, usually have the largest impact on changes in our net interest spread, net interest margin and net interest income during a reporting period. Noninterest Income Noninterest income consists of, among other things: (a) gain on sale of loans; (b) service charges and fees on deposit accounts; (c) net servicing fees; and (d) other noninterest income. Gain on sale of loans includes origination fees, capitalized servicing rights and other related income. Net loan servicing fees are collected as payments are received for loans in the servicing portfolio and offset by the amortization expense of the related servicing asset; this revenue stream is impacted by loan prepayments which are not predictable. Noninterest Expense Noninterest expense includes: (a) salaries and employee benefits; (b) occupancy and equipment; (c) data processing; (d) professional fees; (e) office, postage and telecommunication; (f) deposit insurance and regulatory expenses; (g) loan related expenses; (h) customer service related expenses; (i) merger, integration and public company registration expenses; (j) amortization of core deposit intangible; and (k) other general and administrative expenses. Financial Condition The primary factors we use to evaluate and manage our consolidated financial condition are asset levels, liquidity, capital and asset quality. Asset Levels We manage our asset levels based upon forecasted loan originations and estimated loan sales to ensure we have both the necessary liquidity and capital to fund asset growth while exceeding the required regulatory capital ratios. We evaluate our funding needs by forecasting loan originations and sales of loans. Liquidity We manage our liquidity based upon factors that include the amount of our custodial and brokered deposits as a percentage of total assets and deposits, the level of diversification of our funding sources, the allocation and amount of our deposits among deposit types, the short-term funding sources used to fund assets, the amount of non-deposit funding used to fund assets, the availability of unused funding sources, off-balance sheet obligations, the availability of assets to be readily converted into cash without a material loss on the investment, the amount of cash and cash equivalent securities we hold, the repricing characteristics and maturities of our assets when compared to the repricing characteristics of our liabilities and other factors. Capital We manage our regulatory capital based upon factors that include: (a) the level of capital and our overall financial condition; (b) the trend and volume of problem assets; (c) the level and quality of earnings; (d) the risk exposures and level of reserves in our consolidated balance sheets; and (e) other factors. In addition, we have regularly increased our capital through equity issuances and net income and we return capital to our shareholders through dividends and share repurchases. Asset Quality We manage the diversification and quality of our assets based upon factors that include the level, distribution, severity and trend of problem, classified, delinquent, nonaccrual, nonperforming and restructured assets, the adequacy of our allowance for loan losses, the diversification and quality of loan and investment portfolios, the extent of counterparty risks, credit risk concentrations and other factors. Non-GAAP Financial Measures This following tables present non-GAAP financial measures for: (1) efficiency ratio, (2) adjusted efficiency ratio, (3) adjusted net income, (4) adjusted return on average assets, (5) adjusted return on average equity, (6) return on average tangible equity, (7) adjusted return on average tangible equity, (8) tangible equity to asset ratio, and (9) tangible book value per share. The Company believes the presentation of certain non-GAAP financial measures assists investors in evaluating our financial results. These non-GAAP financial measures are used by management, the Board and investors on a regular basis, in addition to our GAAP results, to facilitate the assessment of our financial performance. These non-GAAP financial measures complement our GAAP reporting and are presented below to provide investors and others information that we use to manage the business each period. Because not all companies use identical calculations, the presentation of these non-GAAP financial measures may not be comparable to other similarly titled measures used by other companies. However, we believe the non-GAAP information shown below provides useful information to investors to assess our consolidated financial condition and consolidated results of operations. In particular, the use of return on average tangible equity, tangible equity to asset ratio, and tangible book value per share is prevalent among banking regulators, investors and analysts. These non-GAAP measures should be taken together with the corresponding GAAP measures and should not be considered a substitute of the GAAP measures. Comparison of Operating Results General Net income was $15.1 million for the year ended December 31, 2018 compared to $7.4 million for the year ended December 31, 2017. The $7.8 million increase in net income was due to higher net interest income of $20.9 million and lower income taxes of $1.7 million partially offset by lower noninterest income of $1.5 million, higher provision for loan losses of $878 thousand, and higher noninterest expense of $12.4 million for the year ended December 31, 2018 compared to the same 2017 period. The increase in net interest income was a result of higher average loan balances, relating to both the PCB acquisition and organic loan growth, and increased yields on loans. Noninterest income decreased due to lower SBA loan sale activity and related gains, partially offset by higher service charges and fees on deposits accounts. Noninterest expense increased due to higher merger, integration and public company registration expenses and higher overhead expenses from the impact of including PCB's operations since the date of acquisition. Net income was also positively impacted by the lower federal income tax rates from the passage of the Tax Act in December 2017. Diluted earnings per share was $1.64 for the year ended December 31, 2018 compared to $1.02 for the year ended December 31, 2017. Net income for the year ended December 31, 2018 included after-tax merger, integration and public company registration expenses of $4.0 million or $0.44 per diluted share; there were no similar costs for the year ended December 31, 2017. Net income for the year ended of December 31, 2017 included a $1.8 million income tax write-down adjustment related to the decline in value of the Company's deferred tax assets to reflect the reduction in the federal corporate tax rate as a result of the Tax Act that was enacted into law on December 22, 2017; this write-down reduced diluted earnings per share by $0.25 for the year of 2017. Net Interest Income Net interest income is affected by changes in both interest rates and the volume of average interest-earning assets and interest-bearing liabilities. The following table summarizes the distribution of average assets, liabilities and stockholders’ equity, as well as interest income and yields earned on average interest-earning assets and interest expense and rates paid on average interest-bearing liabilities for the periods indicated: (1) Average loans include net discounts and deferred costs. Interest income on loans includes $469 thousand, $439 thousand and $1.1 million related to the accretion of net deferred loans fees and $4.0 million, $(293) thousand and $821 thousand related to accretion (amortization) of discounts (premiums) for the years ended December 31, 2018, 2017 and 2016. Rate/Volume Analysis The volume and interest rate variances table below sets forth the dollar difference in interest earned and paid for each major category of interest-earning assets and interest-bearing liabilities for the noted periods, and the amount of such change attributable to changes in average balances (volume) or changes in average interest rates. Volume variances are equal to the increase or decrease in the average balance times the prior period rate, and rate variances are equal to the increase or decrease in the average rate times the prior period average balance. Variances attributable to both rate and volume changes are allocated proportionately based on the amounts of the individual rate and volume changes. Net interest income was $55.7 million during 2018, an increase of $20.9 million from $34.8 million during 2017 due to higher interest income of $23.6 million partially offset by higher interest expense of $2.7 million. Our net interest margin increased 96 basis points to 4.93% for the year ended December 31, 2018 compared to 3.97% for the same 2017 period. The increase in net interest margin was driven by higher market rates on new loan production and loan repricing, higher accelerated accretion of discounts due to early loan payoffs, and additional accretion income from purchase accounting discounts on acquired PCB loans. For the year ended December 31, 2018, interest income included accelerated discount accretion due to early payoffs of loans and prepayment penalties of $1.5 million, which expanded the net interest margin by 14 basis points, compared to $179 thousand for the same 2017 period. In addition, scheduled accretion income from purchase accounting discounts on the acquired loans contributed $1.8 million, or 16 basis points to net interest margin during 2018; there was no similar accretion income for the 2017 period. Average interest-earning assets were $1.13 billion during 2018 compared to $875.6 million during 2017. The average yield on interest-earning assets was 5.70% during 2018 compared to 4.66% during 2017. Average loan balances were $985.5 million during 2018 compared to $739.9 million during 2017. The increase in our average loan balance was attributable to organic loan portfolio growth coupled with the impact of $399.8 million in net loans acquired in the PCB acquisition. Our loan yield was 6.20% during 2018 compared to 5.22% for 2017. The discount accretion from acquired loans and accelerated discount accretion due to early loan payoffs increased our loan yield 34 basis points during 2018. Average funding sources totaled $1.01 billion during 2018 compared to $774.6 million during 2017. Average interest-bearing liabilities were $658.9 million during 2018 compared to $574.8 million during 2017 and our cost of interest-bearing liabilities increased 27 basis points to 1.32% during 2018. Our average cost of funds was 86 basis points during 2018 compared to 78 basis points during 2017. Our average cost of funds increased as overall market interest rates have risen while at the same time we benefited from the more favorable mix of deposits added in the PCB acquisition. Average noninterest-bearing deposits totaled $353.2 million and represented 35.9% of average total deposits during 2018 compared to $199.8 million and 26.5% of total average deposits during 2017. Average short-term borrowings increased $2.7 million during 2018 as we used short-term borrowings to supplement deposit balances used to fund our loan portfolio growth. Average senior secured notes increased $4.5 million during 2018 as we used the funds for cash dividends, share repurchases, operational costs, and merger, integration and public company registration costs. Provision for Loan Losses We maintain an allowance for loan losses, which we also refer to as the allowance, at a level we believe is adequate to absorb probable incurred credit losses. The allowance for loan losses is estimated using past loan loss experience, the nature and volume of the portfolio, information about specific borrower situations and estimated collateral values, economic conditions, and other factors. At December 31, 2018, the allowance for loan losses was $11.1 million, or 0.88% of loans held for investment compared to $10.5 million, or 1.42% of loans held for investment at December 31, 2017. The increase in the allowance at December 31, 2018 primarily results from $1.5 million in provision for loan losses, partially offset by $961 thousand in net charge-offs of previously identified problem loans. The decrease in the allowance for loan losses as a percentage of loans held for investment as of December 31, 2018 as compared to December 31, 2017 primarily relates to the $399.8 million of loans acquired from PCB that were recorded at fair market value without a corresponding allowance for loan losses. The net carrying value of loans acquired through the acquisition of PCB includes a remaining net discount of $9.5 million as of December 31, 2018, which represents 75 basis points of total gross loans. The provision for loan losses totaled $1.5 million for the year ended December 31, 2018 compared to $642 thousand for the year ended December 31, 2017. The change in provision for loan losses was primarily the result of organic loan growth. Noninterest Income The following table shows the components of noninterest income between periods: Noninterest income decreased $1.5 million to $3.6 million for the year ended December 31, 2018 compared to $5.1 million for the year ended December 31, 2017 primarily due to lower gain on sale of loans which was partially offset by higher services charges and fees on deposit accounts during the year. The increase in services charges and fees on deposit accounts was due to the impact of the PCB acquisition. Gain on the sale of loans decreased $2.1 million for the year ended December 31, 2018 compared to the 2017 period due to a decline in the average premium percentage and a lower amount of loans sold. We sold 31 SBA loans with a net carrying value of $25.0 million at an average premium percentage of 6.0%, resulting in a gain of $1.5 million for the year ended December 31, 2018. This compares to 40 SBA loans sold with a net carrying value of $43.3 million at an average premium percentage of 7.8%, resulting in a gain of $3.4 million and whole loan sales of $30.0 million for a gain of $207 thousand for the 2017 period. Services charges and fees on deposit accounts increased $912 thousand to $1.2 million for the year ended December 31, 2018 from $329 thousand for the comparable 2017 period. The increase is attributed to a higher volume of transaction-based accounts and account balances as a result of the PCB acquisition; average demand deposit account balances increased to $353.2 million for the year ended December 31, 2018 from $199.8 million for the same 2017 period. Additionally,we continue to build new customer relationships that are taking advantage of our treasury management services. The decrease in net servicing fees was due to higher amortization expense of our servicing assets offset by higher servicing fee income. Our SBA loan servicing portfolio averaged $164.2 million during 2018 compared to $132.9 million for 2017. The increase in our SBA loan servicing portfolio primarily related to the acquisition of PCB which contributed $73.8 million to the portfolio of serviced SBA loans on the date of acquisition. During the years ended December 31, 2018 and 2017 contractually-specified servicing fees were $1.5 million and $1.2 million. Offsetting these servicing fees was amortization of the servicing assets of $1.0 million and $487 thousand for the years ended December 31, 2018 and 2017. The increase in amortization of the servicing asset was due to amortizing the servicing asset acquired in the PCB acquisition and higher amortization related to early loan pay-offs of $636 thousand for the year ended December 31, 2018 compared to $190 thousand for 2017. Noninterest Expense The following table shows the components of noninterest expense between periods: Noninterest expense for the year ended December 31, 2018 was $36.2 million, an increase of $12.4 million from $23.8 million for the year ended December 31, 2017. The increase was primarily attributable to the impact of the acquired PCB operations and merger, integration and public company registration costs of $5.4 million. Excluding merger, integration and public company registration costs, noninterest expense increased $7.1 million to $30.8 million for the year ended December 31, 2018 compared to $23.8 million for the comparable period in 2017; the increase in most overhead expense categories is due to including PCB's operations since the date of acquisition. Salaries and employee benefits increased $3.5 million to $18.1 million for the year ended December 31, 2018 from $14.6 million for the year ended December 31, 2017. The increase is primarily attributable to the growth in headcount due to the PCB acquisition. During the year ended December 31, 2018, we had an average of 136 full time equivalent ("FTE") employees compared to an average of 102 FTE employees for 2017. Occupancy and equipment costs increased $965 thousand to $3.0 million for the year ended December 31, 2018. The increase in occupancy and equipment costs was primarily due to the additional occupancy costs associated with the six branches added in the PCB acquisition. Data processing increased $802 thousand to $2.3 million for the year ended December 31, 2018. The increase in data processing primarily relates to increases in transaction volume from both organic growth and the PCB acquisition, strengthening automation and delivering risk mitigation solutions to improve our customers’ banking experience. Professional fees increased $626 thousand to $1.6 million for the year ended months ended December 31, 2018. The increase in professional fees primarily relates to increases in legal, consulting and audit fees for enhancements of policies, procedures and internal controls as we transitioned to a publicly-traded company. Merger, integration and public company registration costs totaled $5.4 million for the year ended December 31, 2018; there were no similar costs in 2017. The merger, integration and public company registration costs included $1.8 million in severance costs, $768 thousand in professional fees, $2.5 million in system integration costs, and $414 thousand in other expenses. In connection with the PCB acquisition, we recognized a core deposit intangible (CDI) of $6.9 million. Amortization of CDI was $332 thousand for the year ended December 31, 2018; there was no similar expense for the year ended December 31, 2017. Income Taxes Income tax expense was $6.4 million and $8.1 million for the years ended December 31, 2018 and 2017. The effective tax rate for the year ended December 31, 2018 was 29.8% compared to 52.4% for the year ended December 31, 2017. The reduction in our effective tax rate was primarily attributable to the impact of the Tax Act, which was signed into legislation in December 2017. The Tax Act substantially amended the Internal Revenue Code and reduced the corporate Federal income tax rate from 35% to 21% beginning in 2018. Tax expense for the year ended December 31, 2017 included a $1.8 million write down adjustment related to the decline in value of our deferred tax assets due to the Tax Act. Excluding the deferred tax assets write down adjustment, our effective tax rate for 2017 would have been 40.6%. Comparison of Financial Condition General Total assets at December 31, 2018 were $1.62 billion, an increase of $718.7 million, or 79.5%, from $903.8 million at December 31, 2017. This increase is primarily due to the $508.7 million increase in loans held for investment, net to $1.24 billion at December 31, 2018 from $731.2 million at December 31, 2017. The completion of our acquisition of PCB during the third quarter of 2018 increased assets by $536.5 million on the acquisition date. Total liabilities at December 31, 2018 were $1.37 billion, an increase of $576.3 million, from $798.1 million at December 31, 2017. The completion of our acquisition of PCB during the third quarter of 2018 increased liabilities by $476.6 million on the acquisition date, primarily consisting of deposit balances. Total deposits increased $479.7 million to $1.25 billion at December 31, 2018. Other short-term borrowings increased $85.0 million to $105 million at December 31, 2018. Additionally, senior secured notes increased $8.1 million to $8.5 million at December 31, 2018; we used the funds for cash dividends, share repurchases, operational costs, and merger, integration and public company registration costs. Cash and Cash Equivalents Cash and cash equivalents are comprised of cash and due from banks, interest-bearing deposits at other banks with original maturities of less than 90 days, federal funds sold and securities purchased under agreements to resell. Cash and cash equivalents totaled $197.4 million at December 31, 2018, an increase of $94.2 million from December 31, 2017. The increase in cash and cash equivalents during 2018 was primarily attributable to cash balances acquired from the PCB, which totaled $111.0 million at the date of acquisition. Investment Securities The following table presents the carrying values of investment securities available-for-sale and held-to-maturity as of the periods indicated: (1) With the adoption of ASU 2016-01 on January 1, 2018, equity securities with a readily determinable fair values are measured at fair value at the end of each reporting period and reported separately from securities available-for-sale. The reclassification was retroactively applied to 2017 financial statements to conform to the 2018 presentation. The following table presents the contractual maturities and the weighted average yield of investment securities available-for-sale and held-to-maturity by investment category as of December 31, 2018: (1) Mortgage-backed securities, collateralized mortgage obligations and SBA pools do not have a single stated maturity date and therefore have been included in the "Due after ten years" category. (1) Mortgage-backed securities do not have a single stated maturity date and therefore have been included in the "Due after ten years" category. At December 31, 2018, no issuer represented 10% or more of the Company’s shareholders’ equity. At December 31, 2018, securities held-to-maturity with a carrying amount of $5.3 million were pledged to the Federal Reserve Bank as collateral for a $4.9 million line of credit. There were no borrowings under this line of credit for the year ended December 31, 2018. Loans Loans are the single largest contributor to our net income. At December 31, 2018, loans held for investment, net totaled $1.24 billion. It is our goal to continue to grow the balance sheet through the origination and acquisition of loans. This effort will serve to maximize our yield on earning assets. We continue to manage our loan portfolio in accordance with what we believe are conservative and proper loan underwriting policies. Every effort is made to minimize credit risk, while tailoring loans to meet the needs of our target market. Continued balanced growth is anticipated over the coming years. The following table shows the composition of our loan portfolio as of the dates indicated: (1) Loans held for investment, net of discounts includes purchased credit impaired loans of $2.6 million as of December 31, 2018. There were no purchased credit impaired loans as of December 31, 2017, 2016, 2015 and 2014. During the year ended December 31, 2018, loans held for investment, net increased $508.7 million to $1.24 billion compared to $731.2 million at December 31, 2017. The changes in our total loan portfolio are primarily attributable to the $399.8 million of loans acquired from PCB at acquisition date. Below is a discussion of the changes in our principal loan categories: Construction and land development loans. We provide construction financing for one to four-unit residences and commercial development projects, especially medical office buildings, and land loans for projects in the development process, prior to receiving a building permit. We also provide financing for purchase, refinance, or construction of owner-occupied and non-owner occupied commercial real estate properties. Construction and land development loans increased $68.8 million or 59.6% to $184.2 million at December 31, 2018 from $115.4 million at December 31, 2017. Demand for financing in this area continues to rise. The growth in our construction and land development portfolio also included $15.5 million in loans acquired from PCB at acquisition date. At December 31, 2018 and 2017, construction and land development loans comprised 14.7%, and 15.6% of our total loans held for investment, net of discounts. Real estate loans - residential. Residential loans include loans originated or purchased within the marketplace from unaffiliated third parties. Residential real estate loans decreased $6.0 million or 9.4% to $57.4 million from $63.4 million at December 31, 2017. At December 31, 2018 and 2017, residential real estate loans represented 4.6% and 8.5% of our total loans held for investment, net of discounts. During the year of 2018, we continued to see prepayments within the portfolio and a shift in originations towards higher yielding commercial real estate and commercial and industrial loans. The residential loans acquired from PCB at acquisition date was $11.3 million. Commercial real estate loans. We provide financing for the purchase or refinance of owner-occupied and non-owner-occupied commercial real estate. These loans are typically secured by first mortgages. Commercial real estate loans, including both owner-occupied and non-owner-occupied, increased $276.6 million or 90.8% to $581.2 million from $304.6 million at December 31, 2017. The changes in commercial real estate loans during 2018 are primarily attributable to the $252.4 million in commercial real estate loans acquired from PCB at acquisition date, which included $123.0 million of owner-occupied loans and $129.3 million in non-owner-occupied loans. Our single largest concentration of CRE loans is to hospitality owners, which comprised 13.8% and 26.1% of total commercial real estate loans at December 31, 2018 and December 31, 2017. Some of the members of our Board of Directors are active in the hospitality sector and are therefore able to provide referrals for financing on hotel properties. There are no loans to any of our board members, nor to members of their immediate families, but often to other hotel owners referred to us by these directors. We carefully manage this concentration and the levels of hospitality loans measured against our total risk-based capital are reported to our Board of Directors monthly. Commercial and industrial loans. Commercial lending activity is directed principally toward businesses whose demand for funds falls within our legal lending limit. Our primary business focus is companies which are manufacturers, wholesalers, distributors, services companies and professionals. Our typical customers are businesses whose annual revenue is between $1 million to $50 million. These loans include lines of credit, term loans, equipment financing, letters of credit, and working capital loans. We make loans to borrowers secured by accounts receivable and inventory managed against a borrowing base. Commercial and industrial loans often carry larger loan balances and can involve a greater degree of financial and credit risks. Any significant failure to pay on time by our customers would impact our earnings. The increased financial and credit risk associated with these types of loans is a result of several factors, including the concentration of principal in a limited number of loans and borrowers, the size of the loan balances, the effects of general economic conditions on the underlying businesses, and the increased difficulty of evaluating and monitoring these types of loans. At December 31, 2018, commercial and industrial loans totaled $281.7 million, an increase of $112.5 million or 66.5% from $169.2 million at December 31, 2017. The increase in commercial and industrial loans during 2018 is due to the $74.7 million in commercial and industrial loans acquired from PCB at acquisition date and, to a lesser extent, overall increases in our lending activity during year. At December 31, 2018 and 2017, commercial and industrial loans comprised 22.5% and 22.8% of our total loans held for investment, net of discounts. We also make loans that provide funding for executive retirement benefit programs. These loans are frequently secured to at least 90% and often well above that level by cash equivalent collateral; typically, the cash surrender value, also known as CSV, of one or more life insurance policies. These loans represent our largest concentration within the commercial and industrial loan portfolio. We manage these loans individually against our current house limit of $15 million and legal lending limit of 15% of total risk-based capital. The amount of the acceptable loan to CSV is dependent upon the credit quality of the insurer. A decline in the credit quality of the insurer would require the borrower to either pledge additional collateral, substitute the policy from another insurer, and/or reduce the outstanding loan balance to meet the loan-to-CSV ratio requirement. These loans totaled $36.8 million and $32.8 million at December 31, 2018 and December 31, 2017. At December 31, 2018 and December 31, 2017, the ratio of aggregate unpaid principal balance to aggregate CSV for this portfolio totaled 98.3% and 88.1%. Small Business Administration (SBA) loans. We offer small business loans through the SBA’s 7(a) program. We originate and service, as well as sell the guaranteed portion of these loans. The SBA’s 7(a) program provides up to a 75% guaranty for loans greater than $150,000. For loans $150,000 or less, the program provides up to an 85% guaranty. The maximum 7(a) loan amount is $5 million. The guaranty is conditional and covers a portion of the risk of payment default by the borrower, but not the risk of improper closing and servicing by the lender. At December 31, 2018, SBA 7(a) loans totaled $100.2 million, an increase of $47.5 million or 90.2% from $52.7 million at December 31, 2017. The SBA 504 program consists of real estate backed commercial mortgages where the Company has the first mortgage and the SBA has the second mortgage on the property. Generally, we have a less than 65 percent loan to value ratio on SBA 504 program loans at origination. At December 31, 2018, SBA 504 loans totaled $46.3 million, an increase of $10.3 million or 28.5% from $36.0 million at December 31, 2017. In the PCB acquisition, we gained $45.9 million in total SBA loans as of the acquisition date. We typically retain the entire SBA 504 loans we originate and sell in the secondary market the SBA-guaranteed portion of the SBA (7a) loans (generally 75% of the principal balance) we originate. During the years ended December 31, 2018 and 2017, we originated $48.0 million and $59.3 million, of SBA 7(a) loans and $20.2 million and $27.1 million of SBA 504 loans. We sold $25.0 million and $35.3 million of SBA 7(a) loans and zero and $7.9 million of SBA 504 loans for the years ended December 31, 2018 and 2017. As of December 31, 2018, our SBA portfolio totaled $146.5 million, of which $30.2 million is guaranteed by the SBA and $116.2 million is unguaranteed. Of the $116.2 million unguaranteed SBA portfolio, $31.6 million is secured by industrial/warehouse properties; $22.7 million is secured by hospitality properties; and $47.0 million is secured by other real estate types. As of December 31, 2017, our SBA portfolio totaled $88.7 million of which $10.9 million is guaranteed by the SBA and $77.8 million is unguaranteed. Of the $77.8 million unguaranteed SBA portfolio, $27.8 million is secured by industrial/warehouse properties; $24.4 million is secured by hospitality properties; and $20.9 million is secured by other real estate types. Loan Maturities. The following table presents the contractual maturities and the distribution between fixed and adjustable interest rates for loans held for investment at December 31, 2018: Commercial Real Estate Concentration. Under a 2006 Interagency Guidance issued by the federal banking regulatory agencies, a limitation of 300% of total risk-based capital was established for commercial real estate loans, including multi-family and non-farm nonresidential property and loans for construction and land development. In addition, a limitation of 100% of total risk-based capital was established for construction and land development loans. An institution exceeding the thresholds should have heightened risk management practices appropriate to the degree of commercial real estate loan concentration risk of these loans in their portfolios and consistent with the Interagency Guidance. The Board of Directors has approved pre-established concentration levels (as a percentage of capital) for various loan types based on our business plan and historical loss experience. On a monthly basis, management provides a loan concentration report to the Board with information relating to concentrations. Management’s review of possible concentrations includes an assessment of loans to multiple borrowers engaged in similar activities which would cause them to be similarly impacted by economic or other conditions. In addition, we stress test our CRE portfolios periodically as part of our risk management practices. We believe we are in compliance with the Interagency Guidance, because we have heightened risk management practices for our commercial real estate portfolio, including our construction and land development loans. As of December 31, 2018 and 2017, loans secured by non-owner occupied commercial real estate represented 309% of our total risk-based capital (as defined by the federal bank regulators). Our internal policy is to limit total non-owner occupied commercial real estate loans to 350% of total risk-based capital. In addition, as of December 31, 2018 and 2017, total loans secured by commercial real estate under construction and land development represented 108% and 99% of our total risk-based capital. Our internal policy is to limit loans secured by commercial real estate construction and land development to 150% of total risk-based capital. Historically, we have managed loan concentrations by selling participations in, or whole loan sales of, certain loans, primarily commercial real estate and construction and land development loan production. In addition, as of December 31, 2018 and 2017, total unpaid principal balance of hospitality loans represented approximately 61.2% and 97.1% of our total risk-based capital. We have historically provided loans to borrowers in the hospitality industry. Our internal guidance is to limit hospitality industry commitments to 150% of total risk-based capital, and we attempt to meet this guidance by participating certain hospitality loans to other lenders. At December 31, 2018 and 2017, total commitments to fund hospitality loans represented approximately 64.0% and 103.0% of our total risk-based capital. Most of our real property collateral is located within Southern California. In the past, particularly in the recession of 2007-2009, there has been a significant decline in real estate values in many parts of California, including certain parts of our service areas. If this were to happen again, the collateral for our loans may provide less security than when the loans were originated. A decline in real estate values could have an adverse impact on us by limiting repayment of defaulted loans through sale of commercial and residential real estate collateral and by a likely increase in the number of defaulted loans to the extent that the financial condition of our borrowers is adversely affected by such a decline in real estate values. The adverse effects of the foregoing matters upon our real estate portfolio could necessitate a material increase in our provision for loan losses. The repayment of loans secured by commercial real estate is typically dependent upon the successful operation of the related real estate or commercial project. If the cash flow from the project is reduced, the borrower’s ability to repay the loan may be impaired. This cash flow shortage may result in the failure to make loan payments. In such cases, we may be compelled to modify the terms of the loan. In addition, the nature of these loans is such that they are generally less predictable and more difficult to evaluate and monitor. As a result, repayment of these loans may, to a greater extent than residential loans, be subject to adverse conditions in the real estate market or economy. Problem Loans. Loans are considered delinquent when principal or interest payments are past due 30 days or more; delinquent loans may remain on accrual status between 30 days and 89 days past due. Loans on which the accrual of interest has been discontinued are designated as nonaccrual loans. Typically, the accrual of interest on loans is discontinued when principal or interest payments are past due 90 days or when, in the opinion of management, there is a reasonable doubt as to collectability in the normal course of business. When loans are placed on nonaccrual status, all interest previously accrued but not collected is reversed against current period interest income. We categorize loans into risk categories based on relevant information about the ability of borrowers to service their debt such as current financial information, historical payment experience, collateral adequacy, credit documentation, and current economic trends, among other factors. We analyze loans individually by classifying the loans as to credit risk. This analysis typically includes larger, non-homogeneous loans such as commercial real estate and commercial and industrial loans. This analysis is performed on an ongoing basis as new information is obtained. We use the following definitions for risk ratings: Pass - Loans classified as pass represent assets with a level of credit quality which contain no well-defined deficiency or weakness. Special Mention - Loans classified as special mention have a potential weakness that deserves management’s close attention. If left uncorrected, these potential weaknesses may result in deterioration of the repayment prospects for the loan or of the institution’s credit position at some future date. Substandard - Loans classified as substandard are inadequately protected by the current net worth and paying capacity of the obligor or of the collateral pledged, if any. Loans so classified have a well-defined weakness or weaknesses that jeopardize the liquidation of the debt. They are characterized by the distinct possibility that the institution will sustain some loss if the deficiencies are not corrected. Doubtful - Loans classified as doubtful have all the weaknesses inherent in those classified Substandard with the added characteristic that the weaknesses make collection or liquidation in full, based on currently known facts, conditions and values, highly questionable and improbable. Loss - Loans classified loss are considered uncollectible and of such little value that their continuance as loans is not warranted. The following tables present the recorded investment balances of potential problem loans, excluding PCI loans, classified as special mention or substandard, at December 31, 2018 and 2017: (1) At December 31, 2018, substandard loans include $1.7 million of impaired loans. The Company had no loans classified as doubtful or loss at December 31, 2018. (1) At December 31, 2017, substandard loans include $1.8 million of impaired loans. The Company had no loans classified as doubtful or loss at December 31, 2017. Nonperforming Assets. Nonperforming assets, excluding PCI loans, are defined as nonperforming loans (defined as accruing loans past due 90 days or more, non-accrual loans and non-accrual troubled-debt restructurings (“TDRs”)) plus real estate acquired through foreclosure. The table below reflects the composition of non-performing assets at the periods indicated: At December 31, 2018, one TDR with a recorded investment balance of $95 thousand was not performing in accordance with its restructured terms. At December 31, 2017, all TDRs were performing in accordance with their restructured terms. The following table shows our nonperforming loans among our different asset categories as of the dates indicated. Nonperforming loans, excluding PCI loans, include nonaccrual loans, loans past due 90 days or more and still accruing interest, and non-accrual TDRs. The balances of nonperforming loans reflect our net investment in these assets. (1) There were no purchased credit impaired loans on nonaccrual at December 31, 2018. Troubled Debt Restructurings. At December 31, 2018 and 2017, the Company had approximately $922 thousand and $1.8 million in recorded investment in loans identified as TDRs and had allocated approximately zero and $504 thousand as specific reserves for these loans. The Company has not committed to lend any additional amounts to customers with outstanding loans that are classified as TDR’s as of December 31, 2018. As of December 31, 2018 and 2017, loan modifications resulting in TDR status generally included one or a combination of the following: extensions of the maturity date, principal payment deferments or signed forbearance agreement with a payment plan. During the year ended December 31, 2018 there were no new loan modifications resulting in TDRs. During the year ended December 31, 2017, there were four new loan modifications resulting in TDRs. Allowance for Loan Losses. The allowance for loan losses is a valuation allowance for probable incurred credit losses. Loan losses are charged against the allowance when management believes the un-collectability of a loan balance is confirmed. Subsequent recoveries, if any, are credited to the allowance. Management estimates the allowance balance required using past loan loss experience, the nature and volume of the portfolio, information about specific borrower situations and estimated collateral values, economic conditions, and other factors. Allocations of the allowance may be made for specific loans, but the entire allowance is available for any loan that, in management’s judgment, should be charged off. Amounts are charged-off when available information confirms that specific loans or portions thereof, are uncollectible. This methodology for determining charge-offs is consistently applied to each loan portfolio segment. The Company determines a separate allowance for each loan portfolio segment. The allowance consists of specific and general reserves. Specific reserves relate to loans that are individually classified as impaired. A loan is impaired when, based on current information and events, it is probable that we will be unable to collect all amounts due according to the contractual terms of the loan agreement. Factors considered in determining impairment include payment status, collateral value and the probability of collecting all amounts when due. Measurement of impairment is based on the expected future cash flows of an impaired loan, which are to be discounted at the loan’s effective interest rate, or measured by reference to an observable market value, if one exists, or the fair value of the collateral for a collateral-dependent loan. We select the measurement method on a loan-by-loan basis except that collateral-dependent loans for which foreclosure is probable are measured at the fair value of the collateral. General reserves cover non-impaired loans and are based on historical loss rates for each portfolio segment or peer group historical data, adjusted for the effects of qualitative or environmental factors that are likely to cause estimated credit losses as of the evaluation date to differ from the portfolio segment’s historical loss experience. Qualitative factors include consideration of the following: changes in lending policies and procedures; changes in economic conditions; changes in the nature and volume of the portfolio; changes in the experience, ability and depth of lending management and other relevant staff; changes in the volume and severity of past due, nonaccrual and other adversely graded loans; changes in the loan review system; changes in the value of the underlying collateral for collateral-dependent loans; concentrations of credit; and the effect of other external factors such as competition and legal and regulatory requirements. Portfolio segments identified by the Company include construction and land development, residential and commercial real estate, commercial and industrial, SBA loans, and consumer loans. Relevant risk characteristics for these portfolio segments generally include debt service coverage, loan-to-value ratios, collateral type, borrower financial performance, credit scores, and debt-to-income ratios for consumer loans. In addition, the evaluation of the appropriate allowance for loan losses on purchased non-impaired loans in the various loan segments considers credit discounts recorded as a part of the initial determination of the fair value of the loans. For these loans, no allowance for loan losses is recorded at the acquisition date. Credit discounts representing the principal losses expected over the life of the loans are a component of the initial fair value. Subsequent to the acquisition date, the methods utilized to estimate the required allowance for loan losses for these loans is similar to our originated loans; however, the Company records a provision for loan losses only when the required allowance exceeds any remaining credit discounts. The evaluation of the appropriate allowance for loan losses for purchased credit-impaired loans in the various loan segments considers the expected cash flows to be collected from the borrower. These loans are initially recorded at fair value and, therefore, no allowance for loan losses is recorded at the acquisition date. Subsequent to the acquisition date, the expected cash flows of purchased loans are subject to evaluation. Decreases in expected cash flows are recognized by recording an allowance for loan losses with the related provision for loan losses. If the expected cash flows on the purchased loans increase, a previously recorded impairment allowance can be reversed. Increases in expected cash flows of purchased loans, when there are no reversals of previous impairment allowances, are recognized over the remaining life of the loans. At December 31, 2018, given the composition of our loan portfolio, as well as the unamortized fair value discount of loans acquired, the ALLL was considered adequate to cover probable incurred losses inherent in the loan portfolio. Should any of the factors considered by management in evaluating the appropriate level of the ALLL change, the Company’s estimate of probable incurred loan losses could also change, which could affect the level of future provisions for loan losses. The table below presents a summary of activity in our allowance for loan losses for the periods indicated: The following table shows the allocation of the allowance for loan losses by loan type at the periods indicated: PCI Loans. The following table summarizes the changes in the carrying amount and accretable yield of PCI loans for the period from July 31, 2018 (acquisition date) through December 31, 2018: Loan Held for Sale. Loans held for sale typically consist of the guaranteed portion of SBA 7(a) loans that are originated and intended for sale in the secondary market and may also include commercial real estate loans and SBA 504 loans. Loans held for sale are carried at the lower of carrying value or estimated market value. At December 31, 2018, loans held for sale were $28.0 million an increase of $17.4 million from $10.6 million at December 31, 2017. The increase in loans held for sale during the year ended December 31, 2018 was primarily attributable to the origination of $45.2 million in loans, offset by the sale of loans with an aggregate carrying value of $25.0 million. At December 31, 2018 and 2017, loans held for sale consisted entirely of SBA 7(a) loans. At December 31, 2018 and 2017, the fair value of loans held for sale totaled $29.2 million and $11.5 million. Servicing Asset and Loan Servicing Portfolio. The Company sells loans in the secondary market and, for certain loans retains the servicing responsibility. The loans serviced for others are accounted for as sales and are therefore not included in the accompanying consolidated balance sheets. The total loans serviced for others totaled $288.2 million and $222.0 million at December 31, 2018 and 2017. The loan servicing portfolio includes SBA loans serviced for others of $198.4 million and $140.4 million for which there is a related servicing asset of $3.2 million and $2.6 million at December 31, 2018 and 2017. Consideration for each SBA loan sale includes the cash received and a related servicing asset. The Company receives servicing fees ranging from 0.25% to 1.00% for the services provided over the life of the loan; the servicing asset is based on the estimated fair value of these future cash flows to be collected. The risks inherent in SBA servicing asset relates primarily to changes in prepayments that result from shifts in interest rates and a reduction in the estimated future cash flows. The servicing asset activity includes additions from loan sales with servicing retained and acquired servicing rights and reductions from amortization as the serviced loans are repaid and servicing fees are earned. Servicing rights with a fair value of $1.1 million, at acquisition date, were acquired in the PCB acquisition. Refer to Note 2 - Business Combination to the Consolidated Financial Statements included in Item 8 Financial Statements and Supplementary Data, of this Annual Report. In addition, the loan servicing portfolio includes construction and land development loans, commercial real estate loans and commercial & industrial loans participated out to various other institutions of $89.8 million and $81.6 million for which there is no related servicing asset at December 31, 2018 and 2017. Goodwill and Other Intangible Assets As a result of the PCB acquisition, we recorded goodwill and a core deposit intangible ("CDI"), which total $73.4 million and $6.6 million at December 31, 2018. Due to volatility in the stock market during December 2018, including a 19.9% reduction in the Company's closing stock price from the date PCB was acquired to December 31, 2018, we evaluated goodwill for impairment and concluded there was no impairment as of year-end. Deposits The following table presents the ending balance and percentage of deposits as of the dates indicated: Total deposits increased $479.7 million to $1.25 billion at December 31, 2018 from $772.7 million at December 31, 2017. The increase in deposits was primarily a result of $474.9 million in deposits acquired in the PCB acquisition; the acquired deposits included noninterest-bearing demand deposits of $273.6 million, or 57.6% of total acquired deposits, and money market deposits of $120.4 million, or 25.4% of the total acquired deposits. The deposit portfolio received as part of the PCB acquisition positively impacted our deposit mix resulting in a higher percentage of noninterest-bearing demand deposits. At December 31, 2018, noninterest-bearing deposits represented 43.8% of total deposits compared to 30.4% at December 31, 2017. The Company qualifies to participate in a state public deposits program that allows it to receive deposits from the state or from political subdivisions within the state in amounts that would not be covered by FDIC. This program provides a stable source of funding to the Company. As of December 31, 2018, total deposits from the State of California and other public agencies totaled $59.6 million and are collateralized by letters of credit issued by the FHLB under the Bank's secured line of credit with the FHLB. Refer to Note 8 - Deposits and Note 9 - Borrowing Arrangements to the Consolidated Financial Statements included in Item 8 Financial Statements and Supplementary Data, of this Annual Report. At December 31, 2018, the $53.4 million in callable brokered deposits had a weighted average maturity of 1.9 years, however all such deposits are available to be called. The Bank has an option to call and repay such deposits if rates for newly issued deposits should be lower, or if the Bank no longer has a need for this funding. At December 31, 2018 and 2017, the weighted average yield on brokered deposits was 1.61% and 1.32%. The Company’s ten largest depositor relationships accounted for approximately 25.2% and 29.8% of total deposits at December 31, 2018 and 2017. The following table shows time deposits greater than $250,000 by time remaining until maturity at December 31, 2018: Borrowings The following table presents the components of borrowings as of the periods indicated: Short-term borrowings. In addition to deposits, we use short-term borrowings, such as FHLB advances and Federal fund purchases, as a source of funds to meet the daily liquidity needs of our customers. Short-term borrowings increased to $105.0 million at December 31, 2018 from $20.0 million at December 31, 2017. Federal Home Loan Bank Secured Line of Credit. At December 31, 2018, the Bank has a secured line of credit of $396.8 from the FHLB. This secured borrowing arrangement is subject to the Bank providing adequate collateral and continued compliance with the Advances and Security Agreement and other eligibility requirements established by the FHLB. At December 31, 2018, the Bank had pledged as collateral certain qualifying loans with an unpaid principal balance of $868.4 million under this borrowing agreement. Overnight borrowings outstanding under this arrangement were $90.0 million and $20.0 million with an interest rate of 2.56% and 1.41% at December 31, 2018 and 2017. The average balance of short-term borrowings was $23.2 million and $20.5 million for the years ended December 31, 2018 and 2017. In addition, at December 31, 2018, the Bank used another $90.2 million of its secured FHLB borrowing capacity by having the FHLB issue (i) letters of credit to meet collateral requirements for deposits from the State of California and other public agencies and (ii) standby letters of credit as credit enhancement to guarantee the performance of customers to third parties. At December 31, 2018, the remaining secured line of credit available from the FHLB totaled $216.7 million. Unsecured Borrowings. The Bank has established unsecured overnight borrowing arrangements for an aggregate amount of $77.0 million, subject to availability, with five of its primary correspondent banks. In general, interest rates on these unsecured lines of credit approximate the federal funds target rate. Overnight borrowings under these credit facilities were $15.0 million and zero at December 31, 2018 and 2017. For the year ended December 31, 2018, average borrowings totaled $441 thousand with an average interest rate was 2.43%. Federal Reserve Bank Secured Line of Credit. At December 31, 2018, the Bank has a total secured line of credit of $4.9 million with the Federal Reserve Bank. At December 31, 2018, the Bank had pledged securities held-to-maturity with a carrying value of $5.3 million as collateral for this line. There were no borrowings under this arrangement at or during the years ended December 31, 2018 and 2017. Senior Secured Notes. At December 31, 2018, the holding company has a senior secured line of credit for $25 million. The available credit under this secured borrowing facility increased from $10.0 million to $25.0 million effective July 31, 2018. This facility is secured by 100% of the common stock of the Bank and bears interest, due quarterly, at a rate of U.S. Prime rate plus 0.25% and matures on December 22, 2019 (“Maturity Date”). In addition, the terms include a look-back fee equal to sum of (i) 0.25% of the portion of the loan not requested and drawn between December 22, 2017 (“Note Date”) and December 22, 2018 (“Anniversary Date”) and (ii) 0.25% of the portion of the loan not requested and drawn between the Anniversary Date and Maturity Date. Further, the terms of the loan agreement were amended to require the Bank to maintain minimum capital ratios, a minimum return on average assets, and certain other covenants, all of which became effective no later than December 31, 2018, including (i) leverage ratio greater than or equal to 9.0%, (ii) tier 1 capital ratio greater than or equal to 10.5% and $143.0 million, (iii) total capital ratio greater than or equal to 11.5%, (iv) CET1 capital ratio greater than or equal to 11.5%, (v) return on average assets, excluding one-time expense related to the merger with PCB, greater than or equal to 0.85%, (vi) classified assets to Tier 1 capital plus the allowance for loan losses of less than or equal to 35.0%, (vii) certain defined liquidity ratios of at least 25% and (viii) specific concentration levels for commercial real estate and construction and land development loans. In the event of default, the lender has the option to declare all outstanding balances as immediately due. One of the Company's executives is also a member of the lending bank's board of directors. At December 31, 2018, the outstanding balance under the facility totaled $8.5 million with an interest rate of 5.75%. At December 31, 2017, the outstanding balance under the facility totaled $350 thousand with an interest rate of 4.75%. The average borrowings totaled $4.5 million with an average interest rate of 5.46% for the year ended December 31, 2018. At December 31, 2018, the Company was in compliance with all loan covenants on the facility. Shareholders’ Equity Total shareholders’ equity increased $142.4 million, or 134.7%, to $248.1 million at December 31, 2018 from $105.7 million at December 31, 2017. The increase in shareholders' equity is primarily due to the PCB acquisition with total purchase consideration of $133.3 million and the issuance of 4,386,816 shares of common stock and 420,393 rollover options. Refer to Note 2 - Business Combination to the Consolidated Financial Statements included in Item 8 Financial Statements and Supplementary Data, for additional information related to the acquisition. Shareholders’ equity also increased by $15.1 million in net earnings, $1.7 million of share-based compensation and $1.1 million of stock option exercises, partially offset by $7.6 million in cash dividends, and $792 thousand in stock repurchases during 2018. Liquidity and Capital Resources Liquidity is the ability to raise funds on a timely basis at an acceptable cost in order to meet cash needs. Adequate liquidity is necessary to handle fluctuations in deposit levels, to provide for client credit needs, and to take advantage of investment opportunities as they are presented in the market place. We believe we currently have the ability to generate sufficient liquidity from our operating activities to meet our funding requirements. As a result of our growth, we may need to acquire additional liquidity to fund our activities in the future. Holding Company Liquidity As a bank holding company, we currently have no significant assets other than our equity interest in First Choice Bank. Our primary sources of liquidity at the holding company include dividends from the Bank, cash on hand at the holding company, which was approximately $173 thousand at December 31, 2018, a $25.0 million secured line of credit of which $16.6 million is available at December 31, 2018, and our ability to raise capital, issue subordinated debt, and secure other outside borrowings. Our ability to declare dividends to shareholders depends upon cash on hand, availability on our secured line of credit and dividends from the Bank. Dividends from the Bank to the holding company depends upon the Bank's earnings, financial position, regulatory standing, the ability to meet current and anticipated regulatory capital requirements, and other factors deemed relevant by our Board of Directors. Refer to the Regulatory Capital in this MD&A for dividend limitations at both the holding company and the Bank. Our ability to pay dividends is also limited by state law. California law allows a California corporation to pay dividends if the company’s retained earnings equal at least the amount of the proposed dividend. If a California corporation does not have sufficient retained earnings available for the proposed dividend, it may still pay a dividend to its shareholders if immediately after the dividend the value of the company’s assets would equal or exceed the sum of its total liabilities. Consolidated Company Liquidity Our liquidity ratio is defined as the liquid assets (cash and due from banks, fed funds and repos, interest-bearing deposits, other investments with a remaining maturity of one year or less, available-for-sale and equity securities, held-to-maturity securities and loans held for sale) divided by total assets. Using this definition at December 31, 2018, our liquidity ratio was 16%. Our current policy requires that we maintain a liquidity ratio of at least 15% measured monthly. Our objective is to ensure adequate liquidity at all times by maintaining liquid assets and by being able to raise deposits. Having too little liquidity can present difficulties in meeting commitments to fund loans or honor deposit withdrawals. Having too much liquidity can result in lower income because liquid assets generally yield less than long-term assets. A proper balance is the goal of management and the Board of Directors, as administered by various policies and guidelines. Net cash provided by operating activities for the years ended December 31, 2018 and 2017 was $342 thousand and $11.5 million. Net interest income and noninterest expense are the primary components of cash provided by operations. Net cash provided by (used in) investment activities for the years ended December 31, 2018 and 2017 was $3.6 million and $(49.2) million. During the year ended December 31, 2018, the primary components of cash flows provided by investing activities was the $111.0 million in cash acquired as part of the PCB acquisition, partially offset by a net increase in loans, which totaled $103.8 million, and purchase of restricted stock investments of $6.9 million. During the year ended December 31, 2017, the primary driver of cash flows used in investing activities was purchases of securities available for sale of $8.5 million, purchases of loans of $14.8 million and a net increase in loans of $34.4 million. Net cash provided by financing activities for the years ended December 31, 2018 and 2017 was $90.3 million and $30.8 million. For the year ended December 31, 2018, cash provided by financing activities primarily results from a $4.7 million increase in deposits, a $85.0 million increase in short-term borrowings, a $8.1 million increase in senior secured notes, and $1.1 million in proceeds from stock option exercises, partially offset by $7.6 million in cash dividends paid and $1.1 million in stock repurchases. For the year ended December 31, 2017, cash provided by financing activities primarily came from a $16.1 million increase in deposits and a $20.0 million increase in short-term borrowings, offset by $5.8 million in cash dividends paid. Additional sources of liquidity available to us at December 31, 2018 include $216.7 million in secured borrowing capacity with the FHLB, $4.9 million in borrowing capacity at the discount window with the Federal Reserve Bank, and unsecured lines of credit with correspondent banks with a remaining borrowing capacity of $62.0 million. We believe that we will be able to meet our contractual obligations as they come due through the maintenance of adequate liquidity levels. We expect to maintain adequate liquidity levels through profitability, loan payoffs, securities repayments and maturities, and continued deposit gathering activities. We also have in place various borrowing mechanisms for both short-term and long-term liquidity needs. Stock Repurchase Plan On December 3, 2018, the Company announced a stock repurchase plan, providing for the repurchase of up to 1.2 million shares of the Company’s outstanding common stock, or approximately 10% of its then outstanding shares (the "repurchase plan"). The repurchase plan permits shares to be repurchased in open market or private transactions, through block trades, and pursuant to any trading plan that may be adopted in accordance with Rules 10b5-1 and 10b-18 of the SEC. The repurchase plan may be suspended, terminated or modified at any time for any reason, including market conditions, the cost of repurchasing shares, the availability of tentative investment opportunities, liquidity, and other factors deemed appropriate. These factors may also affect the timing and amount of share repurchases. The repurchase plan does not obligate the Company to purchase any particular number of shares. During the fourth quarter of 2018, the Company repurchased 36,283 shares at an average price of $21.82 under the repurchase plan. The remaining number of shares authorized to be repurchased under this plan was 1,163,717 shares at December 31, 2018. Contractual Obligations The following table summarizes aggregated information about our outstanding contractual obligations and other long-term liabilities as of December 31, 2018. (1) Includes $53.4 million of callable brokered deposits report based on their contractual maturity dates. Off-Balance-Sheet Arrangements In the normal course of operations, we engage in a variety of financial transactions that, in accordance with generally accepted accounting principles are not recorded in our consolidated financial statements. These transactions involve, to varying degrees, elements of credit, interest rate and liquidity risk. These transactions generally take the form of loan commitments, unused lines of credit and standby letters of credit. At December 31, 2018, we had unused loan commitments of $376.1 million and standby letters of credit of $4.0 million. At December 31, 2017, we had unused loan commitments of $237.4 million and standby letters of credit of $1.0 million. As of December 31, 2018, the Company had in place $90.2 million in letters of credit from the FHLB to meet collateral requirements for deposits from the State of California and other public agencies, along with standby letters of credit issued by the FHLB as credit enhancement to guarantee the performance of customers to third parties. Regulatory Capital The Bank is subject to various regulatory capital requirements administered by the federal banking agencies. Failure to meet minimum capital requirements can initiate certain mandatory and possibly additional discretionary actions by regulators that, if undertaken, could have a direct material effect on our consolidated financial statements. Under capital adequacy guidelines and the regulatory framework for prompt corrective action, we must meet specific capital guidelines that involve quantitative measures of our assets, liabilities, and certain off-balance-sheet items as calculated under regulatory accounting practices. Our capital amounts and classification are also subject to qualitative judgments by the regulators about components, risk weightings, and other factors. In July 2013, the federal bank regulatory agencies approved the final rules implementing the Basel Committee on Banking Supervision’s capital guidelines for U.S. banks, “Basel III rules”. The new rules became effective on January 1, 2015, with certain of the requirements phased-in over a multi-year schedule, and fully phased in by January 1, 2019. Under the Basel III rules, the Bank must hold a capital conservation buffer above the adequately capitalized risk-based capital ratios. The capital conservation buffer is being phased in from 0.0% for 2015 to 2.50% by January 1, 2019. The capital conservation buffer during 2018 was 1.875%. The net unrealized gain or loss on investment securities available-for-sale securities is not included in computing regulatory capital. Quantitative measures established by regulation to ensure capital adequacy require us to maintain minimum amounts and ratios (set forth in the table below) of total, Tier 1 and CET1 capital (as defined in the regulations) to risk-weighted assets (as defined), and of Tier 1 capital (as defined) to average assets (as defined). We believe, as of December 31, 2018, that the Bank meets all capital adequacy requirements to which it is subject. As of December 31, 2018, the most recent notification from the FDIC categorized the Bank as well-capitalized under the regulatory framework for prompt corrective action (there are no conditions or events since that notification that management believes have changed the Bank’s category). To be categorized as well-capitalized, the Bank must maintain minimum ratios as set forth in the table below. The following table also sets forth the actual capital ratios for the Bank: (1) Ratios for December 31, 2018 reflect the minimum required plus capital conservation buffer phase-in for 2018; ratios for December 31, 2017 reflect the minimum required plus capital conservation buffer phase-in for 2017. The capital conservation buffer increases by 0.625% each year through 2019. Dividends Our general dividend policy is to pay cash dividends within the range of typical peer payout ratios, provided that such payments do not adversely affect our financial condition and are not overly restrictive to our growth capacity. While we have paid a consistent level of quarterly cash dividends since the first quarter of 2017, no assurance can be given that our financial performance in any given year will justify the continued payment of a certain level of cash dividend, or any cash dividend at all. The primary source of funds for the holding company is dividends from the Bank, as well as availability under our $25 million secured line of credit. The following table sets forth per share dividend amounts declared for the periods indicated: Under the California Financial Code, the Bank is permitted to pay a dividend in the following circumstances: (i) without the consent of either the California Department of Business Oversight ("DBO") or the Bank's shareholders, in an amount not exceeding the lesser of (a) the retained earnings of the Bank; or (b) the net income of the Bank for its last three fiscal years, less the amount of any distributions made during the prior period; (ii) with the prior approval of the DBO, in an amount not exceeding the greatest of: (a) the retained earnings of the Bank; (b) the net income of the Bank for its last fiscal year; or (c) the net income for the Bank for its current fiscal year; and (iii) with the prior approval of the DBO and the Bank's shareholders in connection with a reduction of its contributed capital. In addition, under the Basel III Rule, institutions that seek to pay dividends must maintain 2.5% in Common Equity Tier 1 attributable to the capital conservation buffer, which was phased in over a three-year period that began on January 1, 2016. The Federal Reserve Bank limits the amount of dividends that bank holding companies may pay on common stock to income available over the past year, and only if prospective earnings retention is consistent with the organization’s expected future needs and financial condition. It is also the Federal Reserve’s policy that bank holding companies should not maintain dividend levels that undermine their ability to be a source of strength to its banking subsidiaries. Additionally, in consideration of the current financial and economic environment, the Federal Reserve has indicated that bank holding companies should carefully review their dividend. Summary of Critical Accounting Policies In preparing the consolidated financial statements, management is required to make estimates and assumptions that affect the reported amounts of assets and liabilities as of the dates of the statements of financial position and revenues and expenses for the periods then ended. Actual results could differ significantly from those estimates. A description of selected critical accounting policies that are of particular significance to us include: Business Combinations Business combinations are accounted for using the purchase accounting method. Under the purchase accounting method, the Company measures the identifiable assets acquired, including identifiable intangible assets, and liabilities assumed in a business combination at fair value on acquisition date. Goodwill is generally determined as the excess of the fair value of the consideration transferred, plus the fair value of any noncontrolling interests in the acquiree, over the fair value of the net assets acquired and liabilities assumed as of the acquisition date. Goodwill and other identifiable intangible assets will be tested for impairment no less than annually each year or when circumstances arise indicating impairment may have occurred. We expect our annual impairment measurement date to occur in the fourth quarter in each fiscal year. In determining whether impairment has occurred, we consider a number of factors including, but not limited to, operating results, business plans, economic projections, anticipated future cash flows, and current market data. Any impairment identified as part of this testing is recognized in the accompanying consolidated statements of income. There was no impairment recognized related to goodwill or other identifiable intangible assets for the year ended December 31, 2018. Core deposit intangible ("CDI") is a measure of the value of depositor relationships resulting from the acquisition of PCB. CDI is amortized on an accelerated method over an estimated useful life of approximately 10 years. The Company accounts for merger-related costs, which may include advisory, legal, accounting, valuation, and other professional or consulting fees, as expenses in the periods in which the costs are incurred and the services are received. Allowance for Loan Losses The allowance for loan losses is a valuation allowance for probable incurred credit losses. Management estimates the allowance balance required using past loan loss experience, the nature and volume of the portfolio, information about specific borrower situations and estimated collateral values, economic conditions, and other factors. Allocations of the allowance may be made for specific loans, but the entire allowance is available for any loan that, in management’s judgment, should be charged off. Loan losses are charged against the allowance when we believe available information confirms that specific loans, or portions thereof, are uncollectible. This methodology for determining charge-offs is consistently applied to each segment. Subsequent recoveries, if any, are credited to the allowance. We determine a separate allowance for each portfolio segment. The allowance consists of specific and general reserves. Specific reserves relate to loans that are individually classified as impaired. A loan is impaired when, based on current information and events, it is probable that we will be unable to collect all amounts due according to the contractual terms of the loan agreement. Factors considered in determining impairment include payment status, collateral value and the probability of collecting all amounts when due. Measurement of impairment is based on the expected future cash flows of an impaired loan, which are to be discounted at the loan’s effective interest rate, or measured by reference to an observable market value, if one exists, or the fair value of the collateral for a collateral-dependent loan. We select the measurement method on a loan-by-loan basis except that collateral-dependent loans for which foreclosure is probable are measured at the fair value of the collateral. We recognize interest income on impaired loans based on its existing methods of recognizing interest income on nonaccrual loans. Loans, for which the terms have been modified resulting in a concession, and for which the borrower is experiencing financial difficulties, are considered troubled debt restructurings and classified as impaired with measurement of impairment as described above. If a loan is impaired, a portion of the allowance is allocated so that the loan is reported, net, at the present value of estimated future cash flows using the loan’s existing rate or at the fair value of collateral if repayment is expected solely from the collateral. General reserves cover non-impaired loans and are based on historical loss rates for each portfolio segment, adjusted for the effects of qualitative or environmental factors that are likely to cause estimated credit losses as of the evaluation date to differ from the portfolio segment’s historical loss experience. Qualitative factors include consideration of the following: changes in lending policies and procedures; changes in economic conditions; changes in the nature and volume of the portfolio; changes in the experience, ability and depth of lending management and other relevant staff; changes in the volume and severity of past due, nonaccrual and other adversely graded loans; changes in the loan review system; changes in the value of the underlying collateral for collateral-dependent loans; concentrations of credit; and the effect of other external factors such as competition and legal and regulatory requirements. Portfolio segments identified by us include construction and land development, real estate, commercial and industrial, and consumer loans. Relevant risk characteristics for these portfolio segments generally include debt service coverage, loan-to-value ratios and financial performance on non-consumer loans and credit scores, debt-to-income, collateral type and loan-to-value ratios for consumer loans. Loan Sales and Servicing of Financial Assets We originate SBA loans and sell the guaranteed portions in the secondary market. Servicing rights are recognized separately when they are acquired through sale of loans. Servicing rights are initially recorded at fair value with the income statement effect recorded in gain on sale of loans. Fair value is based on a valuation model that calculates the present value of estimated future cash flows from the servicing assets. The valuation model uses assumptions that market participants would use in estimating cash flows from servicing assets, such as the cost to service, discount rates and prepayment speeds. We compare the valuation model inputs and results to published industry data in order to validate the model results and assumptions. Servicing assets are subsequently measured using the amortization method which requires servicing rights to be amortized into noninterest income in proportion to, and over the period of, the estimated future net servicing income of the underlying loans. Servicing assets are evaluated for impairment based upon the fair value of the rights as compared to the carrying amount. Impairment is determined by stratifying rights into groupings based on predominant risk characteristics, such as interest rate, loan type and investor type. For purposes of measuring impairment, we have identified each servicing asset with the underlying loan being serviced. A valuation allowance is recorded where the fair value is below the carrying amount of the asset. If we later determine that all or a portion of the impairment no longer exists for a particular grouping, a reduction of the allowance may be recorded as an increase in income. The fair values of servicing rights are subject to significant fluctuations as a result of changes in estimated and actual prepayments speeds and changes in the discount rates. Deferred Income Taxes Deferred income taxes are computed using the asset and liability method, which recognizes a liability or asset representing the tax effects, based on current tax law, of future deductible or taxable amounts attributable to events that have been recognized in the consolidated financial statements. Deferred tax assets and liabilities are measured using enacted tax rates expected to apply to taxable income in the years in which those temporary differences are expected to be recovered or settled. The effect of a change in tax rates on deferred tax assets and liabilities is recognized in earnings in the period that includes the enactment date. A valuation allowance is established to reduce the deferred tax asset to the level at which it is “more likely than not” that the tax asset or benefits will be realized. We have adopted guidance issued by the Financial Accounting Standards Board (“FASB”) that clarifies the accounting for uncertainty in tax positions taken or expected to be taken on a tax return and provides that the tax effects from an uncertain tax position can be recognized in the consolidated financial statements only if, based on its merits, the position is more likely than not to be sustained on audit by the taxing authorities. Income tax positions must meet a more likely than not recognition threshold to be recognized. For tax positions not meeting the more likely than not recognition threshold, no tax benefit is recorded. The Company recognizes interest and / or penalties related to income tax matters in income tax expense. Refer to Note 10 - Income Taxes to the Consolidated Financial Statements included in Item 8 Financial Statements and Supplementary Data, of this Annual Report. Fair Value Measurements The fair value of a financial instrument is the amount at which the asset or obligation could be exchanged in a current transaction between willing parties, other than in a forced or liquidation sale. Fair value estimates are made at a specific point in time based on relevant market information and information about the financial instrument. These estimates do not reflect any premium or discount that could result from offering for sale at one time the entire holdings of a particular financial instrument. Because no market value exists for a significant portion of the financial instruments, fair value estimates are based on judgments regarding future expected loss experience, current economic conditions, risk characteristics of various financial instruments, and other factors. These estimates are subjective in nature, involve uncertainties and matters of judgment and, therefore, cannot be determined with precision. Changes in assumptions could significantly affect the estimates. Fair value estimates are based on financial instruments both on and off the balance sheet without attempting to estimate the value of anticipated future business and the value of assets and liabilities that are not considered financial instruments. Additionally, tax consequences related to the realization of the unrealized gains and losses can have a potential effect on fair value estimates and have not been considered in many of the estimates. Recent Accounting Guidance Not Yet Effective The impact that recently issued accounting standards will have on our consolidated financial statements is contained in Note 1 - Basis of Presentation and Summary of Significant Accounting Policies to the Consolidated Financial Statements included in Item 8 Financial Statements and Supplementary Data, of this Annual Report.

<s>[INST] Overview First Choice Bancorp, a California corporation, was organized on September 1, 2017 to serve as the holding company for its wholly owned subsidiary, First Choice Bank (the "Bank"), a California state chartered commercial bank. On December 21, 2017, the Bank received requisite shareholder and regulatory approval necessary for the Bank to reorganize into the holding company form of ownership pursuant to which First Choice Bank became a whollyowned subsidiary of First Choice Bancorp. When we refer to "Bancorp" or the "holding company", we are referring First Choice Bancorp, the parent company, on a standalone basis. When we refer to "we," "us," "our," or the "Company", we are referring to First Choice Bancorp and Bank collectively. We are regulated as a bank holding company by the Board of Governors of the Federal Reserve System (“Federal Reserve”) and the Bank is regulated by the California Department of Business Oversight ("DBO") and the Federal Reserve. The Bank was incorporated under the laws of the State of California in March 2005, is licensed by the DBO, and commenced banking operations in August 2005, as a California statechartered commercial bank headquartered in Cerritos, Los Angeles County, California. On October 1, 2018, the Bank satisfied the requirements of the Federal Reserve Bank and became a state member bank of the Federal Reserve System and purchased the required stock of the Federal Reserve Bank. Accordingly, the Bank is subject to periodic examination and supervision by the DBO and the Federal Reserve as the Bank's primary regulators. In addition, the Bank's deposits are insured under the Federal Deposit Insurance Act by the Federal Deposit Insurance Corporation ("FDIC") and as a result FDIC also has examination authority over the Bank. Recent Developments Common Stock registered with Nasdaq Capital Market and added to the Russell 3000® Index and the Russell 2000® Index We registered and issued outstanding shares of common stock with the Nasdaq Capital Market and on May 1, 2018, our shares commenced trading under our existing ticker symbol “FCBP”. The Company was added to the Russell 3000® Index and the Russell 2000® Index when Russell investments reconstituted its comprehensive set of U.S. and global equity indexes after the market closed on June 22, 2018. Merger with Pacific Commerce Bancorp We completed the previously announced acquisition of Pacific Commerce Bancorp ("PCB") on July 31, 2018 following receipt of all necessary regulatory and shareholder approvals. We had entered into an Agreement and Plan of Reorganization and Merger, dated February 23, 2018 (the "Merger Agreement"), by which PCB would be merged with and into First Choice Bancorp, and PCB’s bank subsidiary, Pacific Commerce Bank, would be merged with and into First Choice Bancorp’s bank subsidiary, First Choice Bank (collectively, the “Merger”). The Merger was an all stock transaction valued at approximately $133.3 million, or $13.69 per share, based on a closing price of our common stock of $28.70 as of July 31, 2018. At the effective time of the Merger, each share of PCB common stock was converted into the right to receive 0.47689 shares (referred to as the "final exchange ratio") of Company common stock, with cash paid in lieu of any fractional shares. The final exchange ratio of the stocktostock transaction was higher than the ratio of 0.46531 announced at the time of the acquisition, as the ratio was subject to certain adjustments as previously described in the joint proxy statement. The higher exchange ratio was primarily due to adjustments resulting from an increase in PCB’s capital from the exercise of stock options, lower than budgeted transaction costs and higher than projected net income during the first six months of 2018. In the aggregate, we issued 4,386,816 shares of our common stock in exchange for all of the outstanding shares of PCB common stock. In addition, we issued [/INST] Negative. </s>

First Choice Bancorp

2020-03-13

2019-12-31

ITEM 7. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS The purpose of this management's discussion and analysis of financial condition and results of operations ("MD&A") is to focus on information about our consolidated financial condition at December 31, 2019 and 2018, and our consolidated results of operations for the two years ended December 31, 2019. Our consolidated financial statements and the supplemental financial data appearing elsewhere in this Annual Report should be read in conjunction with this discussion and analysis. Overview First Choice Bancorp, headquartered in Cerritos, California, is a California corporation that was incorporated on September 1, 2017 and is the registered bank holding company for First Choice Bank. Incorporated in March 2005 and commencing commercial bank operations in August 2005, First Choice Bank is a California-chartered member bank. References herein to “First Choice Bancorp,” “Bancorp,” or the “holding company,” refer to First Choice Bancorp on a standalone basis. The words “we,” “us,” “our,” or the “Company” refer to First Choice Bancorp and First Choice Bank collectively and on a consolidated basis. References to the “Bank” refer to First Choice Bank, on a stand-alone basis. Headquartered in Cerritos, California, the Bank is a community-based financial institution that serves commercial and consumer clients in diverse communities. The Bank specializes in loans to small- to medium-sized businesses and private banking clients, commercial and industrial loans, and commercial real estate loans with a specialization in providing financial solutions for the hospitality industry. The Bank is a Preferred Small Business Administration (“SBA”) Lender. The Bank conducts business through nine full-service branches and two loan production offices located in Los Angeles, Orange and San Diego Counties. As a California-chartered member bank, the Bank is primarily regulated by the California Department of Business Oversight (the “DBO”) and the Board of Governors of the Federal Reserve System (the “Federal Reserve”). The Bank’s deposits are insured up to the maximum legal limit by the Federal Deposit Insurance Corporation (the “FDIC”) and, as a result, the FDIC also has examination authority over the Bank. Effective July 31, 2018, we acquired Pacific Commerce Bancorp (“PCB”) and its wholly-own subsidiary bank, Pacific Commerce Bank by merger in an all-stock transaction. In connection therewith, we issued, in the aggregate, 4,386,816 shares of our common stock in exchange for all of the outstanding shares of PCB common stock and replacement stock options exercisable for 420,393 shares of our common stock in cancellation of PCB stock options. The acquisition has been accounted for using the acquisition method of accounting and, accordingly, the operating results of PCB have been included in the consolidated financial statements since August 1, 2018. Recent Developments Senior Secured Notes Maturity Date Extension Effective December 22, 2019, we extended the maturity date of this line of credit to March 22, 2022. The interest rate decreased from Wall Street Journal Prime + 0.25%, floating to Wall Street Journal Prime, floating (effective January 2, 2020). At the same time, the debt covenants were updated and confirmed as follows (i) Bank leverage ratio greater than or equal to 9.0%, (ii) Bank Tier 1 capital ratio greater than or equal to 11.0% and $150.0 million, (iii) Bank total capital ratio greater than or equal to 12.0%, (iv) Bank CET1 capital ratio greater than or equal to 11.0%, (v) Bank trailing twelve months return on average assets, excluding one-time expense related to the merger with PCB, greater than or equal to 1.0%, (vi) Bank classified assets to Tier 1 capital plus the allowance for loan losses of less than or equal to 35.0%, (vii) certain defined Bank liquidity ratios and (viii) specific concentration levels for commercial real estate and construction and land development loans. Downtown Branch Relocation and Consolidations In December 2019, the Company (1) entered into an agreement to terminate the "Little Tokyo" office lease agreement and (2) relocated the downtown Los Angeles branch to a smaller space within the same building and signed a sublease of the current space which began on January 1, 2020. As a result of these relocation and consolidation efforts, the Company recognized an after-tax impairment charge of $568 thousand, or $0.05 per diluted share, in the fourth quarter of 2019. The year-to-date total impairment charge recognized for these two locations was $1.2 million pre-tax ($850 thousand after tax), which is estimated to result in net cost savings, after impairment charges, of approximately $621 thousand pre-tax ($437 thousand after tax). As a result of the impairment charges in 2019 and expected cost savings, occupancy expense for these locations is expected to be reduced on average by approximately $550 thousand before tax ($390 thousand after tax) annually over the next three years. Stock Repurchase Plan During the fourth quarter of 2019, the Company repurchased 13,547 shares of its common stock at an average price of $22.80 and a total cost of $309 thousand under the stock repurchase program announced in December 2018. For the year ended December 31, 2019, the Company repurchased 429,817 shares at an average price of $21.64 and a total cost of $9.3 million. The remaining number of shares authorized to be repurchased under this program was 733,900 shares at December 31, 2019. Federal Reserve Bank Secured Borrowing Arrangement In the third quarter of 2019, the Bank expanded its existing secured borrowing capacity with the Federal Reserve by participating in the Borrower-in-Custody ("BIC") program. As a result, our borrowing capacity with the Federal Reserve increased to $177.1 million at December 31, 2019. Prior to participating in the BIC program, the Bank only pledged securities held-to-maturity as collateral for access to the discount window. At December 31, 2019, the Bank has pledged certain qualifying loans with an unpaid principal balance of $252.4 million and securities held-to-maturity with a carrying value of $5.1 million as collateral for this line of credit. Borrowings under this BIC program are overnight advances with interest chargeable at the Discount Window ("Primary Credit") borrowing rate. There were no borrowings under this arrangement at or during the years ended December 31, 2019 and 2018. Financial Highlights Financial Performance • Net income increased $12.7 million to $27.8 million or $2.36 per diluted share for 2019 compared to $15.1 million or $1.64 per diluted share for 2018. The increase in net income was driven by organic loan growth, increased yields on loans and the PCB acquisition which was completed on July 31, 2018. Our 2019 financial results include 12 months of PCB operations as compared to 5 months for 2018. In addition, our 2018 financial results included after-tax merger, integration and public company registration expenses of $4.0 million which reduced diluted earnings per share by $0.44 for 2018. There were no such expenses in 2019. Financial results for the full year of 2019 included after-tax impairment charges of $850 thousand, or $0.07 per diluted share, related to branch relocation and consolidation efforts that are expected to result in future cost savings. • Return on average assets and return on average equity was 1.74% and 10.93% for 2019 compared to 1.28% and 9.09% for 2018. The after-tax merger, integration and public company registration expenses lowered the return on average assets and return on average equity by 34 basis points and 242 basis points for 2018. Return on average tangible equity was 15.90% for 2019 compared to 11.38% for 2018. The after-tax merger, integration and public company registration expenses lowered the return on average tangible equity by 304 basis points for 2018. Refer to - Non-GAAP Financial Measures section in this MD&A. • Net interest margin increased 31 basis points to 5.24% for 2019 from 4.93% for 2018. The average cost of funds was 91 basis points for 2019 compared to 86 basis points for 2018. Average noninterest-bearing deposits represented 46.1% of average total deposits for 2019 compared to 35.9% for 2018. • Noninterest income increased $4.1 million due to a full year of PCB's operations included for 2019 versus only five months for 2018 and higher gain on sale of loans. The provision for loan losses increased $1.3 million due to organic loan growth and higher specific reserves. Noninterest expense increased $7.0 million due to higher expense in most of the overhead expense categories due to including PCB's operations since August 1, 2018 and impairment charges related to branch relocation and consolidations in 2019, offset by lower merger, integration and public company registration costs in 2019. • Our operating efficiency ratio was 50.3% in 2019 compared with 61.1% in 2018. Excluding the impact of the merger, integration and public company registration costs incurred in 2018, our operating efficiency ratio was 52.0% in 2018. Refer to - Non-GAAP Financial Measures section in this MD&A. Balance Sheet Performance • Total consolidated assets increased $67.8 million to $1.69 billion at December 31, 2019 from $1.62 billion at December 31, 2018. Total loans held for investment increased $123.7 million, or 9.9%, to $1.37 billion at December 31, 2019 from $1.25 billion at December 31, 2018. Average loans during 2019 increased $331.8 million, or 33.7%, compared to 2018. • Total consolidated liabilities increased $54.1 million to $1.43 billion at December 31, 2019 from $1.37 billion at December 31, 2018. Total deposits increased $61.4 million to $1.31 billion at December 31, 2019 from $1.25 billion at December 31, 2018, offset by lower borrowings of $15.0 million. Senior secured notes increased $1.1 million to $9.6 million at December 31, 2019 from $8.5 million at December 31, 2018. Noninterest-bearing demand deposits totaled $626.6 million, or 47.7% of total deposits at December 31, 2019, compared to $546.7 million, or 43.7% of total deposits at December 31, 2018. • Total consolidated equity increased $13.7 million to $261.8 million at December 31, 2019 from $248.1 million at December 31, 2018 due primarily to net income of $27.8 million and the vesting and exercise of equity awards of $4.5 million, partially offset by stock repurchases of $9.4 million and cash dividends of $9.9 million. At December 31, 2019, tangible book value per share was $15.70 compared to $14.33 at December 31, 2018. Refer to - Non-GAAP Financial Measures section in this MD&A. • The Bank remained well-capitalized from a regulatory perspective. At December 31, 2019, the Bank had a total risk-based capital ratio of 14.03% and a Tier 1 common to risk weighted assets ratio of 13.04% compared to a total risk-based capital ratio of 14.18% and a Tier 1 common to risk weighted assets ratio of 13.26% at December 31, 2018. Credit Quality • Non-performing assets increased to $11.3 million or 0.67% of total assets at December 31, 2019, compared to $1.7 million or 0.11% of total assets at December 31, 2018. The increase in nonperforming assets is due mostly to downgrading 16 SBA 7(a) loans totaling $6.0 million, three commercial real estate loans totaling $4.4 million and one commercial and industrial loan totaling $159 thousand, offset by charge-offs and payoffs totaling $917 thousand. Primary Factors We Use to Evaluate Our Business As a financial institution, we manage and evaluate various aspects of both our consolidated financial condition and consolidated results of operations. We evaluate the comparative levels and trends of the line items in our consolidated balance sheets and consolidated income statements and various financial ratios that are commonly used in our industry. We analyze these financial trends and ratios against our own historical performance, our budgeted performance and the consolidated financial condition and performance of comparable financial institutions in our region. Segment Information We provide a broad range of financial services to individuals and companies through our branch network. Those services include a wide range of deposit and lending products for businesses and individuals. While our chief decision makers monitor the revenue streams of our various product and service offerings, we manage our operations and review our financial performance on a company-wide basis. Accordingly, we consider all of our operations to be aggregated into one reportable operating segment. Impact of Acquisition on Earnings The comparability of our financial information is affected by the acquisition of PCB. We completed this acquisition on July 31, 2018. This acquisition has been accounted for using the acquisition method of accounting and, accordingly, PCB’s operating results have been included in the consolidated financial statements for periods beginning after July 31, 2018. PCB was headquartered in Los Angeles, California, with $544.7 million in total assets, $414.9 million in gross loans and $474.8 million in total deposits as of July 31, 2018. PCB had six full-service branches in Los Angeles and San Diego Counties, including its operating division, ProAmérica Bank, in Downtown Los Angeles. The acquisition of PCB provided the Company with the opportunity to further serve our existing customers and to expand our footprint in Southern California to the Mexican border. Please refer to Note 2 - Business Combination to the Consolidated Financial Statements included in Item 8 Financial Statements and Supplementary Data, of this Annual Report. Results of Operations In addition to net income, the primary factors we use to evaluate and manage our results of operations include net interest income, noninterest income and noninterest expense. Net Interest Income Net interest income represents interest income less interest expense. We generate interest income from interest and fees (net of costs amortized over the expected life of the loans) plus the accretion of net discounts on interest-earning assets, including loans and investment securities and dividends on restricted stock investments. We incur interest expense from interest paid on interest-bearing liabilities, including interest-bearing deposits and borrowings. Net interest income has been the most significant contributor to our revenues and net income. To evaluate net interest income, we measure and monitor: (a) yields and accretable net discount on our loans and other interest-earning assets; (b) the costs of our deposits and other funding sources; and (c) our net interest margin. Net interest margin is calculated as the annualized net interest income divided by average interest-earning assets. Because noninterest-bearing sources of funds, such as noninterest-bearing deposits and shareholders’ equity, also fund interest-earning assets, net interest margin includes the benefit of these noninterest-bearing sources. Changes in market interest rates, the slope of the yield curve, and interest we earn on interest-earning assets or pay on interest-bearing liabilities, as well as the volume and types of interest-earning assets, interest-bearing and noninterest-bearing liabilities, usually have the largest impact on changes in our net interest spread, net interest margin and net interest income during a reporting period. Noninterest Income Noninterest income consists of, among other things: (a) gain on sale of loans; (b) service charges and fees on deposit accounts; (c) net servicing fees; and (d) other noninterest income. Gain on sale of loans includes origination fees, capitalized servicing rights and other related income. Net loan servicing fees are collected as payments are received for loans in the servicing portfolio and offset by the amortization expense of the related servicing asset; this revenue stream is impacted by loan prepayments. Noninterest Expense Noninterest expense includes: (a) salaries and employee benefits; (b) occupancy and equipment; (c) data processing; (d) professional fees; (e) office, postage and telecommunication; (f) deposit insurance and regulatory assessments; (g) loan related expenses; (h) customer service related expenses; (i) merger, integration and public company registration expenses; (j) amortization of core deposit intangible; and (k) other general and administrative expenses. Financial Condition The primary factors we use to evaluate and manage our consolidated financial condition are asset levels, liquidity, capital and asset quality. Asset Levels We manage our asset levels based upon forecasted loan originations and estimated loan sales to ensure we have both the necessary liquidity and capital to fund asset growth while exceeding the required regulatory capital ratios. We evaluate our funding needs by forecasting loan originations and sales of loans. Liquidity We manage our liquidity based upon factors that include the amount of our custodial and brokered deposits as a percentage of total assets and deposits, the level of diversification of our funding sources, the allocation and amount of our deposits among deposit types, the short-term funding sources used to fund assets, the amount of non-deposit funding used to fund assets, the availability of unused funding sources, off-balance sheet obligations, the availability of assets to be readily converted into cash without a material loss on the investment, the amount of cash and cash equivalent securities we hold, the repricing characteristics and maturities of our assets when compared to the repricing characteristics of our liabilities and other factors. Capital We manage our regulatory capital based upon factors that include: (a) the level of capital and our overall consolidated financial condition; (b) the trend and volume of problem assets; (c) the level and quality of earnings; (d) the risk exposures and level of reserves in our consolidated balance sheets; and (e) other factors. In addition, we have regularly increased our capital through equity issuances and net income and we return capital to our shareholders through dividends and share repurchases. Asset Quality We manage the diversification and quality of our assets based upon factors that include the level, distribution, severity and trend of problem, classified, delinquent, nonaccrual, nonperforming and restructured assets, the adequacy of our allowance for loan losses, the diversification and quality of loan and investment portfolios, the extent of counterparty risks, credit risk concentrations and other factors. Non-GAAP Financial Measures This following tables present a reconciliation of non-GAAP financial measures to GAAP measures for: (1) efficiency ratio, (2) adjusted efficiency ratio, (3) adjusted net income, (4) average tangible common equity, (5) adjusted return on average assets, (6) adjusted return on average equity, (7) return on average tangible common equity, (8) adjusted return on average tangible common equity, (9) tangible common equity, (10) tangible assets, (11) tangible common equity to tangible asset ratio, and (12) tangible book value per share. The Company believes the presentation of certain non-GAAP financial measures assists investors in evaluating our financial results. These non-GAAP financial measures are used by management, the Board and investors on a regular basis, in addition to our GAAP results, to facilitate the assessment of our financial performance. These non-GAAP financial measures complement our GAAP reporting and are presented below to provide investors and others information that we use to manage the business each period. Because not all companies use identical calculations, the presentation of these non-GAAP financial measures may not be comparable to other similarly titled measures used by other companies. However, we believe the non-GAAP information shown below provides useful information to investors to assess our consolidated financial condition and consolidated results of operations. In particular, the use of return on average tangible equity, tangible equity to asset ratio, and tangible book value per share is prevalent among banking regulators, investors and analysts. These non-GAAP measures should be taken together with the corresponding GAAP measures and should not be considered a substitute of the GAAP measures. (1) Non-GAAP measure. (1) Non-GAAP measure. (1) Non-GAAP measure. Comparison of Operating Results General Net income was $27.8 million or $2.36 diluted earnings per share for 2019 compared to $15.1 million or $1.64 diluted earnings per share for 2018. The $12.7 million increase in net income was due to higher net interest income of $22.6 million and noninterest income of $4.1 million, partially offset by increases in provision for loan losses of $1.3 million, noninterest expense of $7.0 million and income taxes of $5.6 million for 2019 compared to 2018. The increase in net interest income was a result of higher average loan balances, relating to both the PCB acquisition and organic loan growth, and increased yields on loans. Noninterest income increased due to higher SBA loan sale activity and related gains, as well as higher service charges and fees on deposits accounts. We also had increases in servicing fees and other income. Noninterest expense increased due primarily to higher salaries and employee benefits, occupancy and equipment costs, data processing expenses, customer service related costs and CDI amortization, largely due to the impact of including PCB's operations for the full 2019 fiscal year and the impairment charges related to branch relocation and consolidations, offset by lower merger, integration and public company registration expenses. Net Interest Income Net interest income is affected by changes in both interest rates and the volume of average interest-earning assets and interest-bearing liabilities. The following table summarizes the distribution of average assets, liabilities and stockholders’ equity, as well as interest income and yields earned on average interest-earning assets and interest expense and rates paid on average interest-bearing liabilities for the periods indicated: (1) Average loans include net discounts and net deferred loan fees and costs. Interest income on loans includes $958 thousand, $469 thousand and $439 thousand related to the accretion of net deferred loan fees during 2019, 2018 and 2017. In addition, interest income includes $4.6 million and $2.2 million of discount accretion on loans acquired in a business combination, including the interest recognized on the payoff of PCI loans, during December 31, 2019 and 2018. There was no discount accretion on loans acquired in a business combination during 2017. Rate/Volume Analysis The volume and interest rate variances table below sets forth the dollar difference in interest earned and paid for each major category of interest-earning assets and interest-bearing liabilities for the noted periods, and the amount of such change attributable to changes in average balances (volume) or changes in average interest rates. Volume variances are equal to the increase or decrease in the average balance times the prior period rate, and rate variances are equal to the increase or decrease in the average rate times the prior period average balance. Variances attributable to both rate and volume changes are allocated proportionately based on the amounts of the individual rate and volume changes. Net interest income was $78.3 million during 2019, an increase of $22.6 million from $55.7 million during 2018 due to higher interest and dividend income of $26.0 million partially offset by higher interest expense of $3.4 million. The increase in interest income was due mostly to higher accelerated discount accretion from loans acquired in a business combination, including the payoff of PCI loans of $2.3 million, higher average interest-earning assets of $363.1 million due to assets acquired in the PCB acquisition, organic loan growth and higher average market interest rates during 2019. Average loan balances increased $331.8 million to $1.32 billion during 2019 compared to $985.5 million for the same 2018 period. The average effective federal funds target rate was 2.16% during 2019 compared to 1.83% for the same 2018 period. The PCB acquisition added $399.8 million in net loans at the time of acquisition. Net interest margin increased 31 basis points to 5.24% for the year ended December 31, 2019 compared to 4.93% for the same 2018 period. The increase in the net interest margin was due primarily to a 34 basis point increase in loan yields, including fees and discounts, and a 7 basis point increase in other interest-earning assets yield, offset partially by a 5 basis point increase in funding costs. The increase in the interest-earning assets yield and loan yield were driven by higher market rates on new loan production and loan repricing through the first half of 2019, and higher discount accretion from loans acquired in a business combination, including the payoff of PCI loans. This discount accretion increased our net interest margin and loan yield by 31 basis points and 35 basis points for 2019 compared to 20 basis points and 23 basis points for 2018. The cost of funds increased to 0.91% for 2019, compared to 0.86% for 2018 as a result of an increase in the cost of interest-bearing liabilities due to higher market interest rates in the first half of 2019, offset by an improved funding mix from the PCB acquisition. Average interest-bearing deposits increased $55.9 million to $687.1 million and the cost of such deposits increased 21 basis points to 1.49%. Average borrowings and senior secured notes increased $34.1 million to $61.9 million and the cost of such funds increased 45 basis points to 2.94%. Average noninterest-bearing demand deposits increased $233.4 million to $586.5 million and represented 46.1% of total average deposits for 2019, compared to $353.2 million, or 35.9% of total average deposits, for 2018. The total cost of deposits decreased 1 basis points to 0.81% for 2019, compared to 0.82% for 2018. Provision for Loan Losses We maintain an allowance for loan losses at a level we believe is adequate to absorb probable incurred credit losses. The allowance for loan losses is estimated using past loan loss experience, the nature and volume of the portfolio, information about specific borrower situations and estimated collateral values, economic conditions, and other factors. At December 31, 2019, the allowance for loan losses was $13.5 million, or 0.98% of loans held for investment compared to $11.1 million, or 0.88% of loans held for investment at December 31, 2018. The increase in the allowance for loan losses for 2019 results primarily from loan growth and higher specific reserves for nonaccrual loans primarily from three lending relationships. The net carrying value of loans acquired through the acquisition of PCB, excluding PCI loans, totaled $248.0 million and included a remaining net discount of $6.0 million at December 31, 2019, which represented 2.41% of the net carrying value of acquired loans and 0.43% of total gross loans held for investment. The provision for loan losses totaled $2.8 million during 2019 compared to $1.5 million during 2018. The increase in provision for loan losses was primarily the result of organic loan growth, coupled with an increase in specific reserves of $1.2 million, the majority of which related to three lending relationships. Noninterest Income The following table shows the components of noninterest income between periods: Noninterest income increased $4.1 million to $7.7 million during 2019 compared to $3.6 million during 2018 primarily due to higher net earnings for all of the categories as a result of including PCB's operation since the acquisition date and higher gain on the sale of loans of $2.2 million. The 2019 loan sales related to 51 SBA loans with a net carrying value of $61.6 million at an average premium of 6.0%, resulting in a gain of $3.7 million and three commercial and industrial loans with the net carrying value of $2.3 million, resulting in a gain of $1 thousand during 2019. This compares to 31 SBA loans sold with a net carrying value of $25.0 million at an average premium percentage of 6.0%, resulting in a gain of $1.5 million for the 2018 period. Services charges and fees on deposit accounts increased $701 thousand to $1.9 million during 2019 from $1.2 million for the comparable 2018 period. The increase was attributed to a higher volume of transaction-based accounts and account balances as a result of organic growth and the PCB acquisition. Average demand deposit account balances increased to $586.5 million during 2019 from $353.2 million for the comparable 2018 period. Net servicing fees increased $341 thousand to $850 thousand during 2019 from $509 thousand for the comparable 2018 period. The increase was due primarily to higher servicing fee income, offset with higher amortization expense of the related servicing asset during 2019. During 2019 and 2018, contractually-specified servicing fees were $2.0 million and $1.5 million. Offsetting these servicing fees was amortization of $1.1 million during 2019 and $1.0 million during 2018. The amortization expense for 2019 included a $146 thousand acceleration of amortization expense that resulted from increased prepayment speeds on the related SBA loans. Our average SBA loan servicing portfolio was $208.6 million for 2019 compared to $164.2 million for 2018. The increase in our average SBA loan servicing portfolio primarily related to the acquisition of PCB in 2018 which contributed $73.8 million to the portfolio of serviced SBA loans, coupled with the higher volume of loan sales servicing retained during 2019. Other income increased $879 thousand to $1.2 million during 2019 from $355 thousand for the comparable 2018 period. The increase was attributed primarily to: (i) higher net realized gains on equity securities with a readily determinable fair value of $202 thousand; and (ii) two CDFI Bank Enterprise Awards totaling $466 thousand for which there was no similar income in the same 2018 period. We recognized two Bank Enterprise Awards in 2019 as these awards were granted in 2018 for use and recognition during 2019; one award was granted to PCB prior to its acquisition date in 2018 and the other award was granted to First Choice Bank. Noninterest Expense The following table shows the components of noninterest expense between periods: Noninterest expense increased $7.0 million to $43.2 million during 2019 from $36.2 million for 2018. The increase in most of the overhead expense categories was due to including PCB's operations for a full fiscal year in 2019, compared to just five months during 2018, impairment charges related to branch relocation and consolidations of $1.2 million in 2019 and the increase in customer service related expenses from higher average demand deposits, offset by the decrease of $5.4 million in merger, integration and public company registration costs. The $7.6 million increase in salaries and employee benefits was primarily due to: (i) the growth in headcount from former PCB employees retained subsequent to the acquisition. The average FTE employees for 2019 was 180 compared to 136 FTE employees for the same 2018 period; (ii) annual merit increase in the normal course of business; (iii) higher temporary and overtime costs; and (iv) higher commission from loan and deposit growth. The $2.4 million increase in occupancy and equipment costs was due to the branches added in the PCB acquisition and impairment charges for the right-of-use ("ROU") asset and fixed assets relating to the relocation of our downtown Los Angeles branch and the early termination of the lease for our former Little Tokyo branch. The total impairment charge recognized for these two locations was $1.2 million, which is estimated to result in net cost savings, after impairment charges, of approximately $621 thousand before tax ($437 thousand after tax). The $571 thousand increase in data processing primarily related to increases in transaction volume from both organic growth and the PCB acquisition, enhancing automation and delivering risk mitigation solutions to improve our customers’ banking experience. The $890 thousand increase in customer service related expenses was primarily due to higher average noninterest-bearing demand deposits between periods. Average noninterest-bearing demand deposits totaled $586.5 million for 2019 compared to $353.2 million for 2018. In connection with the PCB acquisition and completion of a S-4 registration statement in 2018, we recognized $5.4 million in merger, integration and public company registration costs, which included $1.8 million in severance costs, $768 thousand in professional fees, $2.5 million in system integration costs, and $414 thousand in other expenses. There were no similar merger related costs in 2019. The $516 thousand increase in the amortization of core deposit intangible (CDI) was a result of including amortization expense for the full fiscal year of 2019 compared to just five months of amortization during 2018, coupled with accelerated amortization of CDI in 2019. Income Taxes Income tax expense was $12.1 million during 2019, compared to $6.4 million for 2018. The effective tax rate for 2019 was 30.2% compared to 29.8% for 2018. The difference in our effective tax rate compared to the statutory rate of 29.6% for the respective reporting periods was primarily attributable to the impact of the vesting and exercise of equity awards combined with changes in the Company's stock price over time. Comparison of Financial Condition General Total assets at December 31, 2019 were $1.69 billion, an increase of $67.8 million, or 4.2%, from $1.62 billion at December 31, 2018. This increase is primarily due to the $121.2 million increase in loans held for investment, net to $1.36 billion at December 31, 2019 from $1.24 billion at December 31, 2018, offset by a $35.6 million reduction in cash balances between periods. Total liabilities at December 31, 2019 were $1.43 billion, an increase of $54.1 million, from $1.37 billion at December 31, 2018. The increase between periods was primarily attributable to the increase in total deposits of $61.4 million to $1.31 billion at December 31, 2019. Borrowings decreased $15.0 million to $90.0 million at December 31, 2019. This decrease was partially offset by a $1.2 million increase in our senior secured notes to $9.6 million at December 31, 2019; we used the funds for cash dividends, share repurchases and operational costs. Cash and Cash Equivalents Cash and cash equivalents are comprised of cash and due from banks, interest-bearing deposits at other banks with original maturities of less than 90 days, and federal funds sold. Cash and cash equivalents totaled $161.8 million at December 31, 2019, a decrease of $35.6 million from December 31, 2018. The decrease in cash and cash equivalents during 2019 was primarily attributable to portfolio growth and reductions in borrowings. Investment Securities The following table presents the carrying values of investment securities available-for-sale and held-to-maturity as of the periods indicated: The following table presents the contractual maturities and the weighted average yield of investment securities available-for-sale and held-to-maturity by investment category as of December 31, 2019: (1) Mortgage-backed securities, collateralized mortgage obligations and SBA pools do not have a single stated maturity date and therefore have been included in the "Due after ten years" category. (1) Mortgage-backed securities do not have a single stated maturity date and therefore have been included in the "Due after ten years" category. At December 31, 2019, no issuer represented 10% or more of the Company’s shareholders’ equity. At December 31, 2019, securities held-to-maturity with a carrying amount of $5.1 million were pledged to the Federal Reserve as collateral for a secured line of credit. There were no borrowings under this line of credit for the year ended December 31, 2019. Loans Loans are the single largest contributor to our net income. At December 31, 2019, loans held for investment, net totaled $1.36 billion. It is our goal to continue to grow the balance sheet through the origination of loans, and to a lesser extent, through loan purchases. This effort will serve to maximize our yield on interest-earning assets. We continue to manage our loan portfolio in accordance with what we believe are conservative and disciplined loan underwriting policies. Every effort is made to minimize credit risk, while tailoring loans to meet the needs of our target market. Our lending strategy emphasizes quality loan growth, product diversification, and competitive and profitable pricing. Continued balanced growth is anticipated over the coming years. The following table shows the composition of our loan portfolio as of the dates indicated: (1) Loans held for investment, net of discounts includes purchased credit impaired loans of $1.1 million and $2.6 million as of December 31, 2019 and December 31, 2018. There were no purchased credit impaired loans as of December 31, 2017, 2016 and 2015. At December 31, 2019, loans held for investment totaled $1.37 billion, an increase of $123.7 million since December 31, 2018. The annual growth rate during 2019 was 9.9%. During 2019 as compared to 2018, construction and land development loans increased $65.3 million, commercial real estate loans ("CRE") increased $14.3 million, commercial and industrial loans increased $27.3 million, SBA loans increased $31.2 million, and residential loans decreased $13.7 million. The diversification and portfolio composition remained similar at December 31, 2019 compared to December 31, 2018. The most significant categories in the loan portfolio are non-owner occupied CRE and commercial and industrial loans which represent 30.8% and 22.5% of total loans held for investments, net of discounts at December 31, 2019. Per the regulatory definition of commercial real estate, at December 31, 2019 and 2018, our concentration of such loans represented 314% and 309% of our total risk-based capital and were below our internal policy limit of 350% of our total risk-based capital. In addition, at December 31, 2019 and 2018, total loans secured by commercial real estate under construction and land development represented 125% and 108% of our total risk-based capital and were likewise below our internal policy of 150% of our total risk-based capital. Historically, we have managed loan concentrations by selling participations in, or whole loan sales of, certain loans, primarily commercial real estate and construction and land development loan production. We have total loans to the hospitality industry (including construction, CRE, C&I and SBA loans) of $158.9 million and $154.1 million at December 31, 2019 and 2018. Some of the members of our Board of Directors are active in the hospitality sector, and therefore, are able to provide referrals for financing on hotel properties. There are no loans to any of our board members or to members of their immediate families, but often to other hotel owners referred to us by these directors. We carefully manage our concentration and the levels of hospitality loans are measured against our total risk-based capital and reported to our Board of Directors regularly. Our internal guidance is to limit CRE and construction hospitality industry commitments to 150% and 75% of total risk-based capital, respectively. At December 31, 2019 and 2018, total commitments to fund CRE loans to the hospitality industry represented 50% and 64% of our total risk-based capital. Total commitments to fund construction loans to the hospitality industry remained at 36% of our total risk-based capital at December 31, 2019 and 2018. We offer small business loans through the SBA 7(a) and 504 loan programs. The SBA 7(a) program provides up to a 75% guaranty for loans greater than $150,000, an 85% guaranty for loans $150,000 or less, and, in certain circumstances, up to a 90% guaranty. The maximum SBA 7(a) loan amount is $5 million. The guaranty is conditional and covers a portion of the risk of payment default by the borrower, but not the risk related to improper closing or servicing by the lender. The SBA 504 program consists of real estate backed commercial mortgages where we have the first mortgage and the SBA has the second mortgage on the property. Generally, we have a less than 50% loan-to-value ratio on SBA 504 program loans at origination. The following table summarizes the SBA loan programs in the portfolio as of the dates indicated: The following table summarizes the amount of guaranteed and unguaranteed SBA loans in the portfolio, and the collateral categories for the unguaranteed portion of SBA loans as of the dates indicated: Loan Maturities. The following table presents the contractual maturities and the distribution between fixed and adjustable interest rates for loans held for investment at December 31, 2019: Potential Problem Loans. Loans are considered delinquent when principal or interest payments are past due 30 days or more; delinquent loans may remain on accrual status between 30 days and 89 days past due. Loans on which the accrual of interest has been discontinued are designated as nonaccrual loans. Typically, the accrual of interest on loans is discontinued when principal or interest payments are past due 90 days or when, in the opinion of management, there is a reasonable doubt as to collectability in the normal course of business. When loans are placed on nonaccrual status, all interest previously accrued but not collected is reversed against current period interest income. We categorize loans into risk categories based on relevant information about the ability of borrowers to service their debt such as current financial information, historical payment experience, collateral adequacy, credit documentation, and current economic trends, among other factors. We analyze loans individually by classifying the loans as to credit risk. This analysis typically includes larger, non-homogeneous loans such as commercial real estate and commercial and industrial loans. This analysis is performed on an ongoing basis as new information is obtained. We use the following definitions for risk ratings: Pass - Loans classified as pass represent assets with a level of credit quality which contain no well-defined deficiency or weakness. Special Mention - Loans classified as special mention have a potential weakness that deserves management’s close attention. If left uncorrected, these potential weaknesses may result in deterioration of the repayment prospects for the loan or of the institution’s credit position at some future date. Substandard - Loans classified as substandard are inadequately protected by the current net worth and paying capacity of the obligor or of the collateral pledged, if any. Loans so classified have a well-defined weakness or weaknesses that jeopardize the liquidation of the debt. They are characterized by the distinct possibility that the institution will sustain some loss if the deficiencies are not corrected. Doubtful - Loans classified as doubtful have all the weaknesses inherent in those classified Substandard with the added characteristic that the weaknesses make collection or liquidation in full, based on currently known facts, conditions and values, highly questionable and improbable. Loss - Loans classified loss are considered uncollectible and of such little value that their continuance as loans is not warranted. The following tables present the recorded investment balances of potential problem loans, excluding PCI loans, classified as special mention or substandard, at December 31, 2019 and 2018: (1) At December 31, 2019, substandard loans include $11.3 million of impaired loans. The Company had no loans classified as doubtful or loss at December 31, 2019. (1) At December 31, 2018, substandard loans include $1.7 million of impaired loans. The Company had no loans classified as doubtful or loss at December 31, 2018. Since December 31, 2018, special mention loans decreased $20.4 million to zero due to $12.0 million in upgrades, $3.2 million in downgrades to substandard, and $5.2 million in payoffs and charge-offs. The increase in the substandard loans is due to $23.6 million in downgrades, offset by charge-offs, payoffs, paydowns and loans sold totaling $4.0 million. Nonperforming Assets. Nonperforming assets, excluding PCI loans, are defined as nonperforming loans (defined as accruing loans past due 90 days or more, non-accrual loans and non-accrual troubled-debt restructurings (“TDRs”)) plus other real estate owned and other assets acquired through foreclosure (“Foreclosed assets”). The balances of nonperforming loans reflect our net investment in these assets. The table below reflects the composition of non-performing assets at the periods indicated: The following table shows our nonperforming loans among our different loan categories as of the dates indicated. (1) There were no purchased credit impaired loans on nonaccrual at December 31, 2019 and 2018. Since December 31, 2018, the increase in nonperforming loans was due mostly to downgrading 16 SBA loans totaling $6.0 million, three commercial real estate loans totaling $4.4 million and one commercial and industrial loans of $159 thousand, offset by a $917 thousand reduction due to loans paid off or charge-offs. Troubled Debt Restructurings. At December 31, 2019 and 2018, the total recorded investment for loans identified as a TDR was approximately $479 thousand and $921 thousand. There were no specific reserves allocated for these loans and the Company has not committed to lend any additional amounts to customers with outstanding loans that are classified as TDR’s as of December 31, 2019 and 2018. Loan modifications resulting in TDR status generally included one or a combination of the following concessions: extensions of the maturity date, principal payment deferments or signed forbearance agreements with a payment plan. During the years ended December 31, 2019 and 2018, there were no new loan modifications resulting in TDRs. A loan is considered to be in payment default once it is 90 days contractually past due under the modification. During the years ended December 31, 2019 and 2018, there was one SBA loan totaling $88 thousand and $95 thousand classified as a TDR for which there was a payment default within twelve months following the modification. Allowance for Loan Losses. The allowance for loan losses is a valuation allowance for probable incurred credit losses. Loan losses are charged against the allowance when management believes the un-collectability of a loan balance is confirmed. Subsequent recoveries, if any, are credited to the allowance. Management estimates the allowance balance required using past loan loss experience, the nature and volume of the portfolio, information about specific borrower situations and estimated collateral values, economic conditions, and other factors. Allocations of the allowance may be made for specific loans, but the entire allowance is available for any loan that, in management’s judgment, should be charged-off. Amounts are charged-off when available information confirms that specific loans or portions thereof, are uncollectible. This methodology for determining charge-offs is consistently applied to each loan portfolio segment. The Company determines a separate allowance for each loan portfolio segment. The allowance consists of specific and general reserves. Specific reserves relate to loans that are individually classified as impaired. A loan is impaired when, based on current information and events, it is probable that we will be unable to collect all amounts due according to the contractual terms of the loan agreement. Factors considered in determining impairment include payment status, collateral value and the probability of collecting all amounts when due. Measurement of impairment is based on the expected future cash flows of an impaired loan, which are to be discounted at the loan’s effective interest rate, or measured by reference to an observable market value, if one exists, or the fair value of the collateral for a collateral-dependent loan. We select the measurement method on a loan-by-loan basis except that collateral-dependent loans for which foreclosure is probable are measured at the fair value of the collateral, less estimated selling costs. General reserves cover non-impaired loans and are based on historical loss rates for each portfolio segment adjusted for the effects of qualitative or environmental factors that are likely to cause estimated credit losses as of the evaluation date to differ from the portfolio segment’s historical loss experience. Qualitative factors include consideration of the following: changes in lending policies and procedures; changes in economic conditions; changes in the nature and volume of the portfolio; changes in the experience, ability and depth of lending management and other relevant staff; changes in the volume and severity of past due, nonaccrual and other adversely graded loans; changes in the loan review system; changes in the value of the underlying collateral for collateral-dependent loans; concentrations of credit; and the effect of other external factors such as competition and legal and regulatory requirements. Portfolio segments identified by the Company include construction and land development, residential and commercial real estate, commercial and industrial, SBA loans, and consumer loans. Relevant risk characteristics for these portfolio segments generally include debt service coverage, loan-to-value ratios, collateral type, borrower financial performance, credit scores, and debt-to-income ratios for consumer loans. In addition, the evaluation of the appropriate allowance for loan losses on non-PCI loans in the various loan segments considers discounts recorded as a part of the initial determination of the fair value of the loans. For these loans, no allowance for loan losses is recorded at the acquisition date. Interest and credit discounts are components of the initial fair value. Additional credit deterioration on acquired non-PCI loans, in excess of the remaining discount will be recognized in the allowance through the provision for loan losses. The evaluation of the appropriate allowance for loan losses for purchased credit-impaired loans in the various loan segments considers the expected cash flows to be collected from the borrower. These loans are initially recorded at fair value and, therefore, no allowance for loan losses is recorded at the acquisition date. Subsequent to the acquisition date, the expected cash flows of purchased loans are subject to evaluation. Decreases in expected cash flows are recognized by recording an allowance for loan losses with the related provision for loan losses. If the expected cash flows on the purchased loans increase, a previously recorded impairment allowance can be reversed. Increases in expected cash flows of purchased loans, when there are no reversals of previous impairment allowances, are recognized over the remaining life of the loans. At December 31, 2019, given the composition of our loan portfolio, as well as the unamortized fair value discount of loans acquired, the ALLL was considered adequate to cover probable incurred losses inherent in the loan portfolio. Should any of the factors considered by management in evaluating the appropriate level of the ALLL change, the Company’s estimate of probable incurred loan losses could also change, which could affect the level of future provisions for loan losses. The table below presents a summary of activity in our allowance for loan losses for the periods indicated: The following table shows the allocation of the allowance for loan losses by loan type at the periods indicated: PCI Loans. The following table summarizes the changes in the carrying amount and accretable yield of PCI loans for the periods indicated: (1) Amounts include activity from July 31, 2018 (acquisition date) through December 31, 2018. Loan Held for Sale. Loans held for sale typically consist of the guaranteed portion of SBA 7(a) loans that are originated and intended for sale in the secondary market and may also include commercial real estate loans, commercial and industrial loans and SBA 504 loans. Loans held for sale are carried at the lower of carrying value or estimated market value. At December 31, 2019, loans held for sale were $7.7 million a decrease of $20.3 million from $28.0 million at December 31, 2018. The decrease in loans held for sale during 2019 was primarily attributable to the origination of $33.3 million in loans, offset by the sale of loans with an aggregate carrying value of $63.9 million. In addition, $10.2 million of loans held for investment were transferred to loans held for sale during the year ended December 31, 2019. At December 31, 2019 and 2018, loans held for sale consisted entirely of SBA 7(a) loans. At December 31, 2019 and 2018, the fair value of loans held for sale totaled $8.4 million and $29.2 million. Servicing Asset and Loan Servicing Portfolio. We sell loans in the secondary market and, for certain loans retain the servicing responsibility. The loans serviced for others are accounted for as sales and are therefore not included in the accompanying consolidated balance sheets. We receive servicing fees ranging from 0.25% to 1.00% for the services provided over the life of the loan; the servicing asset is initially recognized at fair value based on the present value of the estimated future net servicing income, incorporating assumptions that market participants would use in their estimates of fair value. The risks inherent in the SBA servicing asset relates primarily to changes in prepayments that result from shifts in interest rates and a reduction in the estimated future cash flows. The servicing asset activity includes additions from loan sales with servicing retained and acquired servicing rights and reductions from amortization as the serviced loans are repaid and servicing fees are earned. Loans serviced for others totaled $278.6 million and $288.2 million at December 31, 2019 and 2018. The loan servicing portfolio includes SBA loans serviced for others of $214.8 million and $198.4 million for which there is a related servicing asset of $3.2 million and $3.2 million at December 31, 2019 and 2018. Consideration for each SBA loan sale includes the cash received and a related servicing asset. In addition, the loan servicing portfolio includes construction and land development loans, commercial real estate loans and commercial & industrial loans participated out to various other institutions of $63.8 million and $89.8 million for which there is no related servicing asset at December 31, 2019 and 2018. Goodwill and Other Intangible Assets As a result of the PCB acquisition in 2018, we recorded goodwill and a core deposit intangible ("CDI"), which total $73.4 million and $5.7 million at December 31, 2019. Goodwill is tested for impairment no less than annually or more frequently when circumstances arise indicating impairment may have occurred. The Company evaluated goodwill for impairment and concluded there was no impairment as of December 31, 2019 and 2018. Deposits The following table presents the ending balance and percentage of deposits as of the periods indicated: (1) Included brokered deposits of $33.0 million at December 31, 2019. There were no brokered deposits at December 31, 2018 and December 31, 2017. (2) Included brokered money market deposits of $15.1 million, $21.6 million and $1 thousand at December 31, 2019, 2018 and 2017. Total deposits increased $61.4 million to $1.31 billion at December 31, 2019 from $1.25 billion at December 31, 2018. The increase in deposits was primarily a result of higher noninterest-bearing demand deposits of $79.9 million and interest-bearing non-maturity deposits of $49.2 million, offset by reductions in time deposits of $67.7 million. The increase in noninterest-bearing demand deposits and interest-bearing non-maturity deposits is attributed primarily to our continued growth of our relationships related to our core deposits in addition to participating in a new non-maturity brokered deposit program in 2019. The decrease in time deposits includes a $54.8 million decrease in retail time deposits due to maturities that were not renewed at our current offer rates and a $13.0 million decrease in wholesale time deposits due to our strategy of lowering our cost of funds. At December 31, 2019, noninterest-bearing deposits represented 47.7% of total deposits compared to 43.7% at December 31, 2018. Wholesale time deposits includes brokered time deposits and collateralized time deposits from the State of California. At December 31, 2019, brokered time deposits totaled $50.4 million, of which $32.6 million are callable, and the weighted average remaining maturity, including call options, is 1.2 years. At December 31, 2018, brokered time deposits totaled $53.4 million. At December 31, 2019, collateralized time deposits from the State of California totaled $25.1 million compared to $35.1 million at December 31, 2018. These deposits are collateralized by letters of credit issued by the FHLB under the Bank's secured line of credit with the FHLB. Refer to Note 9 - Deposits and Note 10 - Borrowing Arrangements to the Consolidated Financial Statements in Item 8 Financial Statements and Supplementary Data, of this Annual Report. The Company’s ten largest depositor relationships accounted for approximately 28.2% and 25.2% of total deposits at December 31, 2019 and 2018. The following table shows the maturities of time deposits greater than $250,000 at December 31, 2019: Borrowings In addition to deposits, we use borrowings, including short-term and long-term FHLB advances, Federal Reserve secured lines of credit, federal funds unsecured lines of credit, and floating rate senior secured notes, as secondary sources of funds to meet our liquidity needs. At December 31, 2019, borrowings totaled $90.0 million which were secured fixed-rate term FHLB advances that mature in March 2020 and June 2021, and there were no overnight borrowings. At December 31, 2018, borrowings totaled $105.0 million which included $90.0 million of overnight FHLB advances and $15.0 million of unsecured Federal fund purchases. At December 31, 2019 and 2018, senior secured notes were $9.6 million and $8.5 million. The following table presents the ending balance of borrowings and senior secured notes as of the periods indicated: Federal Home Loan Bank Secured Line of Credit. At December 31, 2019, the Bank has a secured line of credit of $407.3 million from the FHLB, of which $229.8 million was available. This secured borrowing arrangement is collateralized under a blanket lien and is subject to the Bank providing adequate collateral and continued compliance with the Advances and Security Agreement and other eligibility requirements established by the FHLB. At December 31, 2019, the Bank had pledged $1.1 billion of loans under a blanket lien, of which $738.0 million was considered as eligible collateral under this borrowing agreement. The Bank had a short term fixed-rate advance of $60.0 million that matures in March 2020 with a weighted average interest rate of 1.72% at December 31, 2019. The Bank also had a long term fixed-rate advance of $30.0 million that matures in June 2021 with a weighted average interest rate of 1.93% at December 31, 2019. There were no short term and long term fixed-rated advances at December 31, 2018. There were no overnight borrowings outstanding under this arrangement at December 31, 2019. Overnight borrowings were $90.0 million with a weighted average interest rate of 2.56% at December 31, 2018. In addition, at December 31, 2019, the Bank used $87.5 million of its secured FHLB borrowing capacity by having the FHLB issue letters of credit to meet collateral requirements for deposits from the State of California and other public agencies. The following table presents certain information with respect to only our FHLB borrowings as of the periods indicated. Federal Reserve Bank Secured Line of Credit. At December 31, 2019, the Bank had a secured line of credit of $177.1 million from the Federal Reserve Bank. During the third quarter of 2019, the Bank expanded the existing secured borrowing capacity with the Federal Reserve through the Borrower-in-Custody ("BIC") program. At December 31, 2019, the Bank had pledged qualifying loans with an unpaid principal balance of $252.4 million and securities held-to-maturity with a carrying value of $5.1 million as collateral for this line. Borrowings under this BIC program are overnight advances with interest chargeable at the Federal Reserve discount window ("Primary Credit") borrowing rate. There were no borrowings under this arrangement at or during the years ended December 31, 2019 and 2018. Federal Funds Unsecured Lines of Credit. The Bank has established unsecured overnight borrowing arrangements for an aggregate amount of $77.0 million, subject to availability, with five of its correspondent banks. In general, interest rates on these lines approximate the federal funds target rate. There were no overnight borrowings under these credit facilities at December 31, 2019 and $15.0 million at December 31, 2018. The following table presents certain information with respect to only our federal funds unsecured lines of credit as of the periods indicated. Senior Secured Notes. At December 31, 2019, the holding company has a senior secured revolving line of credit for $25 million. This facility is secured by 100% of the common stock of the Bank. The outstanding balance under this facility totaled $9.6 million with a floating interest rate of 5.00% at December 31, 2019. At December 31, 2018, the outstanding balance totaled $8.5 million with an interest rate of 5.75%. The average outstanding borrowings under this facility totaled $11.9 million and $4.5 million with an average interest rate of 5.68% and 5.46% during 2019 and 2018. In December 2019, we extended the maturity date of this line of credit from December 22, 2019 to March 22, 2022. The interest rate decreased from Wall Street Journal Prime + 0.25%, floating to Wall Street Journal Prime, floating (effective January 2, 2020). At the same time, the debt covenants were updated and confirmed as follows (i) Bank leverage ratio greater than or equal to 9.0%, (ii) Bank Tier 1 capital ratio greater than or equal to 11.0% and $150.0 million, (iii) Bank total capital ratio greater than or equal to 12.0%, (iv) Bank CET1 capital ratio greater than or equal to 11.0%, (v) Bank trailing twelve months return on average assets, excluding one-time expense related to the merger with PCB, greater than or equal to 1.0%, (vi) Bank classified assets to Tier 1 capital plus the allowance for loan losses of less than or equal to 35.0%, (vii) certain defined Bank liquidity ratios and (viii) specific concentration levels for commercial real estate and construction and land development loans. At December 31, 2019, we were in compliance with all loan covenants on the facility and the remaining available credit was $15.4 million. One of our executives is also a member of the lending bank's Board of Directors. Shareholders’ Equity Total shareholders’ equity increased $13.7 million, or 5.5%, to $261.8 million at December 31, 2019 from $248.1 million at December 31, 2018. The increase in shareholders' equity is primarily due to $27.8 million in net earnings, $1.9 million of share-based compensation, $2.6 million of stock options exercised and $693 thousand related to changes in the fair value of investment securities, available-for-sale and the resulting impact on accumulated other comprehensive income, partially offset by $9.9 million in cash dividends, and $9.4 million in stock repurchases during 2019. Liquidity and Capital Resources Liquidity is the ability to raise funds on a timely basis at an acceptable cost in order to meet cash needs. Adequate liquidity is necessary to handle fluctuations in deposit levels, to provide for client credit needs, and to take advantage of investment opportunities as they are presented in the market place. We believe we currently have the ability to generate sufficient liquidity from our operating activities to meet our funding requirements. As a result of our growth, we may need to acquire additional liquidity to fund our activities in the future. Holding Company Liquidity As a bank holding company, we currently have no significant assets other than our equity interest in First Choice Bank. Our primary sources of liquidity at the holding company include dividends from the Bank, cash on hand, which was approximately $337 thousand at December 31, 2019, a $25.0 million secured revolving line of credit of which $15.4 million was available at December 31, 2019, and our ability to raise capital, issue subordinated debt, and secure other outside borrowings. Our ability to declare dividends to shareholders and repurchase our common stock depends upon cash on hand, availability on our secured line of credit and dividends from the Bank. Dividends from the Bank to the holding company depend upon the Bank's earnings, financial position, regulatory standing, the ability to meet current and anticipated regulatory capital requirements, and other factors deemed relevant by our Board of Directors. The Bank paid $19.0 million in dividends to the holding company during 2019. Refer to - Regulatory Capital and Dividends in this MD&A for dividend limitations at both the holding company and the Bank. Consolidated Company Liquidity Our liquidity ratio is defined as the liquid assets (cash and due from banks, fed funds sold and repos, interest-bearing deposits at other banks, other investments with a remaining maturity of one year or less, unpledged available-for-sale and equity securities, held-to-maturity securities and fully funded loans held for sale) divided by total assets. Using this definition, at December 31, 2019, our liquidity ratio was 12%. Our objective is to ensure adequate liquidity at all times by maintaining liquid assets, gathering deposits and arranging for secondary sources of funding. Having too little liquidity can present difficulties in meeting commitments to fund loans or honor deposit withdrawals. Having too much liquidity can result in lower income because highly liquid assets are short-term in nature and generally yield less than long-term assets. A proper balance is the goal of management and the Board of Directors, as administered by various policies and guidelines. Our policy was updated during the third quarter of 2019 to require a minimum daily liquidity ratio of 11%. Previously, our policy required that we maintain a sufficient level of daily on balance sheet liquidity and achieve a liquidity ratio of 15% as of each month end. Net cash provided by operating activities for the years ended December 31, 2019 and 2018 was $60.4 million and $342 thousand. Net interest income and noninterest expense are the primary components of cash provided by operations. Net cash (used in) provided by investment activities for the years ended December 31, 2019 and 2018 was $(126.7) million and $3.6 million. For the year ended December 31, 2019, the primary components of cash flows used in investing activities was the net increase in loans, which totaled $128.7 million. For the year ended December 31, 2018, the primary components of cash flows provided by investing activities was the $111.0 million in cash acquired as part of the PCB acquisition, partially offset by a net increase in loans, which totaled $103.8 million, and purchase of restricted stock investments of $6.9 million. Net cash provided by financing activities for the years ended December 31, 2019 and 2018 was $30.8 million and $90.3 million. For the year ended December 31, 2019, cash provided by financing activities primarily results from a $61.4 million increase in deposits, a $1.2 million increase in senior secured notes, and $2.6 million in proceeds from stock option exercises, partially offset by $15.0 million decrease in net borrowings, $9.9 million in cash dividends paid and $9.4 million in stock repurchases. For the year ended December 31, 2018, cash provided by financing activities primarily results from a $4.7 million increase in deposits, a $85.0 million increase in borrowings, a $8.1 million increase in senior secured notes, and $1.1 million in proceeds from stock option exercises, partially offset by $7.6 million in cash dividends paid and $1.1 million in stock repurchases. Additional sources of liquidity available to us at December 31, 2019 included $229.8 million in remaining secured borrowing capacity with the FHLB, $177.1 million in secured borrowing capacity with the Federal Reserve Bank through the Borrower-in-Custody Program ("BIC") and discount window, and unsecured lines of credit with correspondent banks with a remaining borrowing capacity of $77.0 million. We believe that we will be able to meet our contractual obligations as they come due through the maintenance of adequate liquidity levels. We expect to maintain adequate liquidity levels through profitability, loan payoffs, securities repayments and maturities, and continued deposit gathering activities. We also have in place various borrowing mechanisms for both short-term and long-term liquidity needs. Stock Repurchase Plan On December 3, 2018, we announced a stock repurchase plan, providing for the repurchase of up to 1.2 million shares of our outstanding common stock, or approximately 10% of our then outstanding shares (the "repurchase plan"). The repurchase plan permits shares to be repurchased in open market or private transactions, through block trades, and pursuant to any trading plan that may be adopted in accordance with Rules 10b5-1 and 10b-18 of the SEC. The repurchase plan may be suspended, terminated or modified at any time for any reason, including market conditions, the cost of repurchasing shares, the availability of tentative investment opportunities, liquidity, and other factors deemed appropriate. These factors may also affect the timing and amount of share repurchases. The repurchase plan does not obligate us to purchase any particular number of shares. During the fourth quarter of 2019, we repurchased 13,547 shares of its common stock at an average price of $22.80 and a total cost of $309 thousand under the stock repurchase program. For the year ended December 31, 2019, we repurchased 429,817 shares at an average price of $21.64 and a total cost of $9.3 million. The remaining number of shares authorized to be repurchased under this program was 733,900 shares at December 31, 2019. Contractual Obligations The following table summarizes aggregated information about our outstanding contractual obligations and other long-term liabilities as of December 31, 2019. (1) Includes $32.6 million of callable brokered deposits based on their contractual maturity dates. Off-Balance-Sheet Arrangements In the normal course of operations, we engage in a variety of financial transactions that, in accordance with generally accepted accounting principles, are not recorded in our consolidated financial statements. These transactions involve, to varying degrees, elements of credit, interest rate and liquidity risk. These transactions generally take the form of loan commitments, unused lines of credit and standby letters of credit. At December 31, 2019, we had unused loan commitments of $376.9 million, standby letters of credit of $7.6 million and commitments to contribute capital to a low income housing tax credit project partnership of $1.7 million and other CRA investments of $236 thousand. At December 31, 2018, we had unused loan commitments of $375.8 million, standby letters of credit of $4.0 million and commitments to contribute capital to other CRA investments of $385 thousand. As of December 31, 2019, the Company had in place $87.5 million in letters of credit from the FHLB to meet collateral requirements for deposits from the State of California and other public agencies. Regulatory Capital First Choice Bank is subject to various regulatory capital requirements administered by the federal banking agencies. Failure to meet minimum capital requirements can initiate certain mandatory and possibly additional discretionary actions by regulators that, if undertaken, could have a direct material effect on our consolidated financial statements. Under capital adequacy guidelines and the regulatory framework for prompt corrective action, we must meet specific capital guidelines that involve quantitative measures of our assets, liabilities, and certain off-balance-sheet items as calculated under regulatory accounting practices. Our capital amounts and classification are also subject to qualitative judgments by the regulators about components, risk weightings, and other factors. In July 2013, the federal bank regulatory agencies approved the final rules implementing the Basel Committee on Banking Supervision’s capital guidelines for U.S. banks, “Basel III rules.” The new rules became effective on January 1, 2015, with certain of the requirements phased-in over a multi-year schedule, and fully phased in by January 1, 2019. Specifically, the capital conservation buffer was subject to a three-year phase-in period that began on January 1, 2016 and was fully phased-in on January 1, 2019 at 2.50%. The net unrealized gain or loss on investment securities available-for-sale is not included in computing regulatory capital. Quantitative measures established by regulation to ensure capital adequacy require us to maintain minimum amounts and ratios (set forth in the table below) of total Tier 1 and Common Tier 1 Capital ("CET1") (as defined in the regulations) to risk-weighted assets (as defined), and of Tier 1 capital (as defined) to average assets (as defined). At December 31, 2019, the Bank meets all capital adequacy requirements to which it is subject, and is categorized as well-capitalized under the regulatory framework for prompt corrective action (there are no conditions or events since that notification that management believes have changed the Bank’s category) by the FDIC. To be categorized as well-capitalized, the Bank must maintain minimum ratios as set forth in the table below: At December 31, 2019, we qualify for treatment under the Small Bank Holding Company Policy Statement (Regulation Y, Appendix C) and, therefore, are not subject to consolidated capital rules at the bank holding company level. On May 24, 2018, the Economic Growth, Regulatory Relief and Consumer Protection Act (the “Relief Act”) was signed into law. Among the Relief Act's key provisions are targeted tailoring measures to reduce the regulatory burden on community banks, including increasing the threshold for institutions qualifying for relief under the Policy Statement from $1 billion to $3 billion. The Relief Act tasked federal banking regulators to develop a community bank leverage ratio (the “CBLR”) applicable to certain depository institutions and depository institution holding companies with total consolidated assets of less than $10 billion. On September 17, 2019, the federal banking regulators adopted a final rule as required by the Relief Act that provides for a simple measure of capital adequacy for certain community banking organizations. This final rule will become effective on January 1, 2020. Under this final rule, banks and their bank holding companies that have less than $10 billion in total consolidated assets and meet other qualifying criteria, including a leverage ratio (equal to Tier 1 capital divided by average total consolidated assets) of greater than 9%, will be eligible to opt into the CBLR framework. Qualifying community banking organizations that elect to use the CBLR framework and that maintain a leverage ratio of greater than 9% will be considered to have satisfied the generally applicable risk-based and leverage capital requirements in the agencies’ capital rules (generally applicable rule) and, if applicable, will be considered to have met the well-capitalized ratio requirements for purposes of section 38 of the Federal Deposit Insurance Act. Accordingly, a qualifying community banking organization that exceeds the 9% CBLR will be considered to have met: (i) the generally applicable risk-based and leverage capital requirements of the generally applicable capital rules; (ii) the capital ratio requirements in order to be considered well capitalized under the prompt corrective action framework; and (iii) any other applicable capital or leverage requirements. A qualifying community banking organization that elects to be under the CBLR framework generally would be exempt from the current capital framework, including risk-based capital requirements and capital conservation buffer requirements. A banking organization meets the definition of a “qualifying community banking organization” if the organization has: • A leverage ratio of greater than 9%; • Total consolidated assets of less than $10 billion; • Total off-balance sheet exposures (excluding derivatives other than sold credit derivatives and unconditionally cancelable commitments) of 25% or less of total consolidated assets; and • Total trading assets plus trading liabilities of 5% or less of total consolidated assets. Even though a banking organization meets the above-stated criteria, federal banking regulators have reserved the authority to disallow the use of the CBLR framework by a depository institution or depository institution holding company, based on the risk profile of the banking organization. The CBLR framework will be available for banks to use in their March 31, 2020, Call Report. Currently, the Company qualifies as a “qualifying community banking organization” under these rules and we plan to opt into the CBLR framework. Dividends Our general dividend policy is to pay cash dividends within the range of typical peer payout ratios, provided that such payments do not adversely affect our consolidated financial condition and are not overly restrictive to our growth capacity. While we have paid a consistent level of quarterly cash dividends since the first quarter of 2017, no assurance can be given that our financial performance in any given year will justify the continued payment of a certain level of cash dividend, or any cash dividend at all. The following table sets forth per share dividend amounts declared for the periods indicated: The ability of the holding company and the Bank to pay dividends is limited by federal and state laws, regulations and policies of their respective banking regulators. California law allows a California corporation, such as the holding company, to pay dividends if retained earnings equal at least the amount of the proposed dividend. If a California corporation does not have sufficient retained earnings available for the proposed dividend, it may still pay a dividend to its shareholders if, immediately after the dividend, the value of its assets would equal or exceed the sum of its total liabilities. Policies of the Federal Reserve, our primary federal regulator, also limit the amount of dividends that bank holding companies may pay to income available over the past year, and only if prospective earnings retention is consistent with the institution's expected future needs and financial condition and consistent with the Federal Reserve's principle that bank holding companies should serve as a source of strength to their banking subsidiaries. The holding company's primary source of funds is dividends from the Bank, as well as availability under our $25 million secured line of credit. Under the California Financial Code, the Bank is permitted to pay a dividend in the following circumstances: (i) without the consent of either the California Department of Business Oversight ("DBO") or the Bank's shareholders, in an amount not exceeding the lesser of (a) the retained earnings of the Bank; or (b) the net income of the Bank for its last three fiscal years, less the amount of any distributions made during the prior period; (ii) with the prior approval of the DBO, in an amount not exceeding the greatest of: (x) the retained earnings of the Bank; (y) the net income of the Bank for its last fiscal year; or (z) the net income for the Bank for its current fiscal year; and (iii) with the prior approval of the DBO and the Bank's shareholders in connection with a reduction of its contributed capital. Further, as a Federal Reserve-member bank, the Bank is prohibited from declaring or paying a dividend if the dividend would exceed the Bank's undivided profits as reportable on its Reports of Condition and Income in the absence of prior regulatory and shareholder approvals. Summary of Critical Accounting Policies In preparing the consolidated financial statements, management is required to make certain estimates and assumptions that affect the reported amounts of assets and liabilities as of the dates of the statements of financial position and revenues and expenses for the periods then ended. Actual results could differ significantly from those estimates. A description of selected critical accounting policies that are of particular significance to us include: Business Combinations Business combinations are accounted for using the acquisition method of accounting under ASC Topic 805 - Business Combinations. Under the acquisition method, the Company measures the identifiable assets acquired, including identifiable intangible assets, and liabilities assumed in a business combination at fair value on acquisition date. Goodwill is generally determined as the excess of the fair value of the consideration transferred, over the fair value of the net assets acquired and liabilities assumed as of the acquisition date. The Company accounts for merger-related costs, which may include advisory, legal, accounting, valuation, and other professional or consulting fees, as expenses in the periods in which the costs are incurred and the services are received. Goodwill and Other Intangible Assets Goodwill and other identifiable intangible assets are tested for impairment no less than annually in the fourth quarter of each year or when circumstances arise indicating impairment may have occurred. In determining whether impairment has occurred, we consider a number of factors including, but not limited to, operating results, business plans, economic projections, anticipated future cash flows, and current market data. Any impairment identified as part of this testing is recognized in the accompanying consolidated statements of income. There was no impairment recognized related to goodwill or other identifiable intangible assets for the years ended December 31, 2019 and 2018. Core deposit intangible ("CDI") is a measure of the value of depositor relationships resulting from the acquisition of PCB. CDI is amortized on an accelerated method over an estimated useful life of approximately 10 years. Allowance for Loan Losses The allowance for loan losses ("ALLL") is a valuation allowance for probable incurred credit losses inherent within the loan portfolio as of the balance sheet date. Management estimates the allowance balance required using past loan loss experience, the nature and volume of the portfolio, information about specific borrower situations and estimated collateral values, economic conditions, and other factors. Allocations of the allowance may be made for specific loans, but the entire allowance is available for any loan that, in management’s judgment, should be charged-off. Loan losses are charged against the allowance when we believe available information confirms that specific loans, or portions thereof, are uncollectible. Subsequent recoveries, if any, are credited to the allowance. We determine a separate allowance for each portfolio segment. Portfolio segments identified by us include construction and land development, real estate, commercial and industrial, SBA loans and consumer loans. The allowance consists of specific and general reserves. Specific reserves relate to loans that are individually classified as impaired. A loan is impaired when, based on current information and events, it is probable that we will be unable to collect all amounts due according to the contractual terms of the loan agreement. Factors considered in determining impairment include payment status, collateral value and the probability of collecting all amounts when due. Measurement of impairment is based on the expected future cash flows of an impaired loan, which are to be discounted at the loan’s effective interest rate, or measured by reference to an observable market value, if one exists, or the fair value of the collateral for a collateral-dependent loan. We select the measurement method on a loan-by-loan basis except that collateral-dependent loans for which foreclosure is probable are measured at the fair value of the collateral, less estimated selling costs. General reserves cover non-impaired loans and are based on historical loss rates for each portfolio segment or peer group historical data, adjusted for the effects of qualitative or environmental factors that are likely to cause estimated credit losses as of the evaluation date to differ from the portfolio segment’s historical loss experience. Qualitative factors include consideration of the following: changes in lending policies and procedures; changes in economic conditions; changes in the nature and volume of the portfolio; changes in the experience, ability and depth of lending management and other relevant staff; changes in the volume and severity of past due, nonaccrual and other adversely graded loans; changes in the loan review system; changes in the value of the underlying collateral for collateral-dependent loans; concentrations of credit; and the effect of other external factors such as competition and legal and regulatory requirements. Acquired non-PCI loans are recorded at fair value on the date of acquisition with no carryover of the related allowance balance. The premium or discount estimated through the loan fair value calculation is recognized into interest income on an effective interest method or straight-line basis over the remaining contractual life of the loans. Additional credit deterioration on acquired non-PCI loans, in excess of the remaining discount will be recognized in the allowance through the provision for loan losses. Loan Sales and Servicing of Financial Assets We originate SBA loans and sell the guaranteed portions in the secondary market. Servicing assets are recognized separately when they are acquired through sale of loans. Servicing assets are initially recorded at fair value with the income statement effect recorded in gain on sale of loans. Fair value is based on a valuation model that calculates the present value of estimated future net servicing income. The valuation model uses assumptions that market participants would use in estimating the net income stream from the servicing assets, such as the servicing fees, costs to service, discount rates and prepayment speeds. We compare the valuation model inputs and results to published industry data in order to validate the model results and assumptions. Servicing assets are subsequently measured using the amortization method which requires servicing rights to be amortized into noninterest income in proportion to, and over the period of, the estimated future net servicing income of the underlying loans. Servicing assets are evaluated for impairment based upon the fair value of the asset as compared to the carrying amount. Impairment is determined by stratifying servicing assets into groupings based on predominant risk characteristics, such as interest rate, loan type and investor type. For purposes of measuring impairment, we review the total servicing asset. A valuation allowance is recorded when the fair value is below the carrying amount of the total servicing asset. If we later determine that all or a portion of the impairment no longer exists, a reduction of the allowance may be recorded as an increase in income. The fair values of servicing assets are subject to significant fluctuations as a result of changes in estimated and actual prepayments speeds and changes in the discount rates. Deferred Income Taxes Deferred income taxes are computed using the asset and liability method, which recognizes a liability or asset representing the tax effects, based on current tax law, of future deductible or taxable amounts attributable to events that have been recognized in the consolidated financial statements. Deferred tax assets and liabilities are measured using enacted tax rates expected to apply to taxable income in the years in which those temporary differences are expected to be recovered or settled. The effect of a change in tax rates on deferred tax assets and liabilities is recognized in earnings in the period that includes the enactment date. A valuation allowance is established to reduce the deferred tax asset to the level at which it is “more likely than not” that the tax asset or benefits will be realized. We have adopted guidance issued by the Financial Accounting Standards Board (“FASB”) that clarifies the accounting for uncertainty in tax positions taken or expected to be taken on a tax return and provides that the tax effects from an uncertain tax position can be recognized in the consolidated financial statements only if, based on its merits, the position is more likely than not to be sustained on audit by the taxing authorities. Income tax positions must meet a more likely than not recognition threshold to be recognized. For tax positions not meeting the more likely than not recognition threshold, no tax benefit is recorded. The Company recognizes interest and / or penalties related to income tax matters in income tax expense. Refer to Note 11 - Income Taxes to the Consolidated Financial Statements included in Item 8 Financial Statements and Supplementary Data, of this Annual Report. Recent Accounting Guidance Not Yet Effective The impact that recently issued accounting standards will have on our consolidated financial statements is contained in Note 1 - Basis of Presentation and Summary of Significant Accounting Policies to the Consolidated Financial Statements included in Item 8 Financial Statements and Supplementary Data, of this Annual Report.

<s>[INST] Overview First Choice Bancorp, headquartered in Cerritos, California, is a California corporation that was incorporated on September 1, 2017 and is the registered bank holding company for First Choice Bank. Incorporated in March 2005 and commencing commercial bank operations in August 2005, First Choice Bank is a Californiachartered member bank. References herein to “First Choice Bancorp,” “Bancorp,” or the “holding company,” refer to First Choice Bancorp on a standalone basis. The words “we,” “us,” “our,” or the “Company” refer to First Choice Bancorp and First Choice Bank collectively and on a consolidated basis. References to the “Bank” refer to First Choice Bank, on a standalone basis. Headquartered in Cerritos, California, the Bank is a communitybased financial institution that serves commercial and consumer clients in diverse communities. The Bank specializes in loans to small to mediumsized businesses and private banking clients, commercial and industrial loans, and commercial real estate loans with a specialization in providing financial solutions for the hospitality industry. The Bank is a Preferred Small Business Administration (“SBA”) Lender. The Bank conducts business through nine fullservice branches and two loan production offices located in Los Angeles, Orange and San Diego Counties. As a Californiachartered member bank, the Bank is primarily regulated by the California Department of Business Oversight (the “DBO”) and the Board of Governors of the Federal Reserve System (the “Federal Reserve”). The Bank’s deposits are insured up to the maximum legal limit by the Federal Deposit Insurance Corporation (the “FDIC”) and, as a result, the FDIC also has examination authority over the Bank. Effective July 31, 2018, we acquired Pacific Commerce Bancorp (“PCB”) and its whollyown subsidiary bank, Pacific Commerce Bank by merger in an allstock transaction. In connection therewith, we issued, in the aggregate, 4,386,816 shares of our common stock in exchange for all of the outstanding shares of PCB common stock and replacement stock options exercisable for 420,393 shares of our common stock in cancellation of PCB stock options. The acquisition has been accounted for using the acquisition method of accounting and, accordingly, the operating results of PCB have been included in the consolidated financial statements since August 1, 2018. Recent Developments Senior Secured Notes Maturity Date Extension Effective December 22, 2019, we extended the maturity date of this line of credit to March 22, 2022. The interest rate decreased from Wall Street Journal Prime + 0.25%, floating to Wall Street Journal Prime, floating (effective January 2, 2020). At the same time, the debt covenants were updated and confirmed as follows (i) Bank leverage ratio greater than or equal to 9.0%, (ii) Bank Tier 1 capital ratio greater than or equal to 11.0% and $150.0 million, (iii) Bank total capital ratio greater than or equal to 12.0%, (iv) Bank CET1 capital ratio greater than or equal to 11.0%, (v) Bank trailing twelve months return on average assets, excluding onetime expense related to the merger with PCB, greater than or equal to 1.0%, (vi) Bank classified assets to Tier 1 capital plus the allowance for loan losses of less than or equal to 35.0%, (vii) certain defined Bank liquidity ratios and (viii) specific concentration levels for commercial real estate and construction and land development loans. Downtown Branch Relocation and Consolidations In December 2019, the Company (1) entered into an agreement to terminate the "Little Tokyo" office lease agreement and (2) relocated the downtown Los Angeles branch to a smaller space within the same building and signed a sublease of the current space which began on January 1, 2020. As a result of these relocation and consolidation efforts, the Company recognized an aftertax impairment charge of $568 thousand, or $0.05 per diluted share, in the fourth quarter of 2 [/INST] Positive. </s>

ARYA SCIENCES ACQUISITION CORP.

2019-03-25

2018-12-31

Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations References to the “company,” “ARYA Sciences Acquisition Corp.,” “our,” “us” or “we” refer to ARYA Sciences Acquisition Corp. The following discussion and analysis of the company’s financial condition and results of operations should be read in conjunction with the financial statements and the notes thereto contained elsewhere in this Annual Report on Form 10-K. Certain information contained in the discussion and analysis set forth below includes forward-looking statements that involve risks and uncertainties. Cautionary Note Regarding Forward-Looking Statements All statements other than statements of historical fact included in this Annual Report on Form 10-K including, without limitation, statements under “Management’s Discussion and Analysis of Financial Condition and Results of Operations” regarding our financial position, business strategy and the plans and objectives of management for future operations, are forward looking statements. When used in this Annual Report on Form 10-K, words such as “may,” “should,” “could,” “would,” “expect,” “plan,” “anticipate,” “believe,” “estimate,” “continue,” or the negative of such terms or other similar expressions, as they relate to us or our management, identify forward looking statements. Factors that might cause or contribute to such a discrepancy include, but are not limited to, those described in our other SEC filings. Such forward looking statements are based on the beliefs of management, as well as assumptions made by, and information currently available to, our management. No assurance can be given that results in any forward-looking statement will be achieved and actual results could be affected by one or more factors, which could cause them to differ materially. The cautionary statements made in this Annual Report on Form 10-K should be read as being applicable to all forward-looking statements whenever they appear in this Annual Report. For these statements, we claim the protection of the safe harbor for forward-looking statements contained in the Private Securities Litigation Reform Act. Actual results could differ materially from those contemplated by the forward-looking statements as a result of certain factors detailed in our filings with the SEC. All subsequent written or oral forward-looking statements attributable to us or persons acting on our behalf are qualified in their entirety by this paragraph. Overview We are a blank check company incorporated on June 29, 2018 (inception) as a Cayman Islands exempted company for the purpose of effecting a merger, share exchange, asset acquisition, share purchase, reorganization or similar business combination with one or more businesses (the “Business Combination”). While we may pursue an acquisition opportunity in any business, industry, sector or geographical location, we focus on industries that complement our management team’s background, and in our search for targets for our Business Combination seek to capitalize on the ability of our management team to identify and acquire a business, focusing on the healthcare or healthcare related industries. In particular, we are targeting North American or European companies in the biotech, pharmaceutical, medical device and therapeutics subsectors where our management has extensive investment experience. The registration statement for our Initial Public Offering was declared effective on October 4, 2018. On October 10, 2018, we consummated the Initial Public Offering of 14,375,000 Units at $10.00 per Unit, generating gross proceeds of $143.75 million, and incurring offering costs of approximately $9.2 million, inclusive of approximately $4.672 million in deferred underwriting commissions. Each Unit consists of one Class A ordinary share and one-half of one redeemable warrant. Each whole public warrant entitles the holder to purchase one Class A ordinary share at a price of $11.50 per share, subject to adjustment. Simultaneously with the closing of the Initial Public Offering, we consummated the private placement of 5,953,125 private placement warrants at a price of $1.00 per private placement warrant to the sponsor, generating gross proceeds of approximately $5.95 million. Each private placement warrant is exercisable for one Class A ordinary share at a price of $11.50 per share. Upon the closing of the Initial Public Offering and private placement, $143.75 million ($10.00 per Unit) of the net proceeds of the Initial Public Offering and certain of the proceeds of the private placement were placed in the trust account, located in the United States at J.P. Morgan Chase Bank, N.A., with Continental Stock Transfer & Trust Company acting as trustee, and will only be invested in U.S. government securities, within the meaning set forth in Section 2(a)(16) of the Investment Company Act, with a maturity of 180 days or less or in any open-ended investment company that holds itself out as a money market fund selected by us meeting the conditions of paragraphs (d)(2), (d)(3) and (d)(4) of Rule 2a-7 of the Investment Company Act, as determined by us, until the earlier of: (i) the completion of a Business Combination and (ii) the distribution of the assets held in the trust account. Our management has broad discretion with respect to the specific application of the net proceeds of the Initial Public Offering and the private placement, although substantially all of the net proceeds are intended to be applied toward consummating an initial Business Combination. If we are unable to complete a Business Combination within 24 months from the closing of the Initial Public Offering, or October 10, 2020, we will (i) cease all operations except for the purpose of winding up, (ii) as promptly as reasonably possible but not more than ten business days thereafter, redeem the public shares, at a per-share price, payable in cash, equal to the aggregate amount then on deposit in the trust account including interest earned on the funds held in the trust account and not previously released to us to pay for our income taxes (less up to $100,000 of interest to pay dissolution expenses), divided by the number of then outstanding public shares, which redemption will completely extinguish public shareholders’ rights as shareholders (including the right to receive further liquidating distributions, if any), subject to applicable law, and (iii) as promptly as reasonably possible following such redemption, subject to the approval of our remaining shareholders and our board of directors, proceed to commence a voluntary liquidation and thereby a formal dissolution of our company, subject in each case to our obligations under Cayman Islands law to provide for claims of creditors and the requirements of other applicable law. Liquidity and Capital Resources As indicated in the accompanying financial statements, at December 31, 2018, we had approximately $1.2 million our operating bank account, and working capital of approximately $1.3 million, and approximately $738,000 of interest available to pay income taxes (less up to $100,000 of interest to pay dissolution expenses). We expect to continue to incur significant costs in pursuit of our initial Business Combination plans. Our liquidity needs have been satisfied prior to the completion of the Initial Public Offering through receipt of a $25,000 capital contribution from our sponsor in exchange for the issuance of the founder shares to our sponsor and a commitment from our sponsor to loan up to $300,000 to us to cover our expenses in connection with our Initial Public Offering. Our sponsor paid for an aggregate of approximately $148,000 to cover for expenses on our behalf under the note agreement. On October 10, 2018, we repaid the note in full and advanced an additional $1,524 to the sponsor. The sponsor repaid this advance back to us on October 12, 2018. Critical Accounting Policy Class A Ordinary Shares Subject to Possible Redemption We account for our Class A ordinary shares subject to possible redemption in accordance with the guidance in FASB ASC Topic 480 “Distinguishing Liabilities from Equity.” Class A ordinary shares subject to mandatory redemption (if any) are classified as liability instruments and are measured at fair value. Conditionally redeemable Class A ordinary shares (including Class A ordinary shares that feature redemption rights that are either within the control of the holder or subject to redemption upon the occurrence of uncertain events not solely within our control) are classified as temporary equity. At all other times, Class A ordinary shares are classified as shareholders’ equity. Our Class A ordinary shares feature certain redemption rights that are considered to be outside of our control and subject to the occurrence of uncertain future events. Accordingly, at December 31, 2018, 13,614,368 Class A ordinary shares subject to possible redemption at the redemption amount are presented as temporary equity, outside of the shareholders’ equity section of our balance sheet. Results of Operations All activity during the year ended December 31, 2018, was in preparation for our formation, the Initial Public Offering and, since the closing of our Initial Public Offering, a search for initial Business Combination candidates. As of December 31, 2018, $1,198,306 was held outside the trust account and was being used to fund the company’s operating expenses. We will not be generating any operating revenues until the closing and completion of our initial Business Combination. For the period from June 29, 2018 (inception) to December 31, 2018, we had net income of approximately $626,600, which consisted of approximately $738,000 in investment income, offset by approximately $112,000 in general and administrative costs. Related Party Transactions Founder Shares On July 5, 2018, our sponsor paid $25,000 to cover certain expenses and offering costs on behalf of our company in consideration of 3,593,750 Class B ordinary shares, par value $0.0001 per share. Prior to the consummation of the Initial Public Offering, our sponsor transferred 30,000 founder shares to each of Kevin Conroy, Dr. Todd Wider and Dr. David Hung, our independent directors. The founder shares will automatically convert into Class A ordinary shares at the time of our initial Business Combination and are subject to certain transfer restrictions. Our sponsor had agreed to forfeit up to 468,750 founder shares to the extent that the over-allotment option was not exercised in full by the underwriters. On October 10, 2018, the underwriters exercised the over-allotment option in full; thus, these founder shares were no longer subject to forfeiture. The initial shareholders agreed, subject to limited exceptions, not to transfer, assign or sell any of their founder shares until the earlier to occur of: (A) one year after the completion of the initial Business Combination or (B) subsequent to the initial Business Combination, (x) if the last sale price of the Class A ordinary shares equals or exceeds $12.00 per share (as adjusted for share splits, share dividends, reorganizations, recapitalizations and the like) for any 20 trading days within any 30-trading day period commencing at least 150 days after the initial Business Combination, or (y) the date on which we complete a liquidation, merger, share exchange or other similar transaction that results in all of our shareholders having the right to exchange their ordinary shares for cash, securities or other property. Private Placement Warrants Concurrently with the closing of the Initial Public Offering, our sponsor purchased 5,953,125 private placement warrants at a price of $1.00 per private placement warrant, generating proceeds of approximately $5.953 million in the private placement. Each private placement warrant is exercisable for one Class A ordinary share at a price of $11.50 per share. A portion of the proceeds from the sale of the private placement warrants was added to the proceeds from the Initial Public Offering held in the trust account. If we do not complete a business combination within 24 months after the closing of our Initial Public Offering, the private placement warrants will expire worthless. The private placement warrants will be non-redeemable and exercisable on a cashless basis so long as they are held by our sponsor or its permitted transferees. Our sponsor and our officers and directors agreed, subject to limited exceptions, not to transfer, assign or sell any of their private placement warrants until 30 days after the completion of the initial Business Combination. Related Party Loans On July 5, 2018, our sponsor agreed to loan us an aggregate of up to $300,000 to cover expenses related to the Initial Public Offering pursuant to a promissory note (the “Note”). This loan is non-interest bearing and payable on the earlier of December 31, 2018 or the completion of the Initial Public Offering. As of December 31, 2018, our sponsor paid for an aggregate of approximately $103,000 to cover for expenses on our behalf under the Note. On October 10, 2018, we repaid the Note in full and advanced an additional $1,524 to the sponsor. The sponsor repaid this advance back to us on October 12, 2018. In addition, in order to finance transaction costs in connection with a Business Combination, our sponsor or an affiliate of our sponsor, or certain of our officers and directors may, but are not obligated to, loan us funds as may be required (“Working Capital Loans”). If we complete a Business Combination, we would repay the Working Capital Loans out of the proceeds of the trust account released to us. Otherwise, the Working Capital Loans would be repaid only out of funds held outside the trust account. In the event that a Business Combination is not completed, we may use a portion of the proceeds held outside the trust account to repay the Working Capital Loans but no proceeds held in the trust account would be used to repay the Working Capital Loans. Except for the foregoing, the terms of such Working Capital Loans, if any, have not been determined and no written agreements exist with respect to such loans. The Working Capital Loans would either be repaid upon consummation of a Business Combination, without interest, or, at the lender’s discretion, up to $1.5 million of such Working Capital Loans may be convertible into warrants of the post Business Combination entity at a price of $1.00 per warrant. The warrants would be identical to the private placement warrants. As of December 31, 2018, there were no outstanding Working Capital Loans under this arrangement. Administrative Support Agreement We agreed, commencing on the effective date of the Initial Public Offering through the earlier of the company’s consummation of a Business Combination and its liquidation, to pay our sponsor a total of $10,000 per month for office space, utilities and secretarial and administrative support. We recognized approximately $29,000 in expenses incurred in connection with the aforementioned arrangements with the related parties on our Statements of Operations for the period from June 29, 2018 (inception) to December 31, 2018. Private Placement of Ordinary Shares Our sponsor has indicated an interest to purchase up to $25 million of our ordinary shares in a private placement that would occur concurrently with the consummation of the initial Business Combination. The funds from such private placement would be used as part of the consideration to the sellers in the initial Business Combination, and any excess funds from such private placement would be used for working capital in the post-transaction company. However, because indications of interest are not binding agreements or commitments to purchase, our sponsor may determine not to purchase any such shares, or to purchase fewer shares than it indicated an interest in purchasing. Furthermore, we are not under any obligation to sell any such shares. Contractual Obligations Registration and Shareholder Rights The holders of founder shares, private placement warrants and warrants that may be issued upon conversion of Working Capital Loans, if any, will be entitled to registration rights (in the case of the founder shares, only after conversion of such shares into Class A ordinary shares) pursuant to a registration and shareholder rights agreement to be entered into upon consummation of the Initial Public Offering. These holders will be entitled to certain demand and “piggyback” registration and shareholder rights. However, the registration and shareholder rights agreement provides that we will not permit any registration statement filed under the Securities Act to become effective until the termination of the applicable lock-up period for the securities to be registered. We will bear the expenses incurred in connection with the filing of any such registration statements. Underwriting Agreement We granted the underwriters a 45-day option from the date of the final prospectus relating to the Initial Public Offering to purchase up to 1,875,000 additional Units to cover over-allotments, if any, at $10.00 per Unit, less underwriting discounts and commissions. The underwriters exercised this option in full on October 10, 2018. The underwriters were entitled to underwriting discounts of $0.275 per Unit, or approximately $3.953 million in the aggregate, paid upon the closing of the Initial Public Offering. An additional fee of $0.325 per Unit, or approximately $4.672 million in the aggregate will be payable to the underwriters for deferred underwriting commissions. The deferred underwriting commissions will become payable to the underwriters from the amounts held in the trust account solely in the event that we complete a Business Combination, subject to the terms of the underwriting agreement. Off-Balance Sheet Arrangements As of December 31, 2018, we did not have any off-balance sheet arrangements as defined in Item 303(a)(4)(ii) of Regulation S-K and did not have any commitments or contractual obligations. JOBS Act On April 5, 2012, the Jumpstart Our Business Startups Act of 2012 (the “JOBS Act”) was signed into law. The JOBS Act contains provisions that, among other things, relax certain reporting requirements for qualifying public companies. We will qualify as an “emerging growth company” and under the JOBS Act will be allowed to comply with new or revised accounting pronouncements based on the effective date for private (not publicly traded) companies. We are electing to delay the adoption of new or revised accounting standards, and as a result, we may not comply with new or revised accounting standards on the relevant dates on which adoption of such standards is required for non-emerging growth companies. As such, our financial statements may not be comparable to companies that comply with public company effective dates.

<s>[INST] Cautionary Note Regarding ForwardLooking Statements All statements other than statements of historical fact included in this Annual Report on Form 10K including, without limitation, statements under “Management’s Discussion and Analysis of Financial Condition and Results of Operations” regarding our financial position, business strategy and the plans and objectives of management for future operations, are forward looking statements. When used in this Annual Report on Form 10K, words such as “may,” “should,” “could,” “would,” “expect,” “plan,” “anticipate,” “believe,” “estimate,” “continue,” or the negative of such terms or other similar expressions, as they relate to us or our management, identify forward looking statements. Factors that might cause or contribute to such a discrepancy include, but are not limited to, those described in our other SEC filings. Such forward looking statements are based on the beliefs of management, as well as assumptions made by, and information currently available to, our management. No assurance can be given that results in any forwardlooking statement will be achieved and actual results could be affected by one or more factors, which could cause them to differ materially. The cautionary statements made in this Annual Report on Form 10K should be read as being applicable to all forwardlooking statements whenever they appear in this Annual Report. For these statements, we claim the protection of the safe harbor for forwardlooking statements contained in the Private Securities Litigation Reform Act. Actual results could differ materially from those contemplated by the forwardlooking statements as a result of certain factors detailed in our filings with the SEC. All subsequent written or oral forwardlooking statements attributable to us or persons acting on our behalf are qualified in their entirety by this paragraph. Overview We are a blank check company incorporated on June 29, 2018 (inception) as a Cayman Islands exempted company for the purpose of effecting a merger, share exchange, asset acquisition, share purchase, reorganization or similar business combination with one or more businesses (the “Business Combination”). While we may pursue an acquisition opportunity in any business, industry, sector or geographical location, we focus on industries that complement our management team’s background, and in our search for targets for our Business Combination seek to capitalize on the ability of our management team to identify and acquire a business, focusing on the healthcare or healthcare related industries. In particular, we are targeting North American or European companies in the biotech, pharmaceutical, medical device and therapeutics subsectors where our management has extensive investment experience. The registration statement for our Initial Public Offering was declared effective on October 4, 2018. On October 10, 2018, we consummated the Initial Public Offering of 14,375,000 Units at $10.00 per Unit, generating gross proceeds of $143.75 million, and incurring offering costs of approximately $9.2 million, inclusive of approximately $4.672 million in deferred underwriting commissions. Each Unit consists of one Class A ordinary share and onehalf of one redeemable warrant. Each whole public warrant entitles the holder to purchase one Class A ordinary share at a price of $11.50 per share, subject to adjustment. Simultaneously with the closing of the Initial Public Offering, we consummated the private placement of 5,953,125 private placement warrants at a price of $1.00 per private placement warrant to the sponsor, generating gross proceeds of approximately $5.95 million. Each private placement warrant is exercisable for one Class A ordinary share at a price of $11.50 per share. Upon the closing of the Initial Public Offering and private placement, $143.75 million ($10.00 per Unit) of the net proceeds of the Initial Public Offering and certain of the proceeds of the private placement were placed in the trust account, located in the United States at J.P. Morgan Chase Bank, N.A., with Continental Stock Transfer & Trust Company acting as trustee, and will only be invested in U.S. government securities, within the meaning set forth in Section 2(a)(16) of the Investment Company Act, with a maturity [/INST] Negative. </s>

ARYA SCIENCES ACQUISITION CORP.

2020-03-06

2019-12-31

Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations References to the “company,” “ARYA Sciences Acquisition Corp.,” “our,” “us” or “we” refer to ARYA Sciences Acquisition Corp. The following discussion and analysis of the company’s financial condition and results of operations should be read in conjunction with the financial statements and the notes thereto contained elsewhere in this Annual Report on Form 10-K. Certain information contained in the discussion and analysis set forth below includes forward-looking statements that involve risks and uncertainties. Cautionary Note Regarding Forward-Looking Statements All statements other than statements of historical fact included in this Annual Report on Form 10-K including, without limitation, statements under “Management’s Discussion and Analysis of Financial Condition and Results of Operations” regarding our financial position, business strategy and the plans and objectives of management for future operations, are forward looking statements. When used in this Annual Report on Form 10-K, words such as “may,” “should,” “could,” “would,” “expect,” “plan,” “anticipate,” “believe,” “estimate,” “continue,” or the negative of such terms or other similar expressions, as they relate to us or our management, identify forward looking statements. Factors that might cause or contribute to such a discrepancy include, but are not limited to, those described in our other SEC filings. Such forward looking statements are based on the beliefs of management, as well as assumptions made by, and information currently available to, our management. No assurance can be given that results in any forward-looking statement will be achieved and actual results could be affected by one or more factors, which could cause them to differ materially. The cautionary statements made in this Annual Report on Form 10-K should be read as being applicable to all forward-looking statements whenever they appear in this Annual Report. For these statements, we claim the protection of the safe harbor for forward-looking statements contained in the Private Securities Litigation Reform Act. Actual results could differ materially from those contemplated by the forward-looking statements as a result of certain factors detailed in our filings with the SEC. All subsequent written or oral forward-looking statements attributable to us or persons acting on our behalf are qualified in their entirety by this paragraph. Overview We are a blank check company incorporated on June 29, 2018 (inception) as a Cayman Islands exempted company for the purpose of effecting a merger, share exchange, asset acquisition, share purchase, reorganization or similar business combination with one or more businesses. While we may pursue an acquisition opportunity in any business, industry, sector or geographical location, we focus on industries that complement our management team’s background, and in our search for targets for our business combination seek to capitalize on the ability of our management team to identify and acquire a business, focusing on the healthcare or healthcare related industries. In particular, we are targeting North American or European companies in the biotech, pharmaceutical, medical device and therapeutics subsectors where our management has extensive investment experience. Our Sponsor is ARYA Sciences Holdings, a Cayman Islands exempted limited company. The registration statement for our Initial Public Offering was declared effective on October 4, 2018. On October 10, 2018, we consummated the Initial Public Offering of 14,375,000 Units at $10.00 per Unit, generating gross proceeds of $143.75 million, and incurring offering costs of approximately $9.2 million, inclusive of approximately $4.672 million in deferred underwriting commissions. Each Unit consists of one Class A ordinary share and one-half of one redeemable warrant. Each whole Public Warrant entitles the holder to purchase one Class A ordinary share at a price of $11.50 per share, subject to adjustment. Simultaneously with the closing of the Initial Public Offering, we consummated the private placement of 5,953,125 private placement warrants at a price of $1.00 per private placement warrant to the sponsor, generating gross proceeds of approximately $5.95 million. Each private placement warrant is exercisable for one Class A ordinary share at a price of $11.50 per share. Upon the closing of the Initial Public Offering and Private Placement, $143.75 million ($10.00 per Unit) of the net proceeds of the Initial Public Offering and certain of the proceeds of the Private Placement were placed in the Trust Account, located in the United States at J.P. Morgan Chase Bank, N.A., with Continental Stock Transfer & Trust Company acting as trustee, and will only be invested in U.S. government securities, within the meaning set forth in Section 2(a)(16) of the Investment Company Act, with a maturity of 180 days or less or in any open-ended investment company that holds itself out as a money market fund selected by us meeting the conditions of paragraphs (d)(2), (d)(3) and (d)(4) of Rule 2a-7 of the Investment Company Act, as determined by us, until the earlier of: (i) the completion of a business combination and (ii) the distribution of the assets held in the Trust Account. Our management has broad discretion with respect to the specific application of the net proceeds of the Initial Public Offering and the Private Placement, although substantially all of the net proceeds are intended to be applied toward consummating a business combination. If we are unable to complete a business combination within 24 months from the closing of the Initial Public Offering, or October 10, 2020, we will (i) cease all operations except for the purpose of winding up, (ii) as promptly as reasonably possible but not more than ten business days thereafter, redeem the Public Shares, at a per-share price, payable in cash, equal to the aggregate amount then on deposit in the Trust Account including interest earned on the funds held in the Trust Account and not previously released to us to pay for our income taxes (less up to $100,000 of interest to pay dissolution expenses), divided by the number of then outstanding Public Shares, which redemption will completely extinguish public shareholders’ rights as shareholders (including the right to receive further liquidating distributions, if any), subject to applicable law, and (iii) as promptly as reasonably possible following such redemption, subject to the approval of our remaining shareholders and our board of directors, proceed to commence a voluntary liquidation and thereby a formal dissolution of our company, subject in each case to our obligations under Cayman Islands law to provide for claims of creditors and the requirements of other applicable law. Results of Operations All activity up to December 31, 2019 was in preparation for our formation, the Initial Public Offering and, since the closing of our Initial Public Offering, a search for business combination candidates. We will not be generating any operating revenues until the closing and completion of our business combination. For the year ended December 31, 2019, we had net income of approximately $2.6 million, which consisted of approximately $3.4 million in investment income, offset by approximately $775,000 in general and administrative costs. For the period from June 29, 2018 (inception) through December 31, 2018, we had net income of approximately $627,000, which consisted of approximately $738,000 in investment income, offset by approximately $112,000 in general and administrative costs. Going Concern Consideration At December 31, 2019, we had approximately $874,000 in our operating bank account, and working capital of approximately $552,000. Our liquidity needs were satisfied through receipt of a $25,000 capital contribution from our Sponsor in exchange for the issuance of the Founder Shares to the Sponsor, approximately $148,000 in note payable to related parties, and the net proceeds of the Private Placement not held in the Trust Account for working capital needs. We repaid the note back to the Sponsor in October 2018. In connection with our assessment of going concern considerations in accordance with Financial Accounting Standard Board’s Accounting Standards Updated (“ASU”) 2014-15, “Disclosure of Uncertainties about an Entity’s Ability to Continue as a Going Concern”, management has determined that the mandatory liquidation and subsequent dissolution raises substantial doubt about our ability to continue as a going concern. No adjustments have been made to the carrying amounts of assets or liabilities should we be required to liquidate after October 10, 2020. Related Party Transactions Founder Shares On July 5, 2018, our Sponsor paid $25,000 to cover certain expenses and offering costs on behalf of our company in consideration of 3,593,750 Class B ordinary shares, par value $0.0001 per share. Prior to the consummation of the Initial Public Offering, our sponsor transferred 30,000 founder shares to each of Kevin Conroy, Dr. Todd Wider and Dr. David Hung, our independent directors. The founder shares will automatically convert into Class A ordinary shares at the time of our initial business combination and are subject to certain transfer restrictions. Our sponsor had agreed to forfeit up to 468,750 founder shares to the extent that the over-allotment option was not exercised in full by the underwriters. On October 10, 2018, the underwriters exercised the over-allotment option in full; thus, these founder shares were no longer subject to forfeiture. The initial shareholders agreed, subject to limited exceptions, not to transfer, assign or sell any of their founder shares until the earlier to occur of: (A) one year after the completion of the initial business combination or (B) subsequent to the initial business combination, (x) if the last sale price of the Class A ordinary shares equals or exceeds $12.00 per share (as adjusted for share splits, share dividends, reorganizations, recapitalizations and the like) for any 20 trading days within any 30-trading day period commencing at least 150 days after the initial business combination, or (y) the date on which we complete a liquidation, merger, share exchange or other similar transaction that results in all of our shareholders having the right to exchange their ordinary shares for cash, securities or other property. Private Placement Warrants Concurrently with the closing of the Initial Public Offering, our Sponsor purchased 5,953,125 private placement warrants at a price of $1.00 per private placement warrant, generating proceeds of approximately $5.953 million in the private placement. Each private placement warrant is exercisable for one Class A ordinary share at a price of $11.50 per share. A portion of the proceeds from the sale of the private placement warrants was added to the proceeds from the Initial Public Offering held in the trust account. If we do not complete a business combination within 24 months after the closing of our Initial Public Offering, the private placement warrants will expire worthless. The private placement warrants will be non-redeemable and exercisable on a cashless basis so long as they are held by our sponsor or its permitted transferees. Our Sponsor and our officers and directors agreed, subject to limited exceptions, not to transfer, assign or sell any of their private placement warrants until 30 days after the completion of the initial business combination. Related Party Loans On July 5, 2018, our Sponsor agreed to loan us an aggregate of up to $300,000 to cover expenses related to the Initial Public Offering pursuant to a promissory note (the “Note”). This loan was non-interest bearing and payable on the earlier of December 31, 2018 or the completion of the Initial Public Offering. Our Sponsor paid an aggregate of approximately $148,000 to cover for expenses on our behalf under the Note. On October 10, 2018, we repaid the Note in full and advanced an additional $1,524 to the Sponsor. The Sponsor repaid this advance back to us on October 12, 2018. In addition, in order to finance transaction costs in connection with a business combination, our Sponsor or an affiliate of our sponsor, or certain of our officers and directors may, but are not obligated to, loan us funds as may be required (“Working Capital Loans”). If we complete a business combination, we would repay the Working Capital Loans out of the proceeds of the Trust Account released to us. Otherwise, the Working Capital Loans would be repaid only out of funds held outside the Trust Account. In the event that a business combination is not completed, we may use a portion of the proceeds held outside the Trust Account to repay the Working Capital Loans but no proceeds held in the Trust Account would be used to repay the Working Capital Loans. Except for the foregoing, the terms of such Working Capital Loans, if any, have not been determined and no written agreements exist with respect to such loans. The Working Capital Loans would either be repaid upon consummation of a business combination, without interest, or, at the lender’s discretion, up to $1.5 million of such Working Capital Loans may be convertible into warrants of the post business combination entity at a price of $1.00 per warrant. The warrants would be identical to the private placement warrants. To date, we had no outstanding borrowings under any Working Capital Loans under this arrangement. Administrative Support Agreement Commencing on the effective date of the Initial Public Offering in October 2018 through the earlier of our consummation of a business combination and our liquidation, we agreed to pay our Sponsor a total of $10,000 per month for office space, utilities and secretarial and administrative support. We recognized $120,000 and $29,000 in expenses in connection with the aforementioned arrangements with the related parties on the Statements of Operations for the year ended December 31, 2019 and for the period from June 29, 2018 (inception) through December 31, 2018, respectively. Private Placement of Ordinary Shares Our Sponsor has indicated an interest to purchase up to $25 million of our ordinary shares in a private placement that would occur concurrently with the consummation of the initial business combination. The funds from such private placement would be used as part of the consideration to the sellers in the initial business combination, and any excess funds from such private placement would be used for working capital in the post-transaction company. However, because indications of interest are not binding agreements or commitments to purchase, our sponsor may determine not to purchase any such shares, or to purchase fewer shares than it indicated an interest in purchasing. Furthermore, we are not under any obligation to sell any such shares. Critical Accounting Policy Marketable Securities Held in Trust Account Our portfolio of investments held in Trust Account are comprised solely of U.S. government securities, within the meaning set forth in Section 2(a)(16) of the Investment Company Act, with a maturity of 180 days or less, classified as trading securities. Trading securities are presented on the balance sheets at fair value at the end of each reporting period. Gains and losses resulting from the change in fair value of these securities is included in gain on marketable securities (net), dividends and interest, held in Trust Account in our statements of operations. The fair value for trading securities is determined using quoted market prices in active markets. Class A Ordinary Shares Subject to Possible Redemption Class A ordinary shares subject to mandatory redemption (if any) are classified as liability instruments and are measured at fair value. Conditionally redeemable Class A ordinary shares (including Class A ordinary shares that feature redemption rights that are either within the control of the holder or subject to redemption upon the occurrence of uncertain events not solely within our control) are classified as temporary equity. At all other times, Class A ordinary shares are classified as shareholders’ equity. Our Class A ordinary shares feature certain redemption rights that are considered to be outside of our control and subject to the occurrence of uncertain future events. Accordingly, at December 31, 2019 and 2018, 13,872,230 and 13,614,368 Class A ordinary shares subject to possible redemption at the redemption amount are presented as temporary equity, outside of the shareholders’ equity section of our balance sheets. Net Income (Loss) Per Ordinary Share Net income (loss) per share is computed by dividing net income by the weighted-average number of ordinary shares outstanding during the period. We have not considered the effect of warrants sold in the Initial Public Offering and Private Placement to purchase 13,140,625 Class A ordinary shares in the calculation of diluted income per share, since their inclusion would be anti-dilutive under the treasury stock method. Our statements of operation include a presentation of income per share for Class A ordinary shares subject to redemption in a manner similar to the two-class method of income per share. Net income per share, basic and diluted for Class A ordinary shares is calculated by dividing the interest income earned on the Trust Account, by the weighted average number of Class A ordinary shares outstanding for the period. Net loss per share, basic and diluted for Class B ordinary shares is calculated by dividing the net income, less income attributable to Public Shares, by the weighted average number of Class B ordinary shares outstanding for the periods. Fair Value of Financial Instruments Fair value is defined as the price that would be received for sale of an asset or paid for transfer of a liability, in an orderly transaction between market participants at the measurement date. GAAP establishes a three-tier fair value hierarchy, which prioritizes the inputs used in measuring fair value. The hierarchy gives the highest priority to unadjusted quoted prices in active markets for identical assets or liabilities (Level 1 measurements) and the lowest priority to unobservable inputs (Level 3 measurements). These tiers include: • Level 1, defined as observable inputs such as quoted prices (unadjusted) for identical instruments in active markets; • Level 2, defined as inputs other than quoted prices in active markets that are either directly or indirectly observable such as quoted prices for similar instruments in active markets or quoted prices for identical or similar instruments in markets that are not active; and • Level 3, defined as unobservable inputs in which little or no market data exists, therefore requiring an entity to develop its own assumptions, such as valuations derived from valuation techniques in which one or more significant inputs or significant value drivers are unobservable. In some circumstances, the inputs used to measure fair value might be categorized within different levels of the fair value hierarchy. In those instances, the fair value measurement is categorized in its entirety in the fair value hierarchy based on the lowest level input that is significant to the fair value measurement. As of December 31, 2019, and 2018, the carrying values of cash, accounts payable and accrued expenses approximate their fair values due to the short-term nature of the instruments. The Company’s investments held in Trust Account is comprised of investments in U.S. Treasury securities with an original maturity of 180 days or less and are recognized at fair value. The fair value of investments held in Trust Account is determined using quoted prices in active markets. Recent Accounting Pronouncements We do not believe that any recently issued, but not yet effective, accounting pronouncements, if currently adopted, would have a material impact on our financial statements. Off-Balance Sheet Arrangements As of December 31, 2019, we did not have any off-balance sheet arrangements as defined in Item 303(a)(4)(ii) of Regulation S-K and did not have any commitments or contractual obligations. Contractual Obligations Registration and Shareholder Rights The holders of founder shares, private placement warrants and warrants that may be issued upon conversion of Working Capital Loans, if any, will be entitled to registration rights (in the case of the founder shares, only after conversion of such shares into Class A ordinary shares) pursuant to a registration and shareholder rights agreement to be entered into upon consummation of the Initial Public Offering. These holders will be entitled to certain demand and “piggyback” registration and shareholder rights. However, the registration and shareholder rights agreement provides that we will not permit any registration statement filed under the Securities Act to become effective until the termination of the applicable lock-up period for the securities to be registered. We will bear the expenses incurred in connection with the filing of any such registration statements. Underwriting Agreement We granted the underwriters a 45-day option from the date of the final prospectus relating to the Initial Public Offering to purchase up to 1,875,000 additional Units to cover over-allotments, if any, at $10.00 per Unit, less underwriting discounts and commissions. The underwriters exercised this option in full on October 10, 2018. The underwriters were entitled to underwriting discounts of $0.275 per Unit, or approximately $3.953 million in the aggregate, paid upon the closing of the Initial Public Offering. An additional fee of $0.325 per Unit, or approximately $4.672 million in the aggregate will be payable to the underwriters for deferred underwriting commissions. The deferred underwriting commissions will become payable to the underwriters from the amounts held in the trust account solely in the event that we complete a business combination, subject to the terms of the underwriting agreement. JOBS Act On April 5, 2012, the Jumpstart Our Business Startups Act of 2012 (the “JOBS Act”) was signed into law. The JOBS Act contains provisions that, among other things, relax certain reporting requirements for qualifying public companies. We will qualify as an “emerging growth company” and under the JOBS Act will be allowed to comply with new or revised accounting pronouncements based on the effective date for private (not publicly traded) companies. We are electing to delay the adoption of new or revised accounting standards, and as a result, we may not comply with new or revised accounting standards on the relevant dates on which adoption of such standards is required for non-emerging growth companies. As such, our financial statements may not be comparable to companies that comply with public company effective dates.

<s>[INST] Cautionary Note Regarding ForwardLooking Statements All statements other than statements of historical fact included in this Annual Report on Form 10K including, without limitation, statements under “Management’s Discussion and Analysis of Financial Condition and Results of Operations” regarding our financial position, business strategy and the plans and objectives of management for future operations, are forward looking statements. When used in this Annual Report on Form 10K, words such as “may,” “should,” “could,” “would,” “expect,” “plan,” “anticipate,” “believe,” “estimate,” “continue,” or the negative of such terms or other similar expressions, as they relate to us or our management, identify forward looking statements. Factors that might cause or contribute to such a discrepancy include, but are not limited to, those described in our other SEC filings. Such forward looking statements are based on the beliefs of management, as well as assumptions made by, and information currently available to, our management. No assurance can be given that results in any forwardlooking statement will be achieved and actual results could be affected by one or more factors, which could cause them to differ materially. The cautionary statements made in this Annual Report on Form 10K should be read as being applicable to all forwardlooking statements whenever they appear in this Annual Report. For these statements, we claim the protection of the safe harbor for forwardlooking statements contained in the Private Securities Litigation Reform Act. Actual results could differ materially from those contemplated by the forwardlooking statements as a result of certain factors detailed in our filings with the SEC. All subsequent written or oral forwardlooking statements attributable to us or persons acting on our behalf are qualified in their entirety by this paragraph. Overview We are a blank check company incorporated on June 29, 2018 (inception) as a Cayman Islands exempted company for the purpose of effecting a merger, share exchange, asset acquisition, share purchase, reorganization or similar business combination with one or more businesses. While we may pursue an acquisition opportunity in any business, industry, sector or geographical location, we focus on industries that complement our management team’s background, and in our search for targets for our business combination seek to capitalize on the ability of our management team to identify and acquire a business, focusing on the healthcare or healthcare related industries. In particular, we are targeting North American or European companies in the biotech, pharmaceutical, medical device and therapeutics subsectors where our management has extensive investment experience. Our Sponsor is ARYA Sciences Holdings, a Cayman Islands exempted limited company. The registration statement for our Initial Public Offering was declared effective on October 4, 2018. On October 10, 2018, we consummated the Initial Public Offering of 14,375,000 Units at $10.00 per Unit, generating gross proceeds of $143.75 million, and incurring offering costs of approximately $9.2 million, inclusive of approximately $4.672 million in deferred underwriting commissions. Each Unit consists of one Class A ordinary share and onehalf of one redeemable warrant. Each whole Public Warrant entitles the holder to purchase one Class A ordinary share at a price of $11.50 per share, subject to adjustment. Simultaneously with the closing of the Initial Public Offering, we consummated the private placement of 5,953,125 private placement warrants at a price of $1.00 per private placement warrant to the sponsor, generating gross proceeds of approximately $5.95 million. Each private placement warrant is exercisable for one Class A ordinary share at a price of $11.50 per share. Upon the closing of the Initial Public Offering and Private Placement, $143.75 million ($10.00 per Unit) of the net proceeds of the Initial Public Offering and certain of the proceeds of the Private Placement were placed in the Trust Account, located in the United States at J.P. Morgan Chase Bank, N.A., with Continental Stock Transfer & Trust Company acting as trustee, and will only be invested in U.S. government securities, within the meaning set forth in Section 2(a)(16) [/INST] Positive. </s>

Retail Value Inc.

2019-03-05

2018-12-31

Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations Retail Value Inc. (“RVI” or the “Company”) (NYSE: RVI) is an Ohio company formed in December 2017 that, as of December 31, 2018, owned and operated a portfolio of 38 assets, composed of 26 continental U.S. assets and 12 assets in Puerto Rico. These properties consisted of retail shopping centers composed of 14 million square feet of Company-owned gross leasable area (“GLA”) and were located in 15 states and Puerto Rico. The Company’s continental U.S. assets comprised 64% and the properties in Puerto Rico comprised 36% of its total combined and consolidated revenue for the year ended December 31, 2018. The Company’s centers have a diverse tenant base that includes national retailers such as Walmart/Sam’s Club, Bed, Bath & Beyond, the TJX Companies (T.J. Maxx, Marshalls and HomeGoods), Best Buy, Gap, PetSmart, Ross Stores, Kohl’s, Dick’s Sporting Goods and Michaels. At December 31, 2018, the aggregate occupancy of the Company’s shopping center portfolio was 89.3%, and the average annualized base rent per occupied square foot was $15.45. The Company intends to realize value for shareholders through the operations and sales of the Company’s assets. Prior to the Company’s separation on July 1, 2018, the Company was a wholly-owned subsidiary of SITE Centers Corp., formerly known as DDR Corp. (“SITE Centers” or the “Parent Company”). Unless otherwise expressly stated or the context otherwise requires, in the case of information as of dates or for periods prior to the Company’s separation from SITE Centers, references to the “Company” and the “RVI Predecessor” refer to the combined and consolidated entities of SITE Centers that owned the assets comprising the Company’s portfolio as of July 1, 2018, assuming that such entities owned only the assets comprising the Company’s portfolio as of July 1, 2018. Executive Summary In order to consummate the Company’s separation from SITE Centers, on July 1, 2018, the Company and SITE Centers entered into a separation and distribution agreement (the “Separation and Distribution Agreement”), pursuant to which, among other things, SITE Centers agreed to transfer properties and certain related assets, liabilities and obligations to RVI and to distribute 100% of the outstanding common shares of RVI to holders of record of SITE Centers’ common shares as of the close of business on June 26, 2018, the record date. On July 1, 2018, the separation date, holders of SITE Centers’ common shares received one common share of RVI for every ten shares of SITE Centers’ common stock held on the record date. In connection with the separation, SITE Centers retained 1,000 shares of RVI’s series A preferred stock (the “RVI Preferred Shares”) having an aggregate dividend preference equal to $190 million, which amount may increase by up to an additional $10 million depending on the amount of aggregate gross proceeds generated by RVI asset sales. In February 2018, the Company incurred $1.35 billion of mortgage financing. The Company expects to focus on realizing value in its portfolio through operations and sales of its assets. The Company primarily intends to use net asset sale proceeds first to repay mortgage debt and then to make distributions to the Company’s preferred and common shareholders. In addition, pursuant to the Separation and Distribution Agreement, and subject to maintaining its status as a Real Estate Investment Trust (“REIT”), the Company has agreed to repay to SITE Centers certain cash balances held in restricted accounts on the separation date in connection with the mortgage loan. The Company has agreed to pay these amounts to SITE Centers as soon as reasonably possible out of its operating cash flow but in no event later than March 31, 2020. From its formation in December 2017 through December 31, 2018, the Company sold the following assets (in thousands): Manager In connection with the Company’s separation from SITE Centers, on July 1, 2018, the Company entered into an external management agreement (the “External Management Agreement”) which, together with various property management agreements, governs the fees, terms and conditions pursuant to which SITE Centers serves as the Company’s manager. The Company does not have any employees. In general, either the Company or SITE Centers may terminate these management agreements on December 31, 2019, or at the end of any six-month renewal period thereafter. Pursuant to the External Management Agreement, the Company pays SITE Centers and certain of its subsidiaries a monthly asset management fee in an aggregate amount of 0.5% per annum of the gross asset value of the Company’s properties (calculated in accordance with the terms of the External Management Agreement). The External Management Agreement also provides for the reimbursement of certain expenses incurred by SITE Centers in connection with the services it provides to the Company along with the payment of transaction-based fees to SITE Centers in the event of any debt financings or change of control transactions. Pursuant to the property management agreements, the Company pays SITE Centers and certain of its subsidiaries a monthly property management fee in an aggregate amount of 3.5% and 5.5% of the gross revenue (as calculated in accordance with the terms of the property management agreements) of the Company’s continental U.S. properties and the Puerto Rico properties, respectively, on a monthly basis. The property management agreements also provide for the payment to SITE Centers of certain leasing commissions and financing fees and a disposition fee of 1% of the gross sale price of each asset sold by the Company. Company Activity The following is a summary of the Company’s operational statistics: Retail Environment and Company Fundamentals The Company continues to see steady demand from a broad range of tenants for its continental U.S. space, even as many tenants continue to adapt to an omni-channel retail environment. Value-oriented tenants continue to take market share from conventional and national chain department stores. New demand for space at the Company’s Puerto Rico properties has been more limited especially among big box and national tenants. The 2018 occupancy rate reflects the impact of unabsorbed vacancy related to Toys “R” Us/Babies “R” Us locations rejected in the retailer’s bankruptcy proceeding in 2018, other bankruptcies and lower occupancy rates within the Puerto Rico portfolio, partially offset by new leasing activity, and the sale of assets with a lower occupancy rate versus the portfolio average. The following table lists the Company’s 10 largest tenants based on total annualized rental revenues as of December 31, 2018: (A) Includes Walmart and Sam’s Club (B) Includes T.J. Maxx, Marshalls and HomeGoods (C) Includes Bed Bath & Beyond, World Market and Christmas Tree Shops (D) Includes Gap and Old Navy Critical Accounting Policies The combined and consolidated financial statements of the Company include the accounts of the Company and all subsidiaries where the Company has financial or operating control. The preparation of financial statements in conformity with generally accepted accounting principles (“GAAP”) requires management to make estimates and assumptions in certain circumstances that affect amounts reported in the accompanying combined and consolidated financial statements and related notes. In preparing these financial statements, management has used available information, including the Company’s and SITE Centers’ history, industry standards and the current economic environment, among other factors, in forming its estimates and judgments of certain amounts included in the Company’s combined and consolidated financial statements, giving due consideration to materiality. It is possible that the ultimate outcome as anticipated by management in formulating its estimates inherent in these financial statements might not materialize. Application of the critical accounting policies described below involves the exercise of judgment and the use of assumptions as to future uncertainties. Accordingly, actual results could differ from these estimates. In addition, other companies may use different estimates that may affect the comparability of the Company’s results of operations to those companies in similar businesses. Revenue Recognition and Accounts Receivable The Company adopted the new accounting guidance for revenue from contracts with customers (“Topic 606”) on January 1, 2018 using the modified retrospective approach, and therefore, the comparative information has not been adjusted. The guidance has been applied to contracts that were not completed as of the date of initial application, January 1, 2018. Most significantly for the real estate industry, leasing transactions are not within the scope of the new standard. A majority of the Company’s tenant-related revenue is recognized pursuant to lease agreements and will be governed by the leasing guidance discussed in Note 3. This new standard and its impact on the Company is more fully described in Note 3, “Summary of Significant Accounting Policies - New Accounting Standards to Be Adopted,” of the Company’s consolidated financial statements included herein. Rental revenue is recognized on a straight-line basis that averages minimum rents over the noncancelable term of the leases. Certain of these leases provide for percentage and overage rents based upon the level of sales achieved by the tenant. Percentage and overage rents are recognized after a tenant’s reported sales have exceeded the applicable sales breakpoint set forth in the applicable lease. The leases also typically provide for tenant reimbursements of common area maintenance and other operating expenses and real estate taxes. Accordingly, revenues associated with tenant reimbursements are recognized in the period in which the expenses are incurred based upon the tenant lease provision. Ancillary and other property-related income, which includes the leasing of vacant space to temporary tenants, is recognized in the period earned. Lease termination fees are included in other revenue and recognized and earned upon termination of a tenant’s lease and relinquishment of space in which the Company has no further obligation to the tenant. Management fees are recorded in the period earned. Fee income derived from the Company’s unconsolidated joint venture investments is recognized to the extent attributable to the unaffiliated ownership interest. Payments received in 2018 and 2017 from the Company’s insurance company related to its claims for business interruption losses incurred as a result of hurricanes are recorded as Business Interruption Income. The Company makes estimates of the collectability of its accounts receivable related to base rents, including straight-line rentals, expense reimbursements and other revenue or income. The Company analyzes accounts receivable, tenant credit worthiness and current economic trends when evaluating the adequacy of the allowance for doubtful accounts. In addition, with respect to tenants in bankruptcy, the Company makes estimates of the expected recovery of pre-petition and post-petition claims in assessing the estimated collectability of the related receivable. The time to resolve these claims may exceed one year. These estimates have a direct impact on the Company’s earnings because a higher bad debt reserve and/or a subsequent write-off in excess of an estimated reserve results in reduced earnings. Combination and Consolidation All significant inter-company balances and transactions have been eliminated in combination and consolidation. Real Estate and Long-Lived Assets Properties are depreciated using the straight-line method over the estimated useful lives of the assets. The Company is required to make subjective assessments as to the useful lives of its properties to determine the amount of depreciation to reflect on an annual basis with respect to those properties. These assessments have a direct impact on the Company’s net income. If the Company were to extend the expected useful life of a particular asset, it would be depreciated over more years and result in less depreciation expense and higher annual net income. On a periodic basis, management assesses whether there are any indicators that the value of real estate assets, including construction in progress, and intangibles may be impaired. A property’s value is impaired only if management’s estimate of the aggregate future cash flows (undiscounted and without interest charges) to be generated by the property are less than the carrying value of the property. The determination of undiscounted cash flows requires significant estimates by management. In management’s estimate of cash flows, it considers factors such as expected future operating income (loss), trends and prospects, the effects of demand, competition and other factors. If the Company is evaluating the potential sale of an asset, the undiscounted future cash flows analysis is probability-weighted based upon management’s best estimate of the likelihood of the alternative courses of action. Subsequent changes in estimated undiscounted cash flows arising from changes in anticipated actions could affect the determination of whether an impairment exists and whether the effects could have a material impact on the Company’s net income. To the extent an impairment has occurred, the loss will be measured as the excess of the carrying amount of the property over the fair value of the property. The Company is required to make subjective assessments as to whether there are impairments in the value of its real estate properties. These assessments have a direct impact on the Company’s net income because recording an impairment charge results in an immediate negative adjustment to net income. If the Company’s estimates of the projected future cash flows, anticipated holding periods or market conditions change, its evaluation of the impairment charges may be different, and such differences could be material to the Company’s combined and consolidated financial statements. Plans to hold properties over longer periods decrease the likelihood of recording impairment losses. The Company allocates the purchase price to assets acquired and liabilities assumed at the date of acquisition. In estimating the fair value of the tangible and intangible assets and liabilities acquired, the Company considers information obtained about each property as a result of its due diligence, marketing and leasing activities. It applies various valuation methods, such as estimated cash flow projections using appropriate discount and capitalization rates, estimates of replacement costs net of depreciation and available market information. If the Company determines that an event has occurred after the initial allocation of the asset or liability that would change the estimated useful life of the asset, the Company will reassess the depreciation and amortization of the asset. The Company is required to make subjective estimates in connection with these valuations and allocations. The Company generally considers assets to be held for sale when the transaction has been approved by the appropriate level of management and there are no known significant contingencies relating to the sale such that the sale of the property within one year is considered probable. This generally occurs when a sales contract is executed with no contingencies and the prospective buyer has significant funds at risk to ensure performance. Measurement of Fair Value-Real Estate The Company is required to assess the value of its real estate assets. The fair value of real estate investments used in the Company’s impairment calculations is estimated based on the price that would be received to sell an asset in an orderly transaction between marketplace participants at the measurement date. Assets without a public market are valued based on assumptions made and valuation techniques used by the Company. The availability of observable transaction data and inputs can make it more difficult and/or subjective to determine the fair value of such assets. As a result, amounts ultimately realized by the Company from investments sold may differ from the fair values presented, and the differences could be material. The valuation of impaired real estate assets is determined using widely accepted valuation techniques including the income capitalization approach or discounted cash flow analysis on the expected cash flows of each asset considering prevailing market capitalization rates, analysis of recent comparable sales transactions, actual sales negotiations, bona fide purchase offers received from third parties and/or consideration of the amount that currently would be required to replace the asset, as adjusted for obsolescence. In general, the Company considers multiple valuation techniques when measuring fair value of an investment. However, in certain circumstances, a single valuation technique may be appropriate. For operational real estate assets, the significant assumptions include the capitalization rate used in the income capitalization valuation as well as the projected property net operating income and expected hold period. For projects under redevelopment or not at stabilization, including the Puerto Rico properties that were significantly impacted by Hurricane Maria, the significant assumptions include the discount rate, the timing for the construction completion and project stabilization and the exit capitalization rate. Valuation of real estate assets is calculated based on market conditions and assumptions made by management at the measurement date, which may differ materially from actual results if market conditions or the underlying assumptions change. Deferred Tax Assets and Tax Liabilities The Company accounts for income taxes related to its taxable REIT subsidiary (“TRS”) under the asset and liability method, which requires the recognition of deferred tax assets and liabilities for the expected future tax consequences of events that have been included in the financial statements. The Company records net deferred tax assets to the extent it believes it is more likely than not that these assets will be realized. In making such determinations, the Company considers all available positive and negative evidence, including forecasts of future taxable income, the reversal of other existing temporary differences, available net operating loss carryforwards, tax planning strategies and recent results of operations. Several of these considerations require assumptions and significant judgment about the forecasts of future taxable income that are consistent with the plans and estimates that the Company is utilizing to manage its business. Based on this assessment, management must evaluate the need for, and amount of, valuation allowances against the Company’s deferred tax assets. The Company would record a valuation allowance to reduce deferred tax assets if and when it has determined that an uncertainty exists regarding their realization, which would increase the provision for income taxes. To the extent facts and circumstances change in the future, adjustments to the valuation allowances may be required. In the event the Company were to determine that it would be able to realize the deferred income tax assets in the future in excess of their net recorded amount, the Company would adjust the valuation allowance, which would reduce the provision for income taxes. The Company makes certain estimates in the determination of the use of valuation reserves recorded for deferred tax assets. These estimates could have a direct impact on the Company’s earnings, as a difference in the tax provision would impact the Company’s earnings. The Company has made estimates in assessing the impact of the uncertainty of income taxes. Accounting standards prescribe a recognition threshold and measurement attribute criteria for the financial statement recognition and measurement of a tax position taken or expected to be taken in a tax return. The standards also provide guidance on de-recognition, classification, interest and penalties, accounting in interim periods, disclosure and transition. These estimates have a direct impact on the Company’s net income because higher tax expense will result in reduced earnings. General and Administrative Expenses Prior to the separation from SITE Centers, general and administrative expenses included an allocation of indirect costs and expenses incurred by SITE Centers related to the Company’s business, primarily consisting of compensation and other general and administrative costs that have been allocated using the relative percentage of property revenue of the Company and SITE Centers management’s knowledge of the Company’s business. The amounts allocated are not necessarily indicative of the actual amount of indirect expenses that would have been recorded had the Company been a separate independent entity. The amount of general and administrative expenses allocated to the Company has a direct impact on its net income or loss. COMPARISON OF 2018, 2017 AND 2016 RESULTS OF OPERATIONS Where used, references to “Comparable Portfolio Properties” reflect shopping center properties owned as of December 31, 2018. Revenues from Operations (in thousands) (A) Includes a reduction associated with Hurricane Maria for the Puerto Rico properties that has been partially defrayed by insurance proceeds as noted in (D) and (E) below. The following table presents the statistics for the Company’s portfolio affecting base and percentage rental revenues: Comparison of 2018 to 2017 The decrease in the occupancy rate primarily was due to a combination of anchor store tenant expirations and tenant bankruptcies. The 2018 occupancy rate reflects the impact of unabsorbed vacancy related to Toys “R” Us/Babies “R” Us locations rejected in the retailer’s bankruptcy proceeding in 2018, other bankruptcies and lower occupancy rates within the Puerto Rico portfolio, partially offset by new leasing activity and the sale of assets with a lower occupancy rate versus the portfolio average. Comparison of 2017 to 2016 The decrease in the 2017 occupancy rate as compared to 2016 was impacted by tenant bankruptcies and lower rates within the Puerto Rico properties. The 2017 occupancy rates above reflect the impact of unabsorbed vacancies related to The Sports Authority and Golfsmith bankruptcies that occurred in 2016 and the hhgregg bankruptcy in 2017. In addition, the overall occupancy rate within the Puerto Rico properties declined in 2017 due to the deterioration in local market fundamentals. (B) Recoveries were approximately 73.7% and 78.5% of reimbursable operating expenses and real estate taxes for the years ended December 31, 2018 and 2017, respectively. The overall decreased percentage of recoveries from tenants for the Comparable Portfolio Properties primarily was attributable to the impact of the occupancy loss discussed above, as well as conversions to gross leases in Puerto Rico where tenants did not separately contribute toward expenses. Also, 2018 was impacted by a reduction in income associated with Hurricane Maria for the Puerto Rico properties that has been partially defrayed by insurance proceeds as noted in (D) and (E) below. In addition, includes a reduction in income associated with disposition of assets as noted in (F) below. (C) Composed of the following (in thousands): Comparison of 2018 to 2017 The Company recorded a lease termination fee of $2.2 million in the period from January 1, 2018 to June 30, 2018 related to the receipt of a building triggered by an anchor tenant’s termination of a ground lease at a shopping center in Erie, Pennsylvania. Comparison of 2017 to 2016 The decrease in Ancillary and other property income in 2017 primarily is attributable to Hurricane Maria for the Puerto Rico properties. The Company recorded a lease termination fee of $8.2 million in 2017 related to the receipt of a 132,700 square-foot building triggered by an anchor tenant not exercising its option under a ground lease at Riverdale Village shopping center in Coon Rapids, Minnesota. (D) Represents payments received from the Company’s insurance company related to its claims for business interruption losses incurred at its Puerto Rico properties associated with Hurricane Maria. (E) The Company did not record $10.8 million and $11.7 million of aggregate revenues in 2018 and 2017, respectively, because of lost tenant revenue attributable to Hurricane Maria that has been partially defrayed by the receipt of business interruption insurance proceeds as noted above. See further discussion in both “Contractual Obligations and Other Commitments” and Note 9, “Commitments and Contingencies,” to the Company’s combined and consolidated financial statements included herein. (F) The changes in total Revenues are composed of the following (in millions): Expenses from Operations (in thousands) (A) The changes in Operating and Maintenance and Real Estate Taxes are composed of the following: Comparison of 2018 to 2017 Comparison of 2017 to 2016 (B) The Company and the RVI Predecessor recorded impairment charges in 2018 related to 10 shopping centers marketed for sale. Changes in (i) an asset’s expected future undiscounted cash flows due to changes in market conditions, (ii) various courses of action that may occur or (iii) holding periods each could result in the recognition of additional impairment charges. Impairment charges are presented in Note 10, “Impairment Charges,” to the Company’s combined and consolidated financial statements included herein. (C) The Hurricane Property Loss is more fully described in “Contractual Obligations and Other Commitments” later in this section and Note 9, “Commitments and Contingencies,” to the Company’s combined and consolidated financial statements included herein. (D) Subsequent to the separation from SITE Centers, primarily represents legal, audit, tax and compliance services and board compensation. Prior to the separation from SITE Centers, primarily represents the allocation of indirect costs and expenses incurred by SITE Centers related to the Company’s business consisting of compensation and other general and administrative expenses that have been allocated using the property revenue of the Company. Included in the allocation for the period from January 1, 2018 to June 30, 2018 and the year ended December 31, 2017, are employee separation charges aggregating $1.1 million and $3.7 million, respectively, related to SITE Centers’ management transition and staffing reduction. (E) Reflects the impact of the write-off of assets due to impairment charges. In addition, the sale of assets in 2018 resulted in a decrease of $9.4 million of expense. Other Income and Expenses (in thousands) (A) At December 31, 2018, the interest rate of the Company’s mortgage loan was 6.0% per annum. Prior to the separation from SITE Centers, the weighted-average interest rate of the Company’s Parent Company unsecured debt and mortgages (based on contractual rates, excluding fair market value adjustments, discounts and debt issuance costs) at December 31, 2017 and 2016 was 4.5% and 4.9%, respectively, per annum. The decrease in interest expense primarily was due to a change in the amount of debt outstanding, as well as the terms due to the issuance of the $1.35 billion mortgage loan in February 2018. In addition, the amount of interest expense allocated from SITE Centers was lower due to the issuance of the mortgage loan. Interest costs capitalized in conjunction with redevelopment projects were $0.8 million for the period from July 1, 2018 to December 31, 2018, $0.1 million for the period from January 1, 2018 to June 30, 2018 and $0.3 million and $1.0 million for the years ended December 31, 2017 and 2016, respectively. The change in the amount of interest costs capitalized is a result of a change in the mix of active redevelopment projects year over year. (B) Includes debt extinguishment costs of $107.1 million, which are primarily a result of costs incurred from the redemption of Parent Company unsecured debt and mortgages repaid in connection with the Company entering into the $1.35 billion mortgage loan. (C) Costs related to the Company’s separation from SITE Centers. (D) Related to the sale of 10 assets for the period from July 1, 2018 to December 31, 2018, two assets for the period from January 1, 2018 to June 30, 2018 and a release of a deferred obligation in 2017. Tax expense and Net Income (Loss) (in thousands) (A) In 2015, the Company completed a tax restructuring related to its assets in Puerto Rico, in accordance with temporary legislation of the Puerto Rico Internal Revenue Code. This election permitted the Company to prepay $18.3 million in taxes to step up its tax basis in the Puerto Rican assets and reduce its effective tax rate from 39% to a 10% withholding tax related to those assets. The Company recorded a tax expense of $3.0 million during 2015 related to the difference in the effective tax rate spread between the tax payment rate and the withholding tax rate. In 2017, the Company recorded a valuation allowance aggregating $10.8 million on the prepaid tax asset triggered by the change in asset-hold period assumptions related to the Puerto Rico properties. The Company wrote-off the remaining $4.0 million Puerto Rico prepaid tax asset as of June 30, 2018. Tax matters are more fully described in Note 3, “Summary of Significant Accounting Policies,” to the Company’s combined and consolidated financial statements included herein. (B) The changes in net income (loss) were due to the following: Comparison of 2018 to 2017 The increase in net income primarily is attributable to lower impairment charges, partially offset by debt extinguishment and transaction costs recorded in 2018. Comparison of 2017 to 2016 The increase in net loss primarily was due to an increase in impairment charges, a valuation allowance recorded in 2017 of the Puerto Rico prepaid tax asset, hurricane property and impairment losses related to Hurricane Maria including lost tenant revenues, higher general and administration expenses due to the allocation of SITE Centers employee severance charges, partially offset by a decrease in interest expense and an increase in property-related revenues in excess of property-related operating expenses. NON-GAAP FINANCIAL MEASURES Funds from Operations and Operating Funds from Operations Definition and Basis of Presentation The Company believes that Funds from Operations, or FFO, and Operating FFO, both non-GAAP financial measures, provide additional and useful means to assess the financial performance of REITs. FFO and Operating FFO are frequently used by the real estate industry, as well as securities analysts, investors and other interested parties, to evaluate the performance of REITs. The Company also believes that FFO and Operating FFO more appropriately measure the core operations of the Company and provide benchmarks to its peer group. FFO excludes GAAP historical cost depreciation and amortization of real estate and real estate investments, which assume that the value of real estate assets diminishes ratably over time. Historically, however, real estate values have risen or fallen with market conditions, and many companies use different depreciable lives and methods. Because FFO excludes depreciation and amortization unique to real estate and gains and losses from depreciable property dispositions, it can provide a performance measure that, when compared year over year, reflects the impact on operations from trends in occupancy rates, rental rates, operating costs, interest costs and acquisition, disposition and development activities. This provides a perspective of the Company’s financial performance not immediately apparent from net income determined in accordance with GAAP. FFO is generally defined and calculated by the Company as net income (loss) (computed in accordance with GAAP), adjusted to exclude (i) gains and losses from disposition of depreciable real estate property, which are presented net of taxes, if any, (ii) impairment charges on depreciable real estate property and (iii) certain non-cash items. These non-cash items principally include real property depreciation and amortization of intangibles. The Company’s calculation of FFO is consistent with the definition of FFO provided by the National Association of Real Estate Investment Trusts (“NAREIT”). In December 2018, NAREIT issued NAREIT Funds From Operations White Paper - 2018 Restatement (“2018 FFO White Paper”). The purpose of the 2018 FFO White Paper was not to change the fundamental definition of FFO but clarify existing guidance and consolidate into a single document, alerts and policy bulletins issued by NAREIT since the last FFO white paper was issued in 2002. The 2018 FFO White Paper is effective starting with first quarter 2019 reporting. Although early adoption for the year ended 2018 is permitted, the Company plans to adopt the clarified disclosures in 2019. The Company does not expect to report any changes in the calculation of FFO related to the clarification in the 2018 FFO White Paper. The Company believes that certain charges and income recorded in its operating results are not comparable or reflective of its core operating performance. Operating FFO is useful to investors as the Company removes non-comparable charges and income to analyze the results of its operations and assess performance of the core operating real estate portfolio. As a result, the Company also computes Operating FFO and discusses it with the users of its financial statements, in addition to other measures such as net income (loss) determined in accordance with GAAP and FFO. Operating FFO is generally defined and calculated by the Company as FFO excluding certain charges and gains that management believes are not comparable and indicative of the results of the Company’s operating real estate portfolio. Such adjustments include gains/losses on the sale of non-depreciable real estate, impairments of non-depreciable real estate, gains/losses on the early extinguishment of debt, net hurricane-related losses, transaction costs and other restructuring type costs. The disclosure of these charges and income is generally requested by users of the Company’s financial statements. The adjustment for these charges and income may not be comparable to how other REITs or real estate companies calculate their results of operations, and the Company’s calculation of Operating FFO differs from NAREIT’s definition of FFO. Additionally, the Company provides no assurances that these charges and income are non-recurring. These charges and income could be reasonably expected to recur in future results of operations. These measures of performance are used by the Company for several business purposes and by other REITs. The Company uses FFO and/or Operating FFO in part (i) as a disclosure to improve the understanding of the Company’s operating results among the investing public, (ii) as a measure of a real estate asset’s performance and (iii) to compare the Company’s performance to that of other publicly traded shopping center REITs. For the reasons described above, management believes that FFO and Operating FFO provide the Company and investors with an important indicator of the Company’s operating performance. They provide recognized measures of performance other than GAAP net income, which may include non-cash items (often significant). Other real estate companies may calculate FFO and Operating FFO in a different manner. The Company’s management recognizes the limitations of FFO and Operating FFO when compared to GAAP’s net income. FFO and Operating FFO do not represent amounts available for dividends, capital replacement or expansion, debt service obligations or other commitments and uncertainties. The Company’s management does not use FFO or Operating FFO as an indicator of the Company’s cash obligations and funding requirements for future commitments or redevelopment activities. Neither FFO nor Operating FFO represents cash generated from operating activities in accordance with GAAP, and neither is necessarily indicative of cash available to fund cash needs. Neither FFO nor Operating FFO should be considered an alternative to net income (computed in accordance with GAAP) or as an alternative to cash flow as a measure of liquidity. FFO and Operating FFO are simply used as additional indicators of the Company’s operating performance. The Company believes that to further understand its performance, FFO and Operating FFO should be compared with the Company’s reported net loss and considered in addition to cash flows determined in accordance with GAAP, as presented in its combined and consolidated financial statements. Reconciliations of these measures to their most directly comparable GAAP measure of net loss have been provided below. Reconciliation Presentation FFO and Operating FFO were as follows (in thousands): Comparison of 2018 to 2017 The decrease in FFO primarily was a result of debt extinguishment charges and transaction costs incurred in connection with the Company’s mortgage loan and the payoff of certain Parent Company indebtedness with proceeds thereof as part of the spin-off transaction. The decrease in Operating FFO primarily was due to the impact of asset sales. Comparison of 2017 to 2016 The decrease in FFO primarily was due to the allocation of SITE Centers’ employee severance charges and a valuation allowance of the Puerto Rico prepaid tax asset partially offset by lower interest expense. The increase in Operating FFO primarily was due to higher property-related revenues in excess of property-related expenses as well as lower interest expense. The Company’s reconciliation of net income (loss) to FFO and Operating FFO is as follows (in thousands). The Company provides no assurances that these charges and income adjusted in the calculation of Operating FFO are non-recurring. These charges and gains could reasonably be expected to recur in future results of operations. (A) The hurricane property loss is summarized as follows (in thousands): (B) Amounts included in other income/expense as follows (in millions): LIQUIDITY, CAPITAL RESOURCES AND FINANCING ACTIVITIES The Company requires capital to fund its operating expenses, capital expenditures and investment activities. Absent the occurrence of an Amortization Period (as described below), the Company’s capital sources may include cash flow from operations as well as availability under its Revolving Credit Agreement (as defined below). Debt outstanding was $988.6 million and $1.1 billion at December 31, 2018 and December 31, 2017, respectively. The Company’s mortgage loan generally requires interest only payments. The Company intends to utilize net asset sale proceeds to repay the principal of the mortgage loan. In January 2019, loan repayments of $27.0 million were made from the use of restricted cash and additional asset sales. Pursuant to the Separation and Distribution Agreement, all unrestricted cash in excess of $1 million was retained by SITE Centers in the separation. In addition, and subject to maintaining its status as a REIT, the Company has agreed to repay SITE Centers for certain cash held in restricted accounts at the time of the separation and other amounts as soon as reasonably possible out of the Company’s operating cash flow but in no event later than March 31, 2020. The amount payable to SITE Centers is $34.0 million at December 31, 2018. While the Company currently believes it has several viable sources to obtain capital and fund its business, including capacity under the Revolving Credit Agreement, no assurance can be provided that its obligations, including the mortgage loan, will be refinanced or repaid as currently anticipated. 2018 Financing Activities Overview In February 2018, certain subsidiaries of the Company entered into a $1.35 billion mortgage loan, discussed below. The proceeds from the loan were used to repay all of the outstanding mortgage debt with respect to the Company’s properties and Parent Company unsecured debt. In connection with this financing, the Company entered into an interest rate cap agreement with a LIBOR strike rate of 3.0% and a notional amount of $1.35 billion. Furthermore, in June 2018, the Company issued the RVI Preferred Shares to SITE Centers. Subject to the Company’s ability to distribute to the holders of the Company’s common shares amounts necessary to maintain its status as a REIT and to avoid payment of U.S. federal income taxes, the RVI Preferred Shares are entitled to a dividend preference for all dividends declared on the Company’s capital stock at any time up to the preference amount, as discussed below. The Company entered into the Revolving Credit Agreement in July 2018, which provides for borrowings of up to $30.0 million. The Company currently believes its existing sources of funds should be adequate for purposes of meeting its short-term liquidity needs. Mortgage Financing On February 14, 2018, certain wholly-owned subsidiaries of the Company entered into a mortgage loan with an initial aggregate principal amount of $1.35 billion. Proceeds of the loan were used to repay all mortgage debt then outstanding with respect to the Company’s properties and Parent Company unsecured debt. The borrowers’ obligations to pay principal, interest and other amounts under the mortgage loan are evidenced by certain promissory notes executed by the borrowers, which are referred to collectively as the notes, and which are secured by, among other things: (i) mortgages encumbering the borrowers’ respective continental U.S. properties (a total of 38 properties at closing), (ii) a pledge of the equity of the Company’s subsidiaries that own the 12 Puerto Rico properties and a pledge of rents and other cash flows, insurance proceeds and condemnation awards in connection with the 12 Puerto Rico properties and (iii) a pledge of any reserves and accounts of any borrower. Subsequent to closing, the originating lenders placed the notes into a securitization trust, which issued and sold mortgage-backed securities to investors. The mortgage loan facility will mature on February 9, 2021, subject to two one-year extensions at borrowers’ option conditioned upon, among other items, (i) an event of default shall not be continuing, (ii) in the case of the first one-year extension option, evidence that the Debt Yield (as defined and calculated in accordance with the loan agreement, but which is the ratio of net cash flow of the continental U.S. properties to the outstanding principal amount of the loan facility) equals or exceeds 11% and the ratio of the outstanding principal amount of the notes to the value of the continental U.S. properties (based on appraisal values determined at the time of the initial closing) is less than 50% and (iii) in the case of the second one-year extension option, evidence that the Debt Yield equals or exceeds 12% and the loan-to-value ratio is less than 45%. The initial weighted-average interest rate applicable to the notes was equal to one-month LIBOR plus a spread of 3.15% per annum, provided that such spread is subject to an increase of 0.25% per annum in connection with any exercise of the first extension option and an additional increase of 0.25% per annum in connection with any exercise of the second extension option. The borrowers are required to maintain an interest rate cap with respect to the principal amount of the notes having (i) during the initial three-year term of the loan, a LIBOR strike rate equal to 3.0% and (ii) with respect to any extension period, a LIBOR strike rate that would result in a debt service coverage ratio of 1.20x based on the continental U.S. properties. Application of voluntary prepayments as described below may cause the weighted-average interest rate to increase over time. As of December 31, 2018, the weighted-average interest rate applicable to the notes was equal to one-month LIBOR plus a spread of 3.2% per annum. The loan facility is structured as an interest only loan throughout the initial three-year term and any exercised extension options. As a result, so long as no Amortization Period (as described below) or event of default exists, any property cash flows available following payment of debt service and funding of certain required reserve accounts (including reserves for payment of real estate taxes, insurance premiums, ground rents, tenant improvements and capital expenditures) will be available to the borrowers to pay operating expenses and for other general corporate purposes. An Amortization Period will be deemed to commence in the event the borrowers fail to achieve a Debt Yield of 10.8% as of March 31, 2019, 11.9% as of September 30, 2019, 14.1% as of March 31, 2020 and 19.2% as of September 30, 2020. The Debt Yield as of December 31, 2018 was 10.4%. During the pendency of an Amortization Period, any property cash flows available following payment of debt service and the funding of certain reserve accounts (including the reserve accounts referenced above and additional reserves established for payment of approved operating expenses, SITE Centers’ management fees, certain public company costs, certain taxes and the minimum cash portion of required REIT distributions) shall be applied to the repayment of the notes. During an Amortization Period, cash flow from the borrowers’ operations will only be made available to the Company to pay required REIT distributions in an amount equal to the minimum portion of required REIT distributions allowed by law to be paid in cash (currently 20%), with the remainder of required REIT distributions during an Amortization Period likely to be paid by the Company in common shares of the Company. Subject to certain conditions described in the mortgage loan agreement, the borrowers may prepay principal amounts outstanding under the loan facility in whole or in part by providing (i) advance notice of prepayment to the lenders and (ii) remitting the prepayment premium described in the mortgage loan agreement. No prepayment premium is required with respect to any prepayments made after March 9, 2019. Additionally, no prepayment premium will apply to prepayments made in connection with permitted property sales. Each continental U.S. property has a portion of the original principal amount of the mortgage loan allocated to it. The amount of proceeds from the sale of an individual continental U.S. property required to be applied towards prepayment of the notes (i.e., the property’s “release price”) will depend upon the Debt Yield at the time of the sale as follows: • if the Debt Yield is less than or equal to 12.0%, the release price is the greater of (i) 100% of the property’s net sale proceeds and (ii) 110% of its allocated loan amount; • if the Debt Yield is greater than 12.0% but less than or equal to 15.0%, the release price is the greater of (i) 90% of the property’s net sale proceeds and (ii) 105% of its allocated loan amount and • if the Debt Yield is greater than 15.0%, the release price is the greater of (i) 80% of the property’s net sale proceeds and (ii) 100% of its allocated loan amount. To the extent the net cash proceeds from the sale of a continental U.S. property that are applied to repay the mortgage loan exceed the amount specified in applicable clause (ii) above with respect to such property, the excess may be applied by the Company as a credit against the release prices applicable to future sales of continental U.S. properties. Once the aggregate principal amount of the notes is less than 20% of the initial notes outstanding, 100% of net proceeds from the sales of continental U.S. properties must be applied toward prepayment of the notes. Properties in Puerto Rico do not have allocated loan amounts or minimum release prices; all proceeds from sales of Puerto Rico properties are required to be used to prepay the notes, except that the borrowers can obtain a release of all of the Puerto Rico properties for a minimum release price of $350 million. Voluntary prepayments made by the borrowers (including prepayments made with proceeds from asset sales) up to the first 25% of notes in the aggregate will be applied ratably to the senior and junior tranches of the notes. All other prepayments (including prepayments made with property cash flows following commencement of any Amortization Period) will be applied to tranches of notes (i) absent an event of default, in descending order of seniority (i.e., such prepayments will first be applied to the most senior tranches of notes) and (ii) following any event of default, in such order as the loan servicer determines in its sole discretion. As a result, the Company expects that the weighted-average interest rate of the notes will increase during the term of the loan facility. In the event of a default, the contract rate of interest on the notes will increase to the lesser of (i) the maximum rate allowed by law or (ii) the greater of (A) 4% above the interest rate otherwise applicable and (B) the Prime Rate (as defined in the mortgage loan) plus 1.0%. The notes contain other terms and provisions that are customary for instruments of this nature. In addition, the Company executed a certain environmental indemnity agreement and a certain guaranty agreement in favor of the lenders under which the Company agreed to indemnify the lenders for certain environmental risks and guarantee the borrowers’ obligations under the exceptions to the non-recourse provisions in the mortgage loan agreement. The mortgage loan agreement includes representations, warranties, affirmative and restrictive covenants and other provisions customary for agreements of this nature. The mortgage loan agreement also includes customary events of default, including, among others, principal and interest payment defaults and breaches of affirmative or negative covenants; the mortgage loan agreement does not contain any financial maintenance covenants. Upon the occurrence of an event of default, the lenders may avail themselves of various customary remedies under the loan agreement and other agreements executed in connection therewith or applicable law, including accelerating the loan facility and realizing on the real property collateral or pledged collateral. Credit Agreement The Company entered into a Credit Agreement (the “Revolving Credit Agreement”) with PNC Bank, National Association (“PNC”). The Revolving Credit Agreement provides for borrowings of up to $30.0 million. The Company’s borrowings under the Revolving Credit Agreement bear interest at variable rates at the Company’s election, based on either (i) LIBOR plus a specified spread ranging from 1.05% to 1.50% depending on the Company’s Leverage Ratio (as defined in the Revolving Credit Agreement) or (ii) the Alternate Base Rate (as defined in the Revolving Credit Agreement) plus a specified spread ranging from 0.05% to 0.50% depending on the Company’s Leverage Ratio. The Company is also required to pay a facility fee on the aggregate revolving commitments at a rate per annum that ranges from 0.15% to 0.30% depending on the Company’s Leverage Ratio. The Revolving Credit Agreement matures on the earliest to occur of (i) February 9, 2021, (ii) the date on which the External Management Agreement is terminated, (iii) the date on which DDR Asset Management, LLC or another wholly-owned subsidiary of SITE Centers ceases to be the “Service Provider” under the External Management Agreement as a result of assignment or operation of law or otherwise and (iv) the date on which the principal amount outstanding under the Company’s $1.35 billion mortgage loan is repaid or refinanced. The affirmative covenants include, but are not limited to: payment of taxes; maintenance of properties; maintenance of insurance; compliance with laws; tangible net worth and conduct of business. The negative covenants include, but are not limited to, restrictions on the ability of the Company (and its wholly-owned subsidiaries) to: contract, create, incur, assume or suffer to exist indebtedness except in certain circumstances; create, incur, assume or suffer to exist liens on properties except in certain circumstances; make or pay dividends or distributions on the Company’s common shares during the existence of a default; merge, liquidate, dissolve or dispose of all or substantially all of the Company’s assets subject to certain exceptions and deal with any affiliate except on fair and reasonable arm’s length terms. Upon the occurrence of certain customary events of default, the Company’s obligations under the Revolving Credit Agreement may be accelerated and the lending commitments thereunder terminated. The Company may not borrow under the Revolving Credit Agreement, and a Default (as defined therein) occurs under the Revolving Credit Agreement, if there is a “Default” under SITE Centers’ corporate credit facility with JPMorgan Chase Bank, N.A., SITE Centers’ corporate credit facility with Wells Fargo Bank, National Association or SITE Centers’ corporate credit facility with PNC. Additionally, the Company may not borrow under the Revolving Credit Agreement if there is a “Default” under the Revolving Credit Agreement or an “Event of Default” under the Company’s $1.35 billion mortgage loan, if the External Management Agreement is no longer in full force and effect or if the Company has delivered or received a notice of termination or a notice of default under the External Management Agreement. The Company’s obligations under the Revolving Credit Agreement are guaranteed by SITE Centers in favor of PNC. In consideration thereof, on July 2, 2018, the Company entered into a guaranty fee and reimbursement letter agreement with SITE Centers pursuant to which the Company has agreed to pay to SITE Centers the following amounts: (i) an annual guaranty commitment fee of 0.20% of the aggregate commitments under the Revolving Credit Agreement, (ii) for all times other than those referenced in clause (iii) below, when any amounts are outstanding under the Revolving Credit Agreement, an amount equal to 5.00% per annum times the average aggregate outstanding daily principal amount of such loans plus the aggregate stated average daily amount of outstanding letters of credit and (iii) in the event SITE Centers pays any amounts to PNC pursuant to SITE Centers’ guaranty and the Company fails to reimburse SITE Centers for such amount within three business days, an amount in cash equal to the amount of such paid obligations plus default interest, which will accrue from the date of such payment by SITE Centers until repaid by the Company at a rate per annum equal to the sum of the LIBOR rate plus 8.50%. Series A Preferred Stock On June 30, 2018, the Company issued RVI Preferred Shares to SITE Centers that are noncumulative and have no mandatory dividend rate. The RVI Preferred Shares rank, with respect to dividend rights and rights upon liquidation, dissolution or winding up of the Company, senior in preference and priority to the Company’s common shares and any other class or series of the Company’s capital stock. Subject to the requirement that the Company distribute to its common shareholders the minimum amount required to be distributed with respect to any taxable year in order for the Company to maintain its status as a REIT and to avoid U.S. federal income taxes, the RVI Preferred Shares will be entitled to a dividend preference for all dividends declared on the Company’s capital stock at any time up to a “preference amount” equal to $190 million in the aggregate, which amount may increase by up to an additional $10 million if the aggregate gross proceeds of the Company’s asset sales subsequent to July 1, 2018 exceed $2.0 billion. Notwithstanding the foregoing, the RVI Preferred Shares are entitled to receive dividends only when, as and if declared by the Company’s Board of Directors and the Company’s ability to pay dividends is subject to any restrictions set forth in the terms of its indebtedness. Upon payment to SITE Centers of aggregate dividends on the RVI Preferred Shares equaling the maximum preference amount of $200 million, the RVI Preferred Shares are required to be redeemed by the Company for $1.00 per share. Subject to the terms of any of the Company’s indebtedness and unless prohibited by Ohio law governing distributions to stockholders, the RVI Preferred Shares must be redeemed upon (i) the Company’s failure to maintain its status as a REIT, (ii) any failure by the Company to comply with the terms of the RVI Preferred Shares or (iii) the consummation of any transaction (including, without limitation, any merger or consolidation) the result of which is that the Company sells, assigns, transfers, conveys or otherwise disposes of all or substantially all of its properties or assets, in one or more related transactions, to any person or entity, or any person or entity, directly or indirectly, becomes the beneficial owner of 40% or more of the Company’s common shares, measured by voting power. The RVI Preferred Shares also contain restrictions on the Company’s ability to invest in joint ventures, acquire assets or properties, develop or redevelop real estate or make loans or advances to third parties. The Company may redeem the RVI Preferred Shares, or any part thereof, at any time at a price payable per share calculated by dividing the number of RVI Preferred Shares outstanding on the redemption date into the difference of (x) $200 million minus (y) the aggregate amount of dividends previously distributed on the RVI Preferred Shares to be redeemed. As of February 15, 2019, no dividends have been paid on the RVI Preferred Shares. Common Shares On July 1, 2018, the Company issued 18,465,165 common shares, $0.10 par value per share, in connection with the separation from SITE Centers. After payment of a dividend on January 25, 2019, to holders of record of the Company’s common shares on December 17, 2018, the Company had 19,043,126 common shares outstanding. See Note 1, “Nature of Business,” and Note 8, “Preferred Stock, Common Shares and Redeemable Preferred Equity.” Dividend Distributions In August 2018, the Company entered into a closing agreement with the Puerto Rico Department of Treasury which provides that the Company will be exempt from Puerto Rico income taxes so long as it qualifies as a REIT in the U.S. and distributes at least 90% of its Puerto Rico net taxable income to its shareholders every year. Distributions of Puerto Rico sourced net taxable income to Company shareholders are subject to a 10% Puerto Rico withholding tax. In order to comply with the terms of the closing agreement, on December 7, 2018, the Company’s Board of Directors declared a common share dividend of $1.30 per share (subject to a 10% withholding tax) payable to holders of record of the Company’s common shares on December 17, 2018 on account of taxable income generated in Puerto Rico in 2018. In order to retain capital given the expected pace of spending on the repair of hurricane damage to the Company’s assets in Puerto Rico, the Board of Directors determined that it was in the Company’s best interest to limit the cash component of the aggregate dividend to 20%, with the remainder payable in the Company’s common shares. The dividend was paid on January 25, 2019, through the payment of approximately $4.3 million in cash and the issuance of 578,233 common shares (after giving effect to the Puerto Rico withholding tax of 10%). The amount of this dividend is expected to exceed the amount of REIT taxable income generated by the Company in 2018. Accordingly, federal income taxes were not incurred by the REIT for 2018. In the future, the Company anticipates making distributions to holders of its common shares to satisfy the requirements to qualify as a REIT and generally not be subject to U.S. federal income and excise tax (other than with respect to operations conducted through the Company’s TRS). U.S. federal income tax law generally requires that a REIT distribute annually to holders of its capital stock at least 90% of its REIT taxable income, without regard to the deduction for dividends paid and excluding net capital gains, and that it pay tax at regular corporate rates to the extent that it annually distributes less than 100% of its REIT taxable income. The Company generally intends to make distributions with respect to each taxable year in an amount at least equal to its REIT taxable income for such taxable year. The Company also anticipates making future distributions to holders of its common shares in order to satisfy the requirements of its closing agreement with the Puerto Rico Department of Treasury in order to be exempt from Puerto Rico income taxes. Although the Company expects to declare and pay distributions on or around the end of each calendar year, the Company’s Board of Directors will evaluate its dividend policy regularly. To the extent that cash available for future distributions is less than the Company’s REIT taxable income or its taxable income generated in Puerto Rico, or if amortization requirements commence with respect to the terms of the mortgage loan, or if the Company determines it is advisable for other reasons, the Company may make a portion of its distributions in the form of common shares, and any such distribution of common shares may be taxable as a dividend to shareholders. The Company may also distribute debt or other securities in the future, which also may be taxable as a dividend to shareholders. Any distributions the Company makes to its shareholders will be at the discretion of the Company’s Board of Directors and will depend upon, among other things, the Company’s actual and anticipated results of operations and liquidity, which will be affected by various factors, including the income from its portfolio, its operating expenses (including management fees and other obligations owing to SITE Centers), repayments of restricted cash balances to SITE Centers in connection with the mortgage loan and other expenditures and the terms of the mortgage financing and the limitations set forth in the mortgage loan agreements. Distributions will also be impacted by the pace and success of the Company’s property disposition strategy. As a result of the terms of the mortgage financing, the Company anticipates that the majority of distributions of sales proceeds to be made to shareholders will not occur until after the mortgage loan has been repaid or refinanced. Furthermore, subject to the Company’s ability to make distributions to the holders of the Company’s common shares in amounts necessary to maintain its status as a REIT and to avoid payment of U.S. federal income taxes, the RVI Preferred Shares will be entitled to a dividend preference for all dividends declared on the Company’s capital stock, at any time up to the preference amount. Subsequent to the payment of dividends on the RVI Preferred Shares equaling the maximum preference amount, the RVI Preferred Shares are required to be redeemed by the Company for an aggregate amount of $1.00 per share. Due to the dividend preference of the RVI Preferred Shares, distributions of sales proceeds to holders of common shares are unlikely to occur until after aggregate dividends have been paid on the RVI Preferred Shares in an amount equal to the maximum preference amount. At this time, the Company cannot predict when or if it will declare dividends to the holders of RVI Preferred Shares and when or if such dividends, if paid, will equal the maximum preference amount. Dispositions For the year ended December 31, 2018, the Company sold 12 shopping centers aggregating 2.5 million square feet, for an aggregate sales price of $401.7 million. In addition, from January 1, 2019 through March 5, 2019, the Company sold two shopping centers, Millenia Plaza in Orlando, Florida, and Lowe’s Home Improvement, in Hendersonville, Tennessee and two outparcels for an aggregate amount of $78.8 million. Cash Flow Activity The Company expects that its core business of leasing space to well capitalized tenants will continue to generate consistent and predictable cash flow after expenses and interest payments. As discussed above, in general, the Company intends to utilize net asset sale proceeds to: first, repay its mortgage loan and any other indebtedness (including any amounts owed to SITE Centers); second, make distributions on account of the RVI Preferred Shares up to the preference amount and third, make distributions to holders of the Company’s common shares. Changes in cash flow compared to the prior comparable period are described as follows (in thousands): Comparison of 2018 to 2017 Operating Activities: Cash provided by operating activities decreased $23.4 million primarily due to reduced operating income from the Puerto Rico portfolio as well as property disposals, transaction costs related to the Company’s separation from SITE Centers and interest rate hedging activities, partially offset by a reduction in allocated costs and expenses from SITE Centers. Investing Activities: Cash provided by investing activities increased $364.5 million primarily due to proceeds from dispositions of real estate. Financing Activities: Cash used for financing activities increased by $235.5 million due to a $202.1 million increase in debt repayments, net of issuances, and loan costs and a $33.5 million increase in net transactions with SITE Centers. CAPITALIZATION At December 31, 2018, the Company’s capitalization consisted of $988.6 million of mortgage debt, $190.0 million of preferred shares and $472.5 million of market equity (market equity is defined as common shares outstanding multiplied by $25.59, the closing price of the Company’s common shares on the New York Stock Exchange at December 31, 2018), resulting in a debt to total market capitalization ratio of 0.60 to 1.0. CONTRACTUAL OBLIGATIONS AND OTHER COMMITMENTS The Company had aggregate outstanding mortgage indebtedness of $988.6 million at December 31, 2018 with a maturity of February 2021. In addition, the Company has two long-term ground leases. These obligations are summarized as follows for the subsequent five years ending December 31 (in millions): (A) Represents interest payments expected to be incurred on the Company’s debt obligations as of December 31, 2018, including capitalized interest. In connection with the separation from SITE Centers, on July 1, 2018, the Company and SITE Centers entered into the Separation and Distribution Agreement, pursuant to which, among other things, SITE Centers transferred properties and certain related assets, liabilities and obligations to the Company and distributed 100% of the outstanding common shares to holders of record of SITE Centers’ common shares as of the close of business on June 26, 2018, the record date. In connection with the separation from SITE Centers, SITE Centers retained the RVI Preferred Shares, which have an aggregate dividend preference equal to $190 million, which amount may increase by up to an additional $10 million depending on the amount of aggregate gross proceeds generated by the Company asset sales. Payable to SITE Centers Pursuant to the terms of the Separation and Distribution Agreement, the Company is obligated to repay SITE Centers for certain cash balances held in restricted cash accounts on the separation date in connection with the Company’s mortgage loan and for certain other amounts. The Company is obligated to repay these amounts to SITE Centers as soon as reasonably possible out of its operating cash flow but in no event later than March 31, 2020. At December 31, 2018, the amount of this obligation totaled $34.0 million and is included in the line item Payable to SITE Centers on the Company’s combined and consolidated balance sheet. Guaranty to SITE Centers On July 2, 2018, SITE Centers provided an unconditional guaranty to PNC with respect to any obligations outstanding from time to time under the Company’s Revolving Credit Agreement. In connection with this arrangement, the Company has agreed to pay to SITE Centers the guaranty commitment fee (credit facility guarantee fee) of 0.20% per annum on the committed amount of the Revolving Credit Agreement and a fee equal to 5.00% per annum on any amounts drawn by the Company under the Revolving Credit Agreement. If in the event SITE Centers pays any of the obligations on the Revolving Credit Agreement and the Company fails to reimburse such amount within three business days, the guaranty provides for default interest that accrues at a rate equal to the sum of the LIBOR rate plus 8.50% per annum. Other Commitments The Company has entered into agreements with general contractors related to its shopping centers aggregating commitments of approximately $19.2 million at December 31, 2018. These obligations, composed principally of construction contracts for the repair of the Puerto Rico properties, are generally due within 12 to 24 months, as the related construction costs are incurred, and are expected to be financed through operating cash flow. The Company routinely enters into contracts for the maintenance of its properties. These contracts typically can be canceled upon 30 to 60 days’ notice without penalty. At December 31, 2018, the Company had purchase order obligations, typically payable within one year, aggregating approximately $0.9 million related to the maintenance of its properties and general and administrative expenses. Hurricane Loss In 2017, Hurricane Maria made landfall in Puerto Rico and the Company’s 12 assets in Puerto Rico, aggregating 4.4 million square feet of Company-owned GLA, were significantly impacted. One of the assets (Plaza Palma Real, consisting of approximately 0.4 million square feet of Company-owned GLA) was severely damaged. At December 31, 2018, three anchor tenants and a few other tenants totaling 0.2 million square feet were open for business approximating 52% of Plaza Palma Real’s Company-owned GLA. The other 11 assets sustained varying degrees of damage, consisting primarily of roof, HVAC system damage and water intrusion. Although some of the tenant spaces remain untenantable, a majority of the Company’s leased space that was open prior to the storm was open for business at December 31, 2018. The Company has engaged various consultants to assist with the damage scoping assessment and restoration work. Restoration work is underway at all of the shopping centers, including Plaza Palma Real. The Company anticipates that the repair and restoration work will be substantially complete by the end of 2019 with certain interior work being completed in 2020. The timing and schedule of additional repair work to be completed are highly dependent upon any changes in the scope of work, the availability of building materials, supplies and skilled labor and the timing and amount of recoveries under the Company’s insurance policies. The Company maintains insurance on its assets in Puerto Rico with policy limits of approximately $330 million for both property damage and business interruption. The Company’s insurance policies are subject to various terms and conditions, including a combined property damage and business interruption deductible of approximately $6.0 million. The Company estimates its aggregate property insurance claim, which includes costs to repair and rebuild, will approximate $160 million, of which $50.2 million had been paid through December 31, 2018 by the insurer. This amount excludes insurance proceeds due from certain continental U.S.-based anchor tenants who maintain their own property insurance on their Company-owned premises and are expected to make the required repairs to their stores at their own expense. In addition, the Company estimates its business interruption claim, which includes costs to clean up and mitigate tenant losses as well as lost revenue, estimated through December 31, 2019, to be approximately $31 million, of which $22.3 million has been paid through December 2018 by the insurer. Of the total amount paid, $15.1 million was received between October 2017 and June 30, 2018 and allocated only to SITE Centers, and $7.2 million was received in the third and fourth quarters of 2018 and allocated between the Company and SITE Centers based upon the period of loss to which the payments related. These estimates are subject to change as the Company continues to assess the costs to repair damage. The Company’s ability to repair its properties, and the cost of such repairs, could be negatively impacted by circumstances and events beyond the Company’s control, such as access to building materials, changes in the scope of work to be performed and the timing and amount of insurance claim proceeds. Therefore, there can be no assurance that the Company’s estimates of property damage and lost rental revenue are accurate. The Company believes it maintains adequate insurance coverage on each of its properties and is working closely with the insurance carrier to obtain the maximum amount of insurance recovery provided under the policies. The insurer has reserved its rights with respect to certain aspects of coverage, and it is possible that the Company’s cost to repair the damages sustained may substantially exceed the amount the Company is ultimately able to recover from the insurer. The Company can give no assurances as to the amount of such recovery, the timing of payments or the resolution of the claims. The Company’s business interruption insurance covers lost revenue through the period of property restoration and for up to 365 days following completion of restoration. For the period from July 1, 2018 to December 31, 2018 and the six months ended June 30, 2018, rental revenues of $4.3 million and $6.6 million, respectively, were not recorded because of lost tenant revenue attributable to Hurricane Maria that has been partially defrayed by insurance proceeds. The Company will record revenue for covered business interruption claims in the period it determines that it is probable it will be compensated. As such, there could be a delay between the rental period and the recording of revenue. The amount of any future lost revenue depends on when properties are fully available for tenants’ re-occupancy which, in turn, is highly dependent upon the timing and progress of repairs. For the period from July 1, 2018 to December 31, 2018 and for the period from January 1, 2018 to June 30, 2018, the Company received insurance proceeds of $4.4 million and $5.1 million, respectively, related to business interruption claims, which is recorded on the Company’s combined and consolidated statements of operations as Business Interruption Income. The Company expects to make claims in future periods for lost revenue. However, there can be no assurance that insurance claims will be resolved favorably to the Company or in a timely manner. See further discussion in “Risk Factors-Damages Sustained on Account of Hurricane Maria May Exceed Insurance Recoveries” and Note 9, “Commitments and Contingencies,” of the Company’s December 31, 2018 combined and consolidated financial statements. Note that pursuant to the terms of the Separation and Distribution Agreement, SITE Centers will be entitled to receive property damage claim proceeds to the extent it incurred unreimbursed repairs costs prior to July 1, 2018 and business interruption claim proceeds to the extent it sustained revenue losses prior to that date. Business interruption proceeds will continue to be recorded to revenue in the period that it is determined that the Company will be compensated. INFLATION Most of the Company’s long-term leases contain provisions designed to mitigate the adverse impact of inflation. Such provisions include clauses enabling the Company to receive additional rental income from escalation clauses that generally increase rental rates during the terms of the leases and/or percentage rentals based on tenants’ gross sales. Such escalations are determined by negotiation, increases in the consumer price index or similar inflation indices. In addition, many of the Company’s leases are for terms of less than 10 years, permitting the Company to seek increased rents at market rates upon renewal. Most of the Company’s leases require the tenants to pay their share of operating expenses, including common area maintenance, real estate taxes, insurance and utilities, thereby reducing the Company’s exposure to increases in costs and operating expenses resulting from inflation. ECONOMIC CONDITIONS Despite recent tenant bankruptcies and increasing e-commerce distribution, the Company believes there is retailer demand for quality locations within well-positioned shopping centers. Further, the Company continues to see demand from a broad range of tenants for its continental U.S. space, particularly in the off-price sector, which the Company believes is a reflection of the general outlook of consumers who are demanding more value for their dollars. The Company also benefits from a diversified tenant base, with only three tenants whose annualized rental revenue equals or exceeds 3% of the Company’s annualized revenues at December 31, 2018 (Walmart/Sam’s Club at 5.2%, TJX Companies, which includes T.J. Maxx, Marshalls and HomeGoods, at 3.5% and Bed Bath & Beyond, which includes Bed Bath & Beyond World Market and Christmas Tree Shops, at 3.1%). Other significant tenants include Best Buy and Ross Stores, both of which have strong credit ratings, remain well-capitalized and have outperformed other retail categories on a relative basis over time. The Company believes these tenants will continue providing a stable revenue base for the foreseeable future, given the long-term nature of these leases. Moreover, the majority of the tenants in the Company’s shopping centers provide day-to-day consumer necessities with a focus toward value and convenience, which the Company believes will enable many of its tenants to outperform even in a challenging economic environment. Property revenues are generally derived from tenants with good credit profiles under long-term leases, with very little reliance on overage rents generated by tenant sales performance. The Company recognizes the risks posed by the economy, but believes that the general diversity and credit quality of its tenant base should enable it to successfully navigate through a potentially challenging retail environment. The retail sector continues to be affected by the competitive nature of the retail business, including the impact of e-commerce and the competition for market share, as well as general economic conditions, where stronger retailers have out-positioned many of their weaker peers. These shifts can lead to store downsizing, closures and tenant bankruptcies. In some cases, the loss of a weaker tenant or downsizing of space creates a value-add opportunity such as re-leasing space to a stronger retailer. There can be no assurance that the loss of a tenant or downsizing of space will not adversely affect the Company in the future (see Item 1A. Risk Factors). On October 15, 2018, Sears Holdings filed for Chapter 11 bankruptcy protection. The Company leases three locations to Sears Holdings, all of which are located in Puerto Rico. These three leases comprise approximately 280,000 square feet and account for approximately $1.5 million of annualized base rent (0.8% of the Company’s annualized base rent as of December 31, 2018). On February 11, 2019, the Bankruptcy Court approved the sale of Sears Holdings’ assets to an affiliate of ESL Investments, Inc. Through the sale, ESL acquired the right to designate Sears’ leases for assumption and assignment, or rejection. The designation deadline is April 12, 2019. In the event ESL directs Sears Holdings to cease operations at these locations or reject these leases during the bankruptcy process, certain other tenants at these properties have the right to terminate their leases or abate rent under the co-tenancy provisions of their agreements with the Company, which could have a material impact on the Company’s rental revenues and results of operations. The Company believes that the quality of its shopping center portfolio is generally strong, as evidenced by the occupancy rates and in the average annualized base rent per occupied square foot. The shopping center portfolio occupancy was 89.3% and 90.6% at December 31, 2018 and 2017, respectively. The net decrease in the rate primarily was attributed to tenant bankruptcies, in particular Toys “R” Us, and lower occupancy rates within the Puerto Rico portfolio. The total portfolio average annualized base rent per occupied square foot was $15.45 at December 31, 2018, as compared to $15.37 at December 31, 2017. At December 31, 2018, the Company owned 12 assets on the island of Puerto Rico aggregating 4.4 million square feet representing 32% of Company-owned GLA. The 12 owned assets represent approximately 36% of both the Company’s total combined and consolidated revenue and the Company’s combined and consolidated revenue less operating expenses (i.e., net operating income) for the year ended December 31, 2018. There is continued concern about the status of the Puerto Rican economy, the ability of the government of Puerto Rico to meet its financial obligations and the impact of territory’s ongoing bankruptcy and debt restructuring process on the economy of Puerto Rico. The impact of Hurricane Maria has further exacerbated the concerns. The Company’s assets experienced varying degrees of damage due to the hurricane. The Company has been actively working with its insurer with respect to both its property damage and business interruption claims. See Note 9, “Commitments and Contingencies,” to the Company’s combined and consolidated financial statements. The Company believes that the tenants at its Puerto Rico assets (several of which are U.S. retailers such as Walmart/Sam’s Club and the TJX Companies (T.J. Maxx and Marshalls)) typically cater to the local consumer’s desire for value and convenience, often provide consumers with day-to-day necessities and represent a source of stable, high-quality cash flow for the Company’s assets. In addition to its goal of maximizing cash flow from property operations, the Company seeks to realize profits through the regular sale of assets to a variety of buyers. The market upon which this aspect of the business plan relies is currently characterized as liquid but fragmented, with a wide range of generally small, non-institutional investors. While some investors do not require debt financing, many seek to capitalize on leveraged returns using mortgage financing at interest rates well below the initial asset-level returns implied by disposition prices. In addition to small, often local buyers, the Company also plans to transact with mid-sized institutional investors, some of which are domestic and foreign publicly traded companies. Many larger domestic institutions, such as pension funds and insurance companies that were traditionally large buyers of retail real estate assets, have generally become less active participants in transaction markets over the last several years. Lower participation of institutions and a generally smaller overall buyer pool has resulted in some level of pressure on retail asset prices, though this impact remains highly heterogeneous and varies widely by market and specific assets. Asset prices for retail real estate in Puerto Rico remain highly uncertain due to lack of transaction activity since Hurricane Maria. New Accounting Standards New Accounting Standards are more fully described in Note 3, “Summary of Significant Accounting Policies,” of the Company’s combined and consolidated financial statements. FORWARD-LOOKING STATEMENTS Management’s Discussion and Analysis of Financial Condition and Results of Operations should be read in conjunction with the Company’s combined and consolidated financial statements and the notes thereto appearing elsewhere in this report. Historical results and percentage relationships set forth in the Company’s combined and consolidated financial statements, including trends that might appear, should not be taken as indicative of future operations. The Company considers portions of this information to be “forward-looking statements” within the meaning of Section 27A of the Securities Act of 1933 and Section 21E of the Securities Exchange Act of 1934 (the “Exchange Act”), both as amended, with respect to the Company’s expectations for future periods. Forward-looking statements include, without limitation, statements related to acquisitions (including any related pro forma financial information) and other business development activities, future capital expenditures, financing sources and availability and the effects of environmental and other regulations. Although the Company believes that the expectations reflected in these forward-looking statements are based upon reasonable assumptions, it can give no assurance that its expectations will be achieved. For this purpose, any statements contained herein that are not statements of historical fact should be deemed to be forward-looking statements. Without limiting the foregoing, the words “will,” “believes,” “anticipates,” “plans,” “expects,” “seeks,” “estimates” and similar expressions are intended to identify forward-looking statements. Readers should exercise caution in interpreting and relying on forward-looking statements because such statements involve known and unknown risks, uncertainties and other factors that are, in some cases, beyond the Company’s control and that could cause actual results to differ materially from those expressed or implied in the forward-looking statements and that could materially affect the Company’s actual results, performance or achievements. For additional factors that could cause the results of the Company to differ materially from those indicated in the forward-looking statements (see Item 1A. Risk Factors). Factors that could cause actual results, performance or achievements to differ materially from those expressed or implied by forward-looking statements include, but are not limited to, the following: • The Company may be unable to dispose of properties on favorable terms or at all, especially in markets or regions experiencing deteriorating economic conditions and properties anchored by tenants experiencing financial challenges. In addition, real estate investments can be illiquid, particularly as prospective buyers may experience increased costs of financing or difficulties obtaining financing due to local, national or global conditions; • The Company is subject to general risks affecting the real estate industry, including the need to enter into new leases or renew leases on favorable terms to generate rental revenues, and any economic downturn may adversely affect the ability of the Company’s tenants, or new tenants, to enter into new leases or the ability of the Company’s existing tenants to renew their leases at rates at least as favorable as their current rates; • The Company could be adversely affected by changes in the local markets where its properties are located, as well as by adverse changes in regional or national economic and market conditions; • The Company may fail to anticipate the effects on its properties of changes in consumer buying practices, including sales over the Internet and the resulting retailing practices and space needs of its tenants, or a general downturn in its tenants’ businesses, which may cause tenants to close stores or default in payment of rent; • The Company is subject to competition for tenants from other owners of retail properties, and its tenants are subject to competition from other retailers and methods of distribution. The Company is dependent upon the successful operations and financial condition of its tenants, in particular its major tenants. The bankruptcy of major tenants could result in a loss of significant rental income and could give rise to termination or rent abatement by other tenants under the co-tenancy clauses of their leases; • The Company relies on major tenants, which makes it vulnerable to changes in the business and financial condition of, or demand for its space by, such tenants; • The Company’s financial condition may be affected by required debt service payments, the risk of default and restrictions on its ability to incur additional debt or to enter into certain transactions under documents governing its debt obligations. In addition, it may encounter difficulties in refinancing existing debt. Borrowings under the mortgage loan or the revolving credit facility are subject to certain representations and warranties and customary events of default, including any event that has had or could reasonably be expected to have a material adverse effect on the Company’s business or financial condition; • Changes in interest rates could adversely affect the market price of the Company’s common shares, its performance and cash flow, and its ability to sell assets and the sales prices applicable thereto; • Debt and/or equity financing necessary for the Company to continue to operate its business or to refinance existing indebtedness may not be available or may not be available on favorable terms; • Disruptions in the financial markets could affect the Company’s ability to obtain financing or to refinance existing indebtedness on reasonable terms and have other adverse effects on the Company and the market price of the Company’s common shares; • The ability of the Company to pay dividends on its common shares in excess of its REIT taxable income is generally subject to its ability to first declare and pay aggregate dividends on the RVI Preferred Shares in an amount equal to the preference amount; • The Company is subject to complex regulations related to its status as a REIT and would be adversely affected if it failed to qualify as a REIT; • The Company must make distributions to shareholders to continue to qualify as a REIT, and if the Company must borrow funds to make distributions, those borrowings may not be available on favorable terms or at all; • The outcome of litigation, including litigation with tenants, may adversely affect the Company’s results of operations and financial condition; • The Company may not realize anticipated returns from its 12 real estate assets located in Puerto Rico, which carry risks in addition to those it faces with its continental U.S. properties and operations; • Property damage, expenses related thereto, and other business and economic consequences (including the potential loss of revenue) resulting from extreme weather conditions in locations where the Company owns properties; • Sufficiency and timing of any insurance recovery payments related to damages from extreme weather conditions; • The Company is subject to potential environmental liabilities; • The Company may incur losses that are uninsured or exceed policy coverage due to its liability for certain injuries to persons, property or the environment occurring on its properties; • The Company could incur additional expenses to comply with or respond to claims under the Americans with Disabilities Act or otherwise be adversely affected by changes in government regulations, including changes in environmental, zoning, tax and other regulations; • The Company’s Board of Directors, which regularly reviews the Company’s business strategy and objectives, may change its strategic plan; • A change in the Company’s relationship with SITE Centers and SITE Centers’ ability to retain qualified personnel and adequately manage the Company and • Potential conflicts of interest with SITE Centers and the Company’s ability to replace SITE Centers as manager (and the fees to be paid to any replacement manager) in the event the management agreements are terminated.

<s>[INST] Retail Value Inc. (“RVI” or the “Company”) (NYSE: RVI) is an Ohio company formed in December 2017 that, as of December 31, 2018, owned and operated a portfolio of 38 assets, composed of 26 continental U.S. assets and 12 assets in Puerto Rico. These properties consisted of retail shopping centers composed of 14 million square feet of Companyowned gross leasable area (“GLA”) and were located in 15 states and Puerto Rico. The Company’s continental U.S. assets comprised 64% and the properties in Puerto Rico comprised 36% of its total combined and consolidated revenue for the year ended December 31, 2018. The Company’s centers have a diverse tenant base that includes national retailers such as Walmart/Sam’s Club, Bed, Bath & Beyond, the TJX Companies (T.J. Maxx, Marshalls and HomeGoods), Best Buy, Gap, PetSmart, Ross Stores, Kohl’s, Dick’s Sporting Goods and Michaels. At December 31, 2018, the aggregate occupancy of the Company’s shopping center portfolio was 89.3%, and the average annualized base rent per occupied square foot was $15.45. The Company intends to realize value for shareholders through the operations and sales of the Company’s assets. Prior to the Company’s separation on July 1, 2018, the Company was a whollyowned subsidiary of SITE Centers Corp., formerly known as DDR Corp. (“SITE Centers” or the “Parent Company”). Unless otherwise expressly stated or the context otherwise requires, in the case of information as of dates or for periods prior to the Company’s separation from SITE Centers, references to the “Company” and the “RVI Predecessor” refer to the combined and consolidated entities of SITE Centers that owned the assets comprising the Company’s portfolio as of July 1, 2018, assuming that such entities owned only the assets comprising the Company’s portfolio as of July 1, 2018. Executive Summary In order to consummate the Company’s separation from SITE Centers, on July 1, 2018, the Company and SITE Centers entered into a separation and distribution agreement (the “Separation and Distribution Agreement”), pursuant to which, among other things, SITE Centers agreed to transfer properties and certain related assets, liabilities and obligations to RVI and to distribute 100% of the outstanding common shares of RVI to holders of record of SITE Centers’ common shares as of the close of business on June 26, 2018, the record date. On July 1, 2018, the separation date, holders of SITE Centers’ common shares received one common share of RVI for every ten shares of SITE Centers’ common stock held on the record date. In connection with the separation, SITE Centers retained 1,000 shares of RVI’s series A preferred stock (the “RVI Preferred Shares”) having an aggregate dividend preference equal to $190 million, which amount may increase by up to an additional $10 million depending on the amount of aggregate gross proceeds generated by RVI asset sales. In February 2018, the Company incurred $1.35 billion of mortgage financing. The Company expects to focus on realizing value in its portfolio through operations and sales of its assets. The Company primarily intends to use net asset sale proceeds first to repay mortgage debt and then to make distributions to the Company’s preferred and common shareholders. In addition, pursuant to the Separation and Distribution Agreement, and subject to maintaining its status as a Real Estate Investment Trust (“REIT”), the Company has agreed to repay to SITE Centers certain cash balances held in restricted accounts on the separation date in connection with the mortgage loan. The Company has agreed to pay these amounts to SITE Centers as soon as reasonably possible out of its operating cash flow but in no event later than March 31, 2020. From its formation in December 201 [/INST] Positive. </s>

Retail Value Inc.

2020-03-02

2019-12-31

Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations Retail Value Inc. (“RVI” or the “Company”) (NYSE: RVI) is an Ohio company formed in December 2017 that, as of December 31, 2019, owned and operated a portfolio of 28 assets, composed of 16 continental U.S. assets and 12 assets in Puerto Rico. These properties consisted of retail shopping centers composed of 11.4 million square feet of Company-owned gross leasable area (“GLA”) and were located in 11 states and Puerto Rico. The Company’s continental U.S. assets comprised 55% and the properties in Puerto Rico comprised 45% of its total consolidated revenue for the year ended December 31, 2019. The Company’s centers have a diverse tenant base that includes national retailers such as Walmart/Sam’s Club, Bed, Bath & Beyond, PetSmart, the TJX Companies (T.J. Maxx, Marshalls and HomeGoods), Kohl’s, Best Buy and Gap. At December 31, 2019, the aggregate occupancy of the Company’s shopping center portfolio was 87.3%, and the average annualized base rent per occupied square foot was $15.72. Prior to the Company’s separation on July 1, 2018, the Company was a wholly-owned subsidiary of SITE Centers Corp. (“SITE Centers” or the “Parent Company”). Unless otherwise expressly stated or the context otherwise requires, in the case of information as of dates or for periods prior to the Company’s separation from SITE Centers, references to the “Company” and the “RVI Predecessor” refer to the combined and consolidated entities of SITE Centers that owned the assets comprising the Company’s portfolio as of July 1, 2018, assuming that such entities owned only the assets comprising the Company’s portfolio as of July 1, 2018. EXECUTIVE SUMMARY The Company expects to focus on realizing value in its portfolio through operations and sales of its assets. The Company primarily intends to use net asset sale proceeds first to repay mortgage debt, second to make distributions on account of the RVI Preferred Shares, up to the preference amount, and third to make distributions to holders of the Company’s common shares. In March 2019, the Company entered into a mortgage loan in the aggregate principal amount of $900 million in order to refinance and prepay all amounts outstanding under its February 2018 mortgage loan, which had an original principal balance of $1.35 billion. The Company incurred costs of $20.2 million in connection with the financing, which included a $1.8 million debt financing fee paid to SITE Centers. On July 1, 2018, in order to consummate the Company’s separation from SITE Centers, the Company and SITE Centers entered into a separation and distribution agreement (the “Separation and Distribution Agreement”), pursuant to which, among other things, SITE Centers agreed to transfer properties and certain related assets, liabilities and obligations to RVI and to distribute 100% of the outstanding common shares of RVI to holders of record of SITE Centers’ common shares as of the close of business on June 26, 2018, the record date. On July 1, 2018, the separation date, holders of SITE Centers’ common shares received one common share of RVI for every ten shares of SITE Centers’ common stock held on the record date. In connection with the separation, SITE Centers retained 1,000 shares of RVI’s series A preferred stock (the “RVI Preferred Shares”) having an aggregate dividend preference equal to $190 million, which amount may increase by up to an additional $10 million depending on the amount of aggregate gross proceeds generated by RVI asset sales. From its formation in December 2017 through December 31, 2019, the Company sold the following assets (in thousands): Manager In connection with the Company’s separation from SITE Centers, on July 1, 2018, the Company entered into an external management agreement (the “External Management Agreement”) which, together with various property management agreements, governs the fees, terms and conditions pursuant to which SITE Centers serves as the Company’s manager. The Company does not have any employees. In general, either the Company or SITE Centers may terminate these management agreements on June 30, 2020, or at the end of any six-month renewal period thereafter. Pursuant to the External Management Agreement, the Company pays SITE Centers and certain of its subsidiaries a monthly asset management fee in an aggregate amount of 0.5% per annum of the gross asset value of the Company’s properties (calculated in accordance with the terms of the External Management Agreement). The External Management Agreement also provides for the reimbursement of certain expenses incurred by SITE Centers in connection with the services it provides to the Company along with the payment of transaction-based fees to SITE Centers in the event of any debt financings or change of control transactions. Pursuant to the property management agreements, the Company pays SITE Centers and certain of its subsidiaries a monthly property management fee in an aggregate amount of 3.5% and 5.5% of the gross revenue (as calculated in accordance with the terms of the property management agreements) of the Company’s continental U.S. properties and the Puerto Rico properties, respectively, on a monthly basis. The property management agreements also provide for the payment to SITE Centers of certain leasing commissions and a disposition fee of 1% of the gross sale price of each asset sold by the Company. Company Activity The following is a summary of the Company’s operational statistics: Retail Environment and Company Fundamentals Though leasing prospects are heavily dependent on local conditions, in general the Company continues to see demand from a broad range of tenants for its continental U.S. space, as many tenants continue to adapt to an omni-channel retail environment. Value-oriented tenants continue to take market share from conventional and national chain department stores. Some conventional department stores and national chains have announced bankruptcies, store closures and/or reduced expansion plans in recent years leading to a smaller overall number of tenants requiring large store formats. New demand for space at the Company’s Puerto Rico properties has been somewhat limited especially among big box and national tenants. The 2019 occupancy rate reflects the impact of asset dispositions and a combination of anchor and store tenant lease expirations and tenant bankruptcies. The following table lists the Company’s 10 largest tenants based on total annualized rental revenues as of December 31, 2019: (A) Includes Walmart and Sam’s Club (B) Includes Bed Bath & Beyond, World Market and Christmas Tree Shops (C) Includes T.J. Maxx, Marshalls and HomeGoods (D) Includes Gap and Old Navy CRITICAL ACCOUNTING POLICIES The combined and consolidated financial statements of the Company include the accounts of the Company and all subsidiaries where the Company has financial or operating control. The preparation of financial statements in conformity with generally accepted accounting principles (“GAAP”) requires management to make estimates and assumptions in certain circumstances that affect amounts reported in the accompanying combined and consolidated financial statements and related notes. In preparing these financial statements, management has used available information, including the Company’s and SITE Centers’ history, industry standards and the current economic environment, among other factors, in forming its estimates and judgments of certain amounts included in the Company’s combined and consolidated financial statements, giving due consideration to materiality. It is possible that the ultimate outcome as anticipated by management in formulating its estimates inherent in these financial statements might not materialize. Application of the critical accounting policies described below involves the exercise of judgment and the use of assumptions as to future uncertainties. Accordingly, actual results could differ from these estimates. In addition, other companies may use different estimates that may affect the comparability of the Company’s results of operations to those companies in similar businesses. Revenue Recognition and Accounts Receivable The Company has adopted Accounting Standards Update No. 2016-02-Leases, as amended (“Topic 842”) as of January 1, 2019, using the modified retrospective approach by applying the transition provisions at the beginning of the period of adoption. Rental Income includes contractual lease payments that generally include the following: • Fixed lease payments, which include fixed payments associated with expense reimbursements from tenants for common area maintenance, taxes and insurance from tenants in shopping centers, are recognized on a straight-line basis over the non-cancelable term of the lease, which generally ranges from one month to 30 years, and include the effects of applicable rent steps and abatements. • Variable lease payments, which include percentage and overage income, which are recognized after a tenant’s reported sales have exceeded the applicable sales breakpoint set forth in the applicable lease. • Variable lease payments associated with expense reimbursements from tenants for common area maintenance, taxes, insurance and other property operating expenses, based upon the tenant’s lease provisions, which are recognized in the period the related expenses are incurred. • Lease termination payments, which are recognized upon the effective termination of a tenant’s lease when the Company has no further obligations under the lease. • Ancillary and other property-related rental payments, primarily composed of leasing vacant space to temporary tenants, kiosk income, and parking income, which are recognized in the period earned. Payments received from the Company’s insurance company related to its claims for business interruption losses incurred as a result of hurricane losses are recorded as Business Interruption Income. The Company makes estimates of the collectability of its accounts receivable related to base rents, including straight-line rentals, expense reimbursements and other revenue or income. Upon adoption of Topic 842, rental income for the periods beginning on or after January 1, 2019, has been reduced for amounts the Company believes are not probable of being collected. The Company analyzes accounts receivable, tenant credit worthiness and current economic trends when evaluating the probability of collection. In addition, with respect to tenants in bankruptcy, the Company makes estimates of the expected recovery of pre-petition and post-petition claims in assessing the probability of collection of the related receivable. The time to resolve these claims may exceed one year. These estimates have a direct impact on the Company’s earnings because once the amount is not considered probable of being collected, earnings are reduced by a corresponding amount until the receivable is collected. Combination and Consolidation All significant inter-company balances and transactions have been eliminated in combination and consolidation. Real Estate and Long-Lived Assets Properties are depreciated using the straight-line method over the estimated useful lives of the assets. The Company is required to make subjective assessments as to the useful lives of its properties to determine the amount of depreciation to reflect on an annual basis with respect to those properties. These assessments have a direct impact on the Company’s net income. If the Company were to extend the expected useful life of a particular asset, it would be depreciated over more years and result in less depreciation expense and higher annual net income. On a periodic basis, management assesses whether there are any indicators that the value of real estate assets, including construction in progress, and intangibles may be impaired. A property’s value is impaired only if management’s estimate of the aggregate future cash flows (undiscounted and without interest charges) to be generated by the property are less than the carrying value of the property. The determination of undiscounted cash flows requires significant estimates by management. In management’s estimate of cash flows, it considers factors such as expected future operating income (loss), trends and prospects, the effects of demand, competition and other factors. If the Company is evaluating the potential sale of an asset, the undiscounted future cash flows analysis is probability-weighted based upon management’s best estimate of the likelihood of the alternative courses of action. Subsequent changes in estimated undiscounted cash flows arising from changes in anticipated actions could affect the determination of whether an impairment exists and whether the effects could have a material impact on the Company’s net income. To the extent an impairment has occurred, the loss will be measured as the excess of the carrying amount of the property over the fair value of the property. The Company is required to make subjective assessments as to whether there are impairments in the value of its real estate properties. These assessments have a direct impact on the Company’s net income because recording an impairment charge results in an immediate negative adjustment to net income. If the Company’s estimates of the projected future cash flows, anticipated holding periods or market conditions change, its evaluation of the impairment charges may be different, and such differences could be material to the Company’s combined and consolidated financial statements. Plans to hold properties over longer periods decrease the likelihood of recording impairment losses. The Company generally considers assets to be held for sale when the transaction has been approved by the appropriate level of management and there are no known significant contingencies relating to the sale such that the sale of the property within one year is considered probable. This generally occurs when a sales contract is executed with no contingencies and the prospective buyer has significant funds at risk to ensure performance. Measurement of Fair Value-Real Estate The Company is required to assess the value of its real estate assets. The fair value of real estate investments used in the Company’s impairment calculations is estimated based on the price that would be received from the sale of an asset in an orderly transaction between marketplace participants at the measurement date. Assets without a public market are valued based on assumptions made and valuation techniques used by the Company. The availability of observable transaction data and inputs can make it more difficult and/or subjective to determine the fair value of such assets. As a result, amounts ultimately realized by the Company from assets sold may differ from the fair values presented, and the differences could be material. The valuation of impaired real estate assets is determined using widely accepted valuation techniques including the income capitalization approach or discounted cash flow analysis on the expected cash flows of each asset considering prevailing market capitalization rates, analysis of recent comparable sales transactions, actual sales negotiations, bona fide purchase offers received from third parties and/or consideration of the amount that currently would be required to replace the asset, as adjusted for obsolescence. In general, the Company considers multiple valuation techniques when measuring fair value of an investment. However, in certain circumstances, a single valuation technique may be appropriate. For operational real estate assets, the significant assumptions include the capitalization rate used in the income capitalization valuation, as well as the projected property net operating income and expected hold period. For the Puerto Rico properties that were significantly impacted by Hurricane Maria, the significant assumptions include the discount rate, the timing for the construction completion and project stabilization and the exit capitalization rate. Valuation of real estate assets is calculated based on market conditions and assumptions made by management at the measurement date, which may differ materially from actual results if market conditions or the underlying assumptions change. Deferred Tax Assets and Tax Liabilities The Company accounts for income taxes related to its taxable REIT subsidiary (“TRS”) under the asset and liability method, which requires the recognition of deferred tax assets and liabilities for the expected future tax consequences of events that have been included in the financial statements. The Company records net deferred tax assets to the extent it believes it is more likely than not that these assets will be realized. In making such determinations, the Company considers all available positive and negative evidence, including forecasts of future taxable income, the reversal of other existing temporary differences, available net operating loss carryforwards, tax planning strategies and recent results of operations. Several of these considerations require assumptions and significant judgment about the forecasts of future taxable income that are consistent with the plans and estimates that the Company is utilizing to manage its business. Based on this assessment, management must evaluate the need for, and amount of, valuation allowances against the Company’s deferred tax assets. The Company would record a valuation allowance to reduce deferred tax assets if and when it has determined that an uncertainty exists regarding their realization, which would increase the provision for income taxes. To the extent facts and circumstances change in the future, adjustments to the valuation allowances may be required. In the event the Company were to determine that it would be able to realize the deferred income tax assets in the future in excess of their net recorded amount, the Company would adjust the valuation allowance, which would reduce the provision for income taxes. The Company makes certain estimates in the determination of the use of valuation reserves recorded for deferred tax assets. These estimates could have a direct impact on the Company’s earnings, as a difference in the tax provision would impact the Company’s earnings. The Company has made estimates in assessing the impact of the uncertainty of income taxes. Accounting standards prescribe a recognition threshold and measurement attribute criteria for the financial statement recognition and measurement of a tax position taken or expected to be taken in a tax return. The standards also provide guidance on de-recognition, classification, interest and penalties, accounting in interim periods, disclosure and transition. These estimates have a direct impact on the Company’s net income because higher tax expense will result in reduced earnings. General and Administrative Expenses Prior to the separation from SITE Centers, general and administrative expenses included an allocation of indirect costs and expenses incurred by SITE Centers related to the Company’s business, primarily consisting of compensation and other general and administrative costs that have been allocated using the relative percentage of property revenue of the Company and SITE Centers management’s knowledge of the Company’s business. The amounts allocated are not necessarily indicative of the actual amount of indirect expenses that would have been recorded had the Company been a separate independent entity. The amount of general and administrative expenses allocated to the Company has a direct impact on its net income or loss. COMPARISON OF 2019 AND 2018 RESULTS OF OPERATIONS Where used, references to “Comparable Portfolio Properties” reflect shopping center properties owned as of December 31, 2019. The discussion of the Company’s 2019 performance compared to 2018 appears below in “Comparison of 2019 and 2018 Results of Operations.” The discussion of the Company’s 2018 performance compared to 2017 performance is set forth in Part II, Item 7. “Management’s Discussion and Analysis of Financial Condition and Results of Operations - Comparison of 2018, 2017 and 2016 Results of Operations,” of the Company’s Annual Report on Form 10-K for the fiscal year ended December 31, 2018. Revenues from Operations (in thousands) (A) Includes a reduction associated with Hurricane Maria for the Puerto Rico properties that has been partially defrayed by insurance proceeds as noted in (B) and (C) below. In addition, the Company adopted Topic 842 using the modified retrospective approach as of January 1, 2019, and elected to apply the transition provisions of the standard at the beginning of the period of adoption. As the Company adopted the practical expedient with regard to not separating lease and non-lease components, all rental income earned pursuant to tenant leases, including the provision for uncollectible amounts, is reflected as one line item, “Rental Income,” in the consolidated statements of operations. See further discussion of 2018 reclassification impact in Note 3, “Summary of Significant Accounting Policies,” to the Company’s combined and consolidated financial statements included herein. The following tables summarize the key components of the 2019 rental income as compared to 2018: (1) The following table presents the statistics for the Company’s portfolio affecting base and percentage rental revenues: The decrease in the occupancy rate primarily was due to disposition of higher occupancy properties and a combination of tenant expirations and tenant bankruptcies. (2) Recoveries from Comparable Portfolio Properties were approximately 71.9% and 73.0% of reimbursable operating expenses and real estate taxes for the years ended December 31, 2019 and 2018, respectively. The overall decrease in the amount of recoveries from tenants related to the disposition of higher occupancy assets as noted in (D) below along with the impact of anchor tenant vacancies and conversions to gross leases in Puerto Rico. The recovery percentage was impacted by the adoption of Topic 842, which resulted in certain financial statement presentation changes that reduced Rental Income but had no impact on net income. (3) Classified in Operating and Maintenance Expense for the period from January 1, 2018 to June 30, 2018 and for the period from July 1, 2018 to December 31, 2018. (B) Represents payments received from the Company’s insurer related to its claims for business interruption losses incurred at its Puerto Rico properties associated with Hurricane Maria. The insurance claims were settled in August 2019. (C) The Company did not record $2.9 million and $10.8 million of aggregate revenues for the years ended December 31, 2019 and 2018, respectively, because of lost tenant revenue attributable to Hurricane Maria that has been partially defrayed by the receipt of business interruption insurance proceeds as noted in (B) above. See further discussion in both “Contractual Obligations and Other Commitments” below and Note 10, “Commitments and Contingencies,” to the Company’s combined and consolidated financial statements included herein related to the Company’s insurance claim. (D) The changes in Total Revenues are composed of the following (in millions): Expenses from Operations (in thousands) (A) The changes in Operating and Maintenance and Real Estate Taxes are composed of the following (in millions): The increase in Operating and Maintenance for the Comparable Portfolio Properties is primarily a result of increased insurance premiums. The decrease in real estate taxes for the Comparable Portfolio Properties is a result of the adoption of Topic 842. (B) The Company and the RVI Predecessor recorded impairment charges in 2019 and 2018 related to shopping centers marketed for sale. Changes in (i) holding periods, (ii) various courses of action that may occur or (iii) an asset’s expected future undiscounted cash flows due to changes in market or leasing conditions each could result in the recognition of additional impairment charges. Impairment charges are presented in Note 11, “Impairment Charges,” to the Company’s combined and consolidated financial statements included herein. (C) The Hurricane Property Insurance (Income) Loss is more fully described in “Contractual Obligations and Other Commitments” later in this section and Note 10, “Commitments and Contingencies,” to the Company’s combined and consolidated financial statements included herein. (D) Subsequent to the separation from SITE Centers, primarily represents legal, audit, tax and compliance services and director compensation. Prior to the separation from SITE Centers, primarily represented the allocation of indirect costs and expenses incurred by SITE Centers related to the Company’s business consisting of compensation and other general and administrative expenses that have been allocated using the property revenue of the Company. Included in the allocation for the period from January 1, 2018 to June 30, 2018, are employee separation charges aggregating $1.1 million related to SITE Centers’ management transition and staffing reduction. (E) The disposition of shopping centers accounts for $21.3 million in the reduction of depreciation expense. Other Income and Expenses (in thousands) (A) At December 31, 2019 and 2018, the interest rate of the Company’s mortgage loan was 4.4% and 6.0% per annum, respectively. The decrease in interest expense primarily was due to a change in the amount of debt outstanding, as well as the lower interest rate applicable to the Company’s mortgage loan refinancing consummated in March 2019. In addition, interest expense in 2018 included expense allocated from SITE Centers prior to the incurrence of the Company’s original mortgage loan in February 2018. Interest costs capitalized in conjunction with capital projects were $1.1 million for the year ended December 31, 2019 and $0.8 million for the period from July 1, 2018 to December 31, 2018 and $0.1 million for the period from January 1, 2018 to June 30, 2018. The change in the amount of interest costs capitalized is a result of the restoration work in Puerto Rico. (B) In 2019, included debt extinguishment costs of $12.7 million, which were recorded primarily in connection with the Company entering into the $900.0 million mortgage loan in March. See further discussion in Note 7, “Mortgage Indebtedness,” to the Company’s combined and consolidated financial statements included herein. In 2018, included debt extinguishment costs of $107.1 million, which were primarily a result of costs incurred from the redemption of Parent Company unsecured debt and mortgages repaid in connection with the Company entering into the original mortgage loan in February 2018. (C) Costs related to the Company’s separation from SITE Centers. (D) Related to the sale of 10 assets and two outparcels for the year ended December 31, 2019, 10 assets for the period from July 1, 2018 to December 31, 2018 and two assets for the period from January 1, 2018 to June 30, 2018. Net Income (Loss) (in thousands) The increase in net income primarily is attributable to the August 2019 settlement of the hurricane property and business interruption insurance claims relating to the Puerto Rico assets and a decrease in debt extinguishments costs and transaction costs relating to the repayment of the Parent Company indebtedness and the Company’s separation from SITE Centers in 2018. NON-GAAP FINANCIAL MEASURES Funds from Operations and Operating Funds from Operations Definition and Basis of Presentation The Company believes that Funds from Operations, or FFO, and Operating FFO, both non-GAAP financial measures, provide additional and useful means to assess the financial performance of REITs. FFO and Operating FFO are frequently used by the real estate industry, as well as securities analysts, investors and other interested parties, to evaluate the performance of REITs. The Company also believes that FFO and Operating FFO more appropriately measure the core operations of the Company and provide benchmarks to its peer group. In December 2018, the National Association of Real Estate Investment Trusts (“NAREIT”) issued NAREIT Funds From Operations White Paper - 2018 Restatement (the “2018 FFO White Paper”). The purpose of the 2018 FFO White Paper was not to change the fundamental definition of FFO but to clarify existing guidance and to consolidate into a single document, alerts and policy bulletins issued by NAREIT since the last FFO white paper was issued in 2002. The 2018 FFO White Paper was effective starting with first quarter 2019 reporting. The Company did not report any changes in the calculation of FFO in 2019 related to the clarification in the 2018 FFO White Paper. FFO excludes GAAP historical cost depreciation and amortization of real estate and real estate investments, which assume that the value of real estate assets diminishes ratably over time. Historically, however, real estate values have risen or fallen with market conditions, and many companies use different depreciable lives and methods. Because FFO excludes depreciation and amortization unique to real estate and gains and losses from property dispositions, it can provide a performance measure that, when compared year over year, reflects the impact on operations from trends in occupancy rates, rental rates, operating costs, interest costs and acquisition, disposition and development activities. This provides a perspective of the Company’s financial performance not immediately apparent from net income determined in accordance with GAAP. FFO is generally defined and calculated by the Company as net income (loss) (computed in accordance with GAAP), adjusted to exclude (i) gains and losses from disposition of real estate property and related investments, which are presented net of taxes, if any, (ii) impairment charges on real estate property and related investments and (iii) certain non-cash items. These non-cash items principally include real property depreciation and amortization of intangibles. The Company’s calculation of FFO is consistent with the definition of FFO provided by NAREIT. The Company believes that certain charges and income recorded in its operating results are not comparable or reflective of its core operating performance. Operating FFO is useful to investors as the Company removes non-comparable charges and income to analyze the results of its operations and assess performance of the core operating real estate portfolio. As a result, the Company also computes Operating FFO and discusses it with the users of its financial statements, in addition to other measures such as net income (loss) determined in accordance with GAAP and FFO. Operating FFO is generally defined and calculated by the Company as FFO excluding certain charges and gains that management believes are not comparable and indicative of the results of the Company’s operating real estate portfolio. Such adjustments include gains/losses on the early extinguishment of debt, net hurricane-related activity, transaction costs and other restructuring type costs. The disclosure of these charges and income is generally requested by users of the Company’s financial statements. The adjustment for these charges and income may not be comparable to how other REITs or real estate companies calculate their results of operations, and the Company’s calculation of Operating FFO differs from NAREIT’s definition of FFO. Additionally, the Company provides no assurances that these charges and income are non-recurring. These charges and income could be reasonably expected to recur in future results of operations. These measures of performance are used by the Company for several business purposes and by other REITs. The Company uses FFO and/or Operating FFO in part (i) as a disclosure to improve the understanding of the Company’s operating results among the investing public, (ii) as a measure of a real estate asset’s performance and (iii) to compare the Company’s performance to that of other publicly traded shopping center REITs. For the reasons described above, management believes that FFO and Operating FFO provide the Company and investors with an important indicator of the Company’s operating performance. They provide recognized measures of performance other than GAAP net income, which may include non-cash items (often significant). Other real estate companies may calculate FFO and Operating FFO in a different manner. The Company’s management recognizes the limitations of FFO and Operating FFO when compared to GAAP’s net income. FFO and Operating FFO do not represent amounts available for dividends, capital replacement or expansion, debt service obligations or other commitments and uncertainties. The Company’s management does not use FFO or Operating FFO as an indicator of the Company’s cash obligations and funding requirements for future commitments or redevelopment activities. Neither FFO nor Operating FFO represents cash generated from operating activities in accordance with GAAP, and neither is necessarily indicative of cash available to fund cash needs. Neither FFO nor Operating FFO should be considered an alternative to net income (computed in accordance with GAAP) or as an alternative to cash flow as a measure of liquidity. FFO and Operating FFO are simply used as additional indicators of the Company’s operating performance. The Company believes that to further understand its performance, FFO and Operating FFO should be compared with the Company’s reported net income (loss) and considered in addition to cash flows determined in accordance with GAAP, as presented in its combined and consolidated financial statements. Reconciliations of these measures to their most directly comparable GAAP measure of net income (loss) have been provided below. Reconciliation Presentation FFO and Operating FFO were as follows (in thousands): The increase in FFO primarily was a result of the hurricane settlement in 2019, debt extinguishment charges and transaction costs incurred in connection with the Company’s mortgage loan and separation from SITE Centers in 2018, partially offset by the dilutive impact from the disposition of assets. The decrease in Operating FFO primarily was due to asset sales. The Company’s reconciliation of net income (loss) to FFO and Operating FFO is as follows (in thousands). The Company provides no assurances that these charges and income adjusted in the calculation of Operating FFO are non-recurring. These charges and income could reasonably be expected to recur in future results of operations. (A) The hurricane activity, net is summarized as follows (in thousands): (B) Amounts included in other expenses as follows (in millions): LIQUIDITY, CAPITAL RESOURCES AND FINANCING ACTIVITIES The Company requires capital to fund its operating expenses, capital expenditures and investment activities. The Company’s capital sources may include cash on hand and cash flow from operations (absent the occurrence of an Amortization Period as described below), as well as availability under its Revolving Credit Agreement (as defined below). Debt outstanding was $674.3 million and $988.6 million at December 31, 2019 and 2018, respectively. The Company’s mortgage loan generally requires interest only payments. The Company intends to utilize net asset sale proceeds to repay the principal of the mortgage loan. In January and February 2020, loan repayments of $17.4 million and $11.1 million, respectively, were made from the use of restricted cash relating to asset sales consummated in December 2019 and January 2020. While the Company currently believes it has several viable sources to obtain capital and fund its business, including capacity under the Revolving Credit Agreement, no assurance can be provided that its obligations, including the mortgage loan, will be refinanced or repaid as currently anticipated. 2019 Financing Activities Mortgage Financing On March 11, 2019, certain wholly-owned subsidiaries of the Company entered into a mortgage loan with an initial aggregate principal amount of $900 million. Substantially all proceeds from the mortgage loan were used to refinance and prepay all amounts outstanding under the Company’s February 2018 mortgage loan, which had an original aggregate principal amount of $1.35 billion. The borrowers’ obligations to pay principal, interest and other amounts under the new mortgage loan are evidenced by certain promissory notes executed by the borrowers, referred to collectively as the notes, which are secured by, among other things: (i) mortgages encumbering the borrowers’ properties located in the continental U.S. (which comprise substantially all of the Company’s properties located in the continental U.S.) and Plaza del Sol located in Bayamon, Puerto Rico (collectively, the “Mortgaged Properties”); (ii) a pledge of the equity of the Company’s subsidiaries that own each of the Company’s properties located in Puerto Rico (collectively, the “Pledged Properties”) and a pledge of related rents and other cash flows, insurance proceeds and condemnation awards and (iii) a pledge of any reserves and accounts of any borrower. Subsequent to closing, the originating lenders placed the notes into a securitization trust that issued and sold mortgage-backed securities to investors. As of December 31, 2019, the aggregate principal amount of the mortgage loan was $674.3 million. The loan facility will mature on March 9, 2021, subject to three one-year extensions at the borrowers’ option conditioned upon, among other items, (i) an event of default shall not be continuing, (ii) in the case of the second one-year extension option, evidence that the Debt Yield (as defined and calculated in accordance with the loan agreement, but which is the ratio of net cash flow of the Mortgaged Properties to the outstanding principal amount of the loan facility) equals or exceeds 13% and (iii) in the case of the third one-year extension option, evidence that the Debt Yield equals or exceeds 14%. As of December 31, 2019, the weighted-average interest rate applicable to the notes was equal to one-month LIBOR plus a spread of 2.68% per annum, provided that such spread is subject to an increase of 0.25% per annum in connection with any exercise of the third extension option. The Borrowers are required to maintain an interest rate cap with respect to the principal amount of the notes having (i) during the initial two-year term of the loan, a LIBOR strike rate equal to 4.5% and (ii) with respect to any extension period, a LIBOR strike rate that would result in a debt service coverage ratio of 1.20x based on the Mortgaged Properties. Application of voluntary prepayments as described below will cause the weighted-average interest rate to increase over time. At December 31, 2019, the interest rate applicable to the mortgage loan was 4.4%. The loan facility is structured as an interest only loan throughout the initial two-year term and any exercised extension options. As a result, so long as no Amortization Period (as described below) or event of default exists, any property cash flows available following payment of debt service and funding of certain required reserve accounts (including reserves for payment of real estate taxes, insurance premiums, ground rents, tenant improvements and capital expenditures) will be available to the borrowers to pay operating expenses and for other general corporate purposes. An Amortization Period will be deemed to commence in the event the borrowers fail to achieve a Debt Yield of 10.0% at the end of any fiscal quarter. The Debt Yield as of December 31, 2019, was 13.7%. During the pendency of an Amortization Period, any property cash flows available following payment of debt service and the funding of certain reserve accounts (including the reserve accounts referenced above and additional reserves established for payment of approved operating expenses, SITE Centers management fees, certain public company costs, certain taxes and the minimum cash portion of required REIT distributions) shall be applied to the repayment of the notes. During an Amortization Period, cash flow from the borrowers’ operations will be made available to the Company only to pay required REIT distributions in an amount equal to the minimum portion of required REIT distributions allowed by law to be paid in cash (currently 20%), with the remainder of required REIT distributions during an Amortization Period likely to be paid in common shares of the Company. Subject to certain conditions described in the mortgage loan agreement, the borrowers may prepay principal amounts outstanding under the loan facility in whole or in part by providing (i) advance notice of prepayment to the lenders and (ii) remitting the prepayment premium described in the mortgage loan agreement. No prepayment premium is required with respect to any prepayments made after April 9, 2020. Additionally, no prepayment premium will apply to prepayments made in connection with permitted property sales. Each Mortgaged Property has a portion of the original principal amount of the mortgage loan allocated to it. The amount of proceeds from the sale of an individual Mortgaged Property required to be applied toward prepayment of the notes (i.e., the property’s “release price”) will depend upon the Debt Yield at the time of the sale as follows: • if the Debt Yield is less than or equal to 14.0%, the release price is the greater of (i) 100% of the property’s net sale proceeds and (ii) 110% of its allocated loan amount and • if the Debt Yield is greater than 14.0%, the release price is the greater of (i) 90% of the property’s net sale proceeds and (ii) 105% of its allocated loan amount. To the extent the net cash proceeds from the sale of a Mortgaged Property that are applied to repay the mortgage loan exceed the amount specified in applicable clause (ii) above with respect to such property, the excess may be applied by the Company as a credit against the release price applicable to future sales of Mortgaged Properties. Pledged Properties other than Plaza del Sol do not have allocated loan amounts or, in general, minimum release prices; all proceeds from sales of Pledged Properties are required to be used to prepay the notes. Notwithstanding the foregoing, in order to obtain a release of all of the Pledged Properties (excluding Plaza del Sol) in connection with a portfolio sale of all of the Pledged Properties, the loan facility requires a minimum release price equal to the greater of (i) $250 million and (ii) 100% of the net sale proceeds. Voluntary prepayments made by the borrowers (including prepayments made with proceeds from asset sales and prepayments made with property cash flows following commencement of any Amortization Period) will be applied to tranches of notes (i) absent an event of default, in descending order of seniority (i.e., such prepayments will first be applied to the most senior tranches of notes) and (ii) following any event of default, in such order as the loan servicer determines in its sole discretion. As a result, the Company expects that the weighted-average interest rate of the notes will increase during the term of the loan facility. In the event of a default, the contract rate of interest on the notes will increase to the lesser of (i) the maximum rate allowed by law or (ii) the greater of (A) 4% above the interest rate otherwise applicable and (B) the Prime Rate (as defined in the mortgage loan) plus 1.0%. The notes contain other terms and provisions that are customary for instruments of this nature. In addition, the Company executed a certain environmental indemnity agreement and a certain guaranty agreement in favor of the lenders under which the Company agreed to indemnify the lenders for certain environmental risks and guarantee the borrowers’ obligations under the exceptions to the non-recourse provisions in the mortgage loan agreement. The mortgage loan agreement includes representations, warranties, affirmative and restrictive covenants and other provisions customary for agreements of this nature. The mortgage loan agreement also includes customary events of default, including, among others, principal and interest payment defaults and breaches of affirmative or negative covenants; the mortgage loan agreement does not contain any financial maintenance covenants. Upon the occurrence of an event of default, the lenders may avail themselves of various customary remedies under the loan agreement and other agreements executed in connection therewith or applicable law, including accelerating the loan facility and realizing on the real property collateral or pledged collateral. In connection with the refinancing in March 2019, the Company incurred $12.7 million of aggregate debt extinguishment costs that included the write-off of unamortized deferred financing costs. See further discussion in Note 7, “Mortgage Indebtedness” of the Company’s combined and consolidated financial statements included herein. Credit Agreement In July 2018, the Company entered into a Credit Agreement (the “Revolving Credit Agreement”) with PNC Bank, National Association (“PNC”). The Revolving Credit Agreement provides for borrowings of up to $30.0 million. The Company’s borrowings under the Revolving Credit Agreement bear interest at variable rates at the Company’s election, based on either (i) LIBOR plus a specified spread ranging from 1.05% to 1.50% depending on the Company’s Leverage Ratio (as defined in the Revolving Credit Agreement) or (ii) the Alternate Base Rate (as defined in the Revolving Credit Agreement) plus a specified spread ranging from 0.05% to 0.50% depending on the Company’s Leverage Ratio. The Company is also required to pay a facility fee on the aggregate revolving commitments at a rate per annum that ranges from 0.15% to 0.30% depending on the Company’s Leverage Ratio. The Revolving Credit Agreement matures on the earliest to occur of (i) March 9, 2021, (ii) the date on which the External Management Agreement is terminated, (iii) the date on which DDR Asset Management, LLC or another wholly-owned subsidiary of SITE Centers ceases to be the “Service Provider” under the External Management Agreement as a result of assignment or operation of law or otherwise and (iv) the date on which the principal amount outstanding under the Company’s $900 million mortgage loan is repaid or refinanced. The Revolving Credit Agreement contains customary affirmative and negative covenants, including a requirement to maintain tangible net worth of $500 million. Upon the occurrence of certain customary events of default, the Company’s obligations under the Revolving Credit Agreement may be accelerated and the lending commitments thereunder terminated. The Company may not borrow under the Revolving Credit Agreement, and a Default (as defined therein) occurs under the Revolving Credit Agreement if there is a “Default” under SITE Centers’ corporate credit facility with JPMorgan Chase Bank, N.A., SITE Centers’ corporate credit facility with Wells Fargo Bank, National Association or SITE Centers’ corporate credit facility with PNC. Additionally, the Company may not borrow under the Revolving Credit Agreement if there is a “Default” under the Revolving Credit Agreement or an “Event of Default” under the Company’s $900 million mortgage loan, if the External Management Agreement is no longer in full force and effect or if the Company has delivered or received a notice of termination or a notice of default under the External Management Agreement. The Company’s obligations under the Revolving Credit Agreement are guaranteed by SITE Centers in favor of PNC. In consideration thereof, the Company has agreed to pay to SITE Centers the following amounts: (i) an annual guaranty commitment fee of 0.20% of the aggregate commitments under the Revolving Credit Agreement, (ii) for all times other than those referenced in clause (iii) below, when any amounts are outstanding under the Revolving Credit Agreement, an amount equal to 5.00% per annum times the average aggregate outstanding daily principal amount of such loans plus the aggregate stated average daily amount of outstanding letters of credit and (iii) in the event SITE Centers pays any amounts to PNC pursuant to SITE Centers’ guaranty and the Company fails to reimburse SITE Centers for such amount within three business days, an amount in cash equal to the amount of such paid obligations plus default interest, which will accrue from the date of such payment by SITE Centers until repaid by the Company at a rate per annum equal to the sum of the LIBOR rate plus 8.50%. Series A Preferred Stock In connection with the Company’s separation from SITE Centers, the Company issued the RVI Preferred Shares to SITE Centers that are noncumulative and have no mandatory dividend rate. The RVI Preferred Shares rank, with respect to dividend rights and rights upon liquidation, dissolution or winding up of the Company, senior in preference and priority to the Company’s common shares and any other class or series of the Company’s capital stock. Subject to the requirement that the Company distribute to its common shareholders the minimum amount required to be distributed with respect to any taxable year in order for the Company to maintain its status as a REIT and to avoid U.S. federal income taxes, the RVI Preferred Shares will be entitled to a dividend preference for all dividends declared on the Company’s capital stock at any time up to a “preference amount” equal to $190 million in the aggregate, which amount may increase by up to an additional $10 million if the aggregate gross proceeds of the Company’s asset sales subsequent to July 1, 2018 exceed $2.0 billion. Notwithstanding the foregoing, the RVI Preferred Shares are entitled to receive dividends only when, as and if declared by the Company’s Board of Directors, and the Company’s ability to pay dividends is subject to any restrictions set forth in the terms of its indebtedness. Upon payment to SITE Centers of aggregate dividends on the RVI Preferred Shares equaling the maximum preference amount of $200 million, the RVI Preferred Shares are required to be redeemed by the Company for $1.00 per share. Subject to the terms of any of the Company’s indebtedness and unless prohibited by Ohio law governing distributions to stockholders, the RVI Preferred Shares must be redeemed upon (i) the Company’s failure to maintain its status as a REIT, (ii) any failure by the Company to comply with the terms of the RVI Preferred Shares or (iii) the consummation of any transaction (including, without limitation, any merger or consolidation), the result of which is that the Company sells, assigns, transfers, conveys or otherwise disposes of all or substantially all of its properties or assets, in one or more related transactions, to any person or entity, or any person or entity, directly or indirectly, becomes the beneficial owner of 40% or more of the Company’s common shares, measured by voting power. The RVI Preferred Shares also contain restrictions on the Company’s ability to invest in joint ventures, acquire assets or properties, develop or redevelop real estate or make loans or advances to third parties. The Company may redeem the RVI Preferred Shares, or any part thereof, at any time at a price payable per share calculated by dividing the number of RVI Preferred Shares outstanding on the redemption date into the difference of (x) $200 million minus (y) the aggregate amount of dividends previously distributed on the RVI Preferred Shares to be redeemed. As of February 14, 2020, no dividends have been paid on the RVI Preferred Shares. Common Share Dividends The Company’s 2018 dividend was paid on January 25, 2019 and the Company’s 2019 dividend was paid on January 8, 2020, in each case in a combination of cash and the Company’s common shares. After the payment of the dividend in January 2020, the Company had 19,816,022 common shares outstanding. For discussion on the dividends paid, see Note 9, “Preferred Stock, Common Shares and Redeemable Preferred Equity,” to the Company’s combined and consolidated financial statements included herein. Distributions of Puerto Rico sourced net taxable income to Company shareholders are subject to a 10% Puerto Rico withholding tax. In 2018, the Company entered into a closing agreement with the Puerto Rico Department of Treasury which provides that the Company will be exempt from Puerto Rico income taxes so long as it qualifies as a REIT in the U.S. and distributes at least 90% of its Puerto Rico net taxable income to its shareholders every year. As such, in each of December 2018 and November 2019, the Company’s Board of Directors declared a common share dividend, subject to a 10% withholding tax, on account of taxable income generated in Puerto Rico. The amount of each divided is expected to exceed the amount of REIT taxable income generated by the Company. Accordingly, federal income taxes were not incurred by the REIT. Dividend Distributions The Company anticipates making distributions to holders of its common shares to satisfy the requirements to qualify as a REIT and generally not be subject to U.S. federal income and excise tax (other than with respect to operations conducted through the Company’s TRS). U.S. federal income tax law generally requires that a REIT distribute annually to holders of its capital stock at least 90% of its REIT taxable income, without regard to the deduction for dividends paid and excluding net capital gains, and that it pay tax at regular corporate rates to the extent that it annually distributes less than 100% of its REIT taxable income. The Company generally intends to make distributions with respect to each taxable year in an amount at least equal to its REIT taxable income for such taxable year. The Company also anticipates making future distributions to holders of its common shares in order to satisfy the requirements of its closing agreement with the Puerto Rico Department of Treasury in order to be exempt from Puerto Rico income taxes. Although the Company expects to declare and pay distributions on or around the end of each calendar year, the Company’s Board of Directors will evaluate its dividend policy regularly. To the extent that cash available for future distributions is less than the Company’s REIT taxable income or its taxable income generated in Puerto Rico, or if amortization requirements commence with respect to the terms of the mortgage loan, or if the Company determines it is advisable for other reasons, the Company may make a portion of its distributions in the form of common shares, and any such distribution of common shares may be taxable as a dividend to shareholders. The Company may also distribute debt or other securities in the future, which also may be taxable as a dividend to shareholders. Any distributions the Company makes to its shareholders will be at the discretion of the Company’s Board of Directors and will depend upon, among other things, the Company’s actual and anticipated results of operations and liquidity, which will be affected by various factors, including the income from its portfolio, its operating expenses (including management fees and other obligations owing to SITE Centers), repayments of restricted cash balances to SITE Centers in connection with the mortgage loan and other expenditures and the terms of the mortgage financing and the limitations set forth in the mortgage loan agreements. Distributions will also be impacted by the pace and success of the Company’s property disposition strategy. As a result of the terms of the mortgage financing, the Company anticipates that the majority of distributions of sales proceeds to be made to shareholders will not occur until after the mortgage loan has been repaid or refinanced. Furthermore, subject to the Company’s ability to make distributions to the holders of the Company’s common shares in amounts necessary to maintain its status as a REIT and to avoid payment of U.S. federal income taxes, the RVI Preferred Shares will be entitled to a dividend preference for all dividends declared on the Company’s capital stock, at any time up to the preference amount. Subsequent to the payment of dividends on the RVI Preferred Shares equaling the maximum preference amount of $200 million, the RVI Preferred Shares are required to be redeemed by the Company for an aggregate amount of $1.00 per share. Due to the dividend preference of the RVI Preferred Shares, distributions of sales proceeds to holders of common shares are unlikely to occur until after aggregate dividends have been paid on the RVI Preferred Shares in an amount equal to the maximum preference amount. At this time, the Company cannot predict when or if it will declare dividends to the holders of RVI Preferred Shares and when or if such dividends, if paid, will equal the maximum preference amount. Dispositions For the year ended December 31, 2019, the Company sold ten shopping centers and two outparcels aggregating 2.6 million square feet, for an aggregate sales price of $335.2 million. In addition, from January 1, 2020 through March 2, 2020, the Company sold three shopping centers: Newnan Crossing (excluding Lowe’s) in Newnan, Georgia; Hamilton Commons in Mays Landing, New Jersey; and Tucson Spectrum in Tucson, Arizona, for an aggregate amount of $155.6 million. For the year ended December 31, 2018, the Company sold 12 shopping centers aggregating 2.5 million square feet, for an aggregate sales price of $401.7 million. Cash Flow Activity The Company expects that its core business of leasing space to well capitalized tenants will continue to generate consistent and predictable cash flow after expenses and interest payments. As discussed above, in general, the Company intends to utilize net asset sale proceeds to: first, repay its mortgage loan and any other indebtedness (including any amounts owed to SITE Centers); second, make distributions on account of the RVI Preferred Shares up to the maximum preference amount and third, make distributions to holders of the Company’s common shares. The Company’s cash flow activities are summarized as follows (in thousands): Changes in cash flow compared to the prior comparable period are described as follows: Operating Activities: Cash provided by operating activities increased $22.1 million primarily due to reduction in Parent Company allocated expenses and separation costs, partially offset by lower income related to property dispositions. Investing Activities: Cash provided by investing activities decreased $14.6 million due to the following: • Decrease in proceeds from dispositions of real estate of $67.5 million; • Increase in real estate improvements of $14.6 million and • Increase in property insurance proceeds of $67.5 million. Financing Activities: Cash used for financing activities increased by $38.3 million primarily due to the following: • Increase in debt repayments, net of proceeds and loan costs of $39.4 million; • Increase in dividends paid of $6.9 million and • Reduction in net transactions with SITE Centers of $8.0 million. CAPITALIZATION At December 31, 2019, the Company’s capitalization consisted of $674.3 million of mortgage debt, $190.0 million of RVI Preferred Shares and $701.1 million of market equity (market equity is defined as common shares outstanding multiplied by $36.80, the closing price of the Company’s common shares on the New York Stock Exchange at December 31, 2019), resulting in a debt to total market capitalization ratio of 0.43 to 1.0, as compared to the ratio of 0.60 to 1.0 at December 31, 2018. The closing price of the Company’s shares on the New York Stock Exchange was $25.59 at December 31, 2018. CONTRACTUAL OBLIGATIONS AND OTHER COMMITMENTS The Company had aggregate outstanding mortgage indebtedness of $674.3 million at December 31, 2019 with a maturity of March 2021, subject to three one-year extension options. In addition, the Company has two long-term ground leases in which it is the lessee. These obligations are summarized as follows for the subsequent five years ending December 31 (in millions): (A) Represents interest payments expected to be incurred on the Company’s debt obligations as of December 31, 2019, including capitalized interest and net of $17.4 million of restricted cash that was obligated to be used to repay indebtedness on January 9, 2020. In connection with the separation from SITE Centers, on July 1, 2018, the Company and SITE Centers entered into the Separation and Distribution Agreement, pursuant to which, among other things, SITE Centers transferred properties and certain related assets, liabilities and obligations to the Company and distributed 100% of the outstanding common shares to holders of record of SITE Centers’ common shares as of the close of business on June 26, 2018, the record date. In connection with the separation from SITE Centers, SITE Centers retained the RVI Preferred Shares, which have an aggregate dividend preference equal to $190 million, which amount may increase by up to an additional $10 million depending on the amount of aggregate gross proceeds generated by the Company asset sales. SITE Centers Guaranty On July 2, 2018, SITE Centers provided an unconditional guaranty to PNC with respect to any obligations outstanding from time to time under the Company’s Revolving Credit Agreement. In connection with this arrangement, the Company has agreed to pay to SITE Centers a guaranty commitment fee of 0.20% per annum on the committed amount of the Revolving Credit Agreement and a fee equal to 5.00% per annum on any amounts drawn by the Company under the Revolving Credit Agreement. In the event SITE Centers pays any of the Company’s obligations on the Revolving Credit Agreement and the Company fails to reimburse such amount within three business days, the guaranty provides for default interest that accrues at a rate equal to the sum of the LIBOR rate plus 8.50% per annum. Other Commitments The Company has entered into agreements with general contractors related to its shopping centers having aggregate commitments of approximately $10.9 million at December 31, 2019. These obligations, composed principally of construction contracts for the repair of the Puerto Rico properties, are generally due within 12 to 24 months, as the related construction costs are incurred, and are expected to be financed through operating cash flow. These contracts typically can be changed or terminated without penalty. The Company routinely enters into contracts for the maintenance of its properties. These contracts typically can be canceled upon 30 to 60 days’ notice without penalty. At December 31, 2019, the Company had purchase order obligations, typically payable within one year, aggregating approximately $0.7 million related to the maintenance of its properties and general and administrative expenses. Hurricane Loss In 2017, Hurricane Maria made landfall in Puerto Rico and the Company’s 12 assets in Puerto Rico, aggregating 4.4 million square feet of Company-owned GLA, were significantly impacted. One of the assets, Plaza Palma Real, consisting of approximately 0.4 million square feet of Company-owned GLA, was severely damaged. At December 31, 2019, tenants totaling 0.3 million square feet were open for business, approximating 67% of Plaza Palma Real’s Company-owned GLA. The other 11 assets sustained varying degrees of damage, consisting primarily of roof, HVAC system damage and water intrusion. A majority of the Company’s leased space that was open prior to the storm was open for business by mid-2018. In August 2019, the Company reached a settlement with its insurer with respect to the Company’s claims related to the hurricane. Pursuant to the settlement, the insurer agreed to pay the Company $154.4 million on account of property damage caused by the hurricane, of which $83.9 million had been paid to the Company prior to the settlement, and $31.3 million on account of the Company’s business interruption claim, of which $24.3 million had been paid to the Company or SITE Centers prior to the settlement. As a result, the insurer made net payments of $77.5 million to the Company in full settlement of the Company’s claims related to the hurricane. Pursuant to the terms of the Separation and Distribution Agreement, $0.8 million of this amount was paid to SITE Centers on account of unreimbursed business interruption losses incurred through June 30, 2018. The Company also received $3.0 million in 2019 from a tenant related to the Company’s restoration of the tenant’s space. The property damage settlement proceeds are reflected in the Company’s consolidated balance sheet as Restricted Cash and will be disbursed to the Company in accordance with the terms of the Company’s mortgage financing. As of December 31, 2019, the Company had expended $112 million in connection with repairing property damage caused by the hurricane. The Company believes the insurance settlement proceeds received will be sufficient to complete its restoration efforts. The Company anticipates that the repair and restoration work will be substantially complete by mid-2020. The timing and schedule of additional repair work to be completed are highly dependent upon any changes in the scope of work, the availability of building materials, supplies and skilled labor. See further discussion in Note 10, “Commitments and Contingencies,” of the Company’s December 31, 2019 combined and consolidated financial statements included herein. INFLATION Most of the Company’s long-term leases contain provisions designed to mitigate the adverse impact of inflation. Such provisions include clauses enabling the Company to receive additional rental income from escalation clauses that generally increase rental rates during the terms of the leases and/or percentage rentals based on tenants’ gross sales. Such escalations are determined by negotiation, increases in the consumer price index or similar inflation indices. In addition, many of the Company’s leases are for terms of less than 10 years, permitting the Company to seek increased rents at market rates upon renewal. Most of the Company’s leases require the tenants to pay their share of operating expenses, including common area maintenance, real estate taxes, insurance and utilities, thereby reducing the Company’s exposure to increases in costs and operating expenses resulting from inflation. ECONOMIC CONDITIONS Despite recent tenant bankruptcies and e-commerce distribution, the Company believes there is tenant demand for quality locations within well-positioned shopping centers. Though leasing prospects are heavily dependent on local conditions, in general, the Company continues to see demand from a broad range of tenants for its continental U.S. space, particularly in the off-price sector, which the Company believes is a reflection of increasingly value-oriented consumers. The RVI Portfolio has a diversified tenant base, with only two tenants whose annualized rental revenue equals or exceeds 3% of the Company’s annualized revenues at December 31, 2019 (Walmart/Sam’s Club at 5.8% and Bed Bath & Beyond, which includes Bed Bath & Beyond, Cost Plus World Market and Christmas Tree Shops, at 3.5%). Other significant tenants include PetSmart, TJX Companies (T.J. Maxx, Marshalls and HomeGoods) and Best Buy, all of which have strong credit ratings, remain well capitalized and have outperformed other retail categories on a relative basis over time. The Company expects these tenants to continue to provide a stable revenue base, given the long-term nature of these leases. Moreover, the majority of the tenants in the Company’s shopping centers provide day-to-day consumer necessities with a focus on value convenience and service, which the Company believes will enable many of its tenants to succeed even in a challenging economic environment. Property revenues are generally derived from tenants with good credit profiles under long-term leases, with very little reliance on overage rents generated by tenant sales performance. The Company recognizes the risks posed by the economy, but believes that the general diversity and credit quality of its tenant base should enable it to successfully navigate through a cyclical downturn. The retail sector continues to be affected by increasing competition, including the impact of e-commerce. These dynamics are expected to continue to lead to tenant bankruptcies, closures and store downsizing. Some conventional department stores and national chains have announced bankruptcies, store closures and/or reduced expansion plans in recent years leading to a smaller overall number of tenants requiring large store formats. In some cases, the loss of a weaker tenant or downsizing of space creates a value-add opportunity such as re-leasing space to a stronger retailer. The loss of a tenant or downsizing of space can adversely affect the Company (see Item 1A. “Risk Factors”). The shopping center portfolio’s occupancy was 87.3% and 89.3% at December 31, 2019 and 2018, respectively. The net decrease in the rate primarily was attributed to the sale of assets having higher occupancy rates and a combination of tenant expirations and tenant bankruptcies. The total portfolio average annualized base rent per occupied square foot was $15.72 at December 31, 2019, as compared to $15.45 at December 31, 2018. At December 31, 2019, the Company owned 12 assets on the island of Puerto Rico aggregating 4.4 million square feet representing 39% of Company-owned GLA and approximately 45% of both the Company’s total consolidated revenue and the Company’s total consolidated revenue less operating expenses (i.e., net operating income) for the year ended December 31, 2019. The Company believes that the tenants at its Puerto Rico assets (many of which are high-quality continental U.S. retailers such as Walmart/Sam’s Club and the TJX Companies (T.J. Maxx and Marshalls)) typically cater to the local consumer’s desire for value, convenience and day-to-day necessities. Nevertheless, there is continued concern about the strength of the Puerto Rican economy, the ability of the government of Puerto Rico to meet its financial obligations and the impact of the territory’s ongoing bankruptcy and debt restructuring process on the economy of Puerto Rico. The impact of Hurricane Maria and recent seismic activity in Puerto Rico has further exacerbated these concerns. As of February 25, 2020, the Company had not identified any material damage to its properties resulting from seismic activity occurring in late 2019 and early 2020. See Note 10, “Commitments and Contingencies,” to the Company’s combined and consolidated financial statements included herein and Item 1A. “Risk Factors”. In addition to its goal of maximizing cash flow from property operations, the Company seeks to realize profits through the regular sale of assets to a variety of buyers. The market upon which this aspect of the business plan relies is currently characterized as liquid but fragmented, with a wide range of generally small, non-institutional investors. While some investors do not require debt financing, many seek to capitalize on leveraged returns using mortgage financing at interest rates well below the initial asset-level returns implied by disposition prices. In addition to small, often local buyers, the Company also plans to transact with mid-sized institutional investors, some of which are domestic and foreign publicly traded companies. Many larger domestic institutions, such as pension funds and insurance companies that were traditionally large buyers of retail real estate assets, have generally become less active participants in retail transaction markets over the last several years. Lower participation of institutions and a generally smaller overall buyer pool has resulted in some level of pressure on asset prices, particularly for larger properties, though this impact remains highly heterogeneous and varies widely by market and specific assets. Asset prices for retail real estate in Puerto Rico remain highly uncertain due to lack of transaction activity since Hurricane Maria. New Accounting Standards New Accounting Standards are more fully described in Note 3, “Summary of Significant Accounting Policies,” to the Company’s combined and consolidated financial statements. FORWARD-LOOKING STATEMENTS Management’s Discussion and Analysis of Financial Condition and Results of Operations should be read in conjunction with the Company’s combined and consolidated financial statements and the notes thereto appearing elsewhere in this report. Historical results and percentage relationships set forth in the Company’s combined and consolidated financial statements, including trends that might appear, should not be taken as indicative of future operations. The Company considers portions of this information to be “forward-looking statements” within the meaning of Section 27A of the Securities Act of 1933 and Section 21E of the Securities Exchange Act of 1934 (the “Exchange Act”), both as amended, with respect to the Company’s expectations for future periods. Forward-looking statements include, without limitation, statements related to acquisitions (including any related pro forma financial information) and other business development activities, future capital expenditures, financing sources and availability and the effects of environmental and other regulations. Although the Company believes that the expectations reflected in these forward-looking statements are based upon reasonable assumptions, it can give no assurance that its expectations will be achieved. For this purpose, any statements contained herein that are not statements of historical fact should be deemed to be forward-looking statements. Without limiting the foregoing, the words “will,” “believes,” “anticipates,” “plans,” “expects,” “seeks,” “estimates” and similar expressions are intended to identify forward-looking statements. Readers should exercise caution in interpreting and relying on forward-looking statements because such statements involve known and unknown risks, uncertainties and other factors that are, in some cases, beyond the Company’s control and that could cause actual results to differ materially from those expressed or implied in the forward-looking statements and that could materially affect the Company’s actual results, performance or achievements. For additional factors that could cause the results of the Company to differ materially from those indicated in the forward-looking statements see Item 1A. Risk Factors. Factors that could cause actual results, performance or achievements to differ materially from those expressed or implied by forward-looking statements include, but are not limited to, the following: • The Company may be unable to dispose of properties on favorable terms or at all, especially in markets or regions experiencing deteriorating economic conditions and properties anchored by tenants experiencing financial challenges. In addition, real estate investments can be illiquid, particularly as prospective buyers may experience increased costs of financing or difficulties obtaining financing due to local, national or global conditions; • The Company is subject to general risks affecting the real estate industry, including the need to enter into new leases or renew leases on favorable terms to generate rental revenues, and any economic downturn may adversely affect the ability of the Company’s tenants, or new tenants, to enter into new leases or the ability of the Company’s existing tenants to renew their leases at rates at least as favorable as their current rates; • The Company could be adversely affected by changes in the local markets where its properties are located, as well as by adverse changes in regional or national economic and market conditions; • The Company may fail to anticipate the effects on its properties of changes in consumer buying practices, including sales over the internet and the resulting retailing practices and space needs of its tenants, or a general downturn in its tenants’ businesses, which may cause tenants to close stores or default in payment of rent; • The Company is subject to competition for tenants from other owners of retail properties, and its tenants are subject to competition from other retailers and methods of distribution. The Company is dependent upon the successful operations and financial condition of its tenants, in particular its major tenants. The bankruptcy of major tenants could result in a loss of significant rental income and could give rise to termination or rent abatement by other tenants under the co-tenancy clauses of their leases; • The Company relies on major tenants, which makes it vulnerable to changes in the business and financial condition of, or demand for its space by, such tenants; • The Company’s financial condition may be affected by required debt service payments, the risk of default and restrictions on its ability to incur additional debt or to enter into certain transactions under documents governing its debt obligations. In addition, it may encounter difficulties in refinancing existing debt. Borrowings under the mortgage loan or the revolving credit facility are subject to certain representations and warranties and customary events of default, including any event that has had or could reasonably be expected to have a material adverse effect on the Company’s business or financial condition; • Changes in interest rates could adversely affect the market price of the Company’s common shares, its performance and cash flow and its ability to sell assets and the sales prices applicable thereto; • Debt and/or equity financing necessary for the Company to continue to operate its business or to refinance existing indebtedness may not be available or may not be available on favorable terms; • Disruptions in the financial markets could affect the Company’s ability to obtain financing or to refinance existing indebtedness on reasonable terms and have other adverse effects on the Company and the market price of the Company’s common shares; • The ability of the Company to pay dividends on its common shares in excess of its REIT taxable income is generally subject to its ability to first declare and pay aggregate dividends on the RVI Preferred Shares in an amount equal to the preference amount; • The Company is subject to complex regulations related to its status as a REIT and would be adversely affected if it failed to qualify as a REIT; • The Company must make distributions to shareholders to continue to qualify as a REIT, and if the Company must borrow funds to make distributions, those borrowings may not be available on favorable terms or at all; • The outcome of litigation, including litigation with tenants, may adversely affect the Company’s results of operations and financial condition; • The Company may not realize anticipated returns from its 12 real estate assets located in Puerto Rico, which carry risks in addition to those it faces with its continental U.S. properties and operations; • Property damage, expenses related thereto, and other business and economic consequences (including the potential loss of revenue) resulting from natural disasters and extreme weather conditions in locations where the Company owns properties; • Sufficiency and timing of any insurance recovery payments related to damages from extreme weather conditions; • The Company is subject to potential environmental liabilities; • The Company may incur losses that are uninsured or exceed policy coverage due to its liability for certain injuries to persons, property or the environment occurring on its properties; • The Company could incur additional expenses to comply with or respond to claims under the Americans with Disabilities Act or otherwise be adversely affected by changes in government regulations, including changes in environmental, zoning, tax and other regulations; • Changes in accounting or other standards may adversely affect the Company’s business; • The Company’s Board of Directors, which regularly reviews the Company’s business strategy and objectives, may change its strategic plan, including to adopt a plan of dissolution and/or delay distributions; • A change in the Company’s relationship with SITE Centers and SITE Centers’ ability to retain qualified personnel and adequately manage the Company; • Potential conflicts of interest with SITE Centers and the Company’s ability to replace SITE Centers as manager (and the fees to be paid to any replacement manager) in the event the management agreements are terminated and • The Company and its vendors, including SITE Centers, could sustain a disruption, failure or breach of their respective networks and systems, including as a result of cyber-attacks, which could disrupt the Company’s business operations, compromise the confidentiality of sensitive information and result in fines and penalties.

<s>[INST] Retail Value Inc. (“RVI” or the “Company”) (NYSE: RVI) is an Ohio company formed in December 2017 that, as of December 31, 2019, owned and operated a portfolio of 28 assets, composed of 16 continental U.S. assets and 12 assets in Puerto Rico. These properties consisted of retail shopping centers composed of 11.4 million square feet of Companyowned gross leasable area (“GLA”) and were located in 11 states and Puerto Rico. The Company’s continental U.S. assets comprised 55% and the properties in Puerto Rico comprised 45% of its total consolidated revenue for the year ended December 31, 2019. The Company’s centers have a diverse tenant base that includes national retailers such as Walmart/Sam’s Club, Bed, Bath & Beyond, PetSmart, the TJX Companies (T.J. Maxx, Marshalls and HomeGoods), Kohl’s, Best Buy and Gap. At December 31, 2019, the aggregate occupancy of the Company’s shopping center portfolio was 87.3%, and the average annualized base rent per occupied square foot was $15.72. Prior to the Company’s separation on July 1, 2018, the Company was a whollyowned subsidiary of SITE Centers Corp. (“SITE Centers” or the “Parent Company”). Unless otherwise expressly stated or the context otherwise requires, in the case of information as of dates or for periods prior to the Company’s separation from SITE Centers, references to the “Company” and the “RVI Predecessor” refer to the combined and consolidated entities of SITE Centers that owned the assets comprising the Company’s portfolio as of July 1, 2018, assuming that such entities owned only the assets comprising the Company’s portfolio as of July 1, 2018. EXECUTIVE SUMMARY The Company expects to focus on realizing value in its portfolio through operations and sales of its assets. The Company primarily intends to use net asset sale proceeds first to repay mortgage debt, second to make distributions on account of the RVI Preferred Shares, up to the preference amount, and third to make distributions to holders of the Company’s common shares. In March 2019, the Company entered into a mortgage loan in the aggregate principal amount of $900 million in order to refinance and prepay all amounts outstanding under its February 2018 mortgage loan, which had an original principal balance of $1.35 billion. The Company incurred costs of $20.2 million in connection with the financing, which included a $1.8 million debt financing fee paid to SITE Centers. On July 1, 2018, in order to consummate the Company’s separation from SITE Centers, the Company and SITE Centers entered into a separation and distribution agreement (the “Separation and Distribution Agreement”), pursuant to which, among other things, SITE Centers agreed to transfer properties and certain related assets, liabilities and obligations to RVI and to distribute 100% of the outstanding common shares of RVI to holders of record of SITE Centers’ common shares as of the close of business on June 26, 2018, the record date. On July 1, 2018, the separation date, holders of SITE Centers’ common shares received one common share of RVI for every ten shares of SITE Centers’ common stock held on the record date. In connection with the separation, SITE Centers retained 1,000 shares of RVI’s series A preferred stock (the “RVI Preferred Shares”) having an aggregate dividend preference equal to $190 million, which amount may increase by up to an additional $10 million depending on the amount of aggregate gross proceeds generated by RVI asset sales. From its formation in December 2017 through December 31, 2019, the Company sold the following assets (in thousands): Manager In connection with the Company’s separation from SITE Centers, on July 1, 2018, the Company entered into [/INST] Negative. </s>

CorePoint Lodging Inc.

2019-03-22

2018-12-31

Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations This Management’s Discussion and Analysis of Financial Condition and Results of Operations (“MD&A”) is intended to help provide an understanding of our business and results of operations. This MD&A should be read in conjunction with our consolidated financial statements and the notes thereto included in this Annual Report on Form 10-K. This report, including the following MD&A, contains forward-looking statements regarding future events or trends that should be read in conjunction with the factors described under “Forward-Looking Statements.” Actual results or developments could differ materially from those projected in such statements as a result of the factors described under “Forward-Looking Statements” as well as the risk factors described in Part I, Item 1A, “Risk Factors,” of this Annual Report on Form 10-K. For purposes of the following discussion and unless otherwise indicated or the context otherwise requires, “we,” “our,” “us,” “CorePoint” and “CorePoint Lodging” refer to CorePoint Lodging Inc. and its consolidated subsidiaries in each case, after giving effect to the Spin-Off, including the internal reorganization and Distribution; “LQH” refers to La Quinta Holdings Inc. and its consolidated subsidiaries; references to “LQH Parent” refer only to La Quinta Holdings Inc. exclusive of its subsidiaries, in each case before giving effect to the Spin-Off; “La Quinta” refers to La Quinta Holdings Inc and its consolidated subsidiaries; and references to “La Quinta Parent” refer only to La Quinta Holdings Inc., exclusive of its subsidiaries, in each case after giving effect to the Spin-Off. See “Overview” below. Overview Our Business CorePoint is a leading owner in the mid-scale and upper mid-scale select service hotel segments, primarily under the La Quinta brand. Our portfolio, as of December 31, 2018, consisted of 315 hotels representing approximately 40,400 rooms across 41 states in attractive locations in or near employment centers, airports, and major travel thoroughfares. All but one of our hotels is wholly-owned. We primarily derive our revenues from our hotel operations. Spin-Off from LQH On May 30, 2018, LQH Parent spun off its hotel ownership business as an independent, publicly traded company as part of a plan approved by LQH Parent’s board of directors prior to the Merger of LQH Parent with a wholly-owned subsidiary of Wyndham Worldwide. CorePoint Parent entered into a Separation and Distribution Agreement in January 2018 and several other agreements with LQH Parent prior to consummation of the Spin-Off. These agreements set forth the principal transactions required to effect CorePoint Lodging’s separation from LQH and provide for the allocation between CorePoint Parent and La Quinta Parent of various assets, liabilities, rights and obligations (including employee benefits, intellectual property, insurance and tax-related assets and liabilities) and govern the relationship between CorePoint Lodging and La Quinta after completion of the Spin-Off. These agreements also include arrangements with respect to transitional services to be provided by La Quinta to CorePoint Lodging. In addition, prior to the Spin-Off, CorePoint Lodging entered into agreements, including long-term hotel management and franchise agreements for each of its hotels, with LQH that have either not existed historically, or that may be on different terms than the terms of the arrangement or agreements that existed prior to the Spin-Off. The consolidated financial statements of CorePoint included herein do not reflect the effect of these new or revised agreements for the entirety of the periods presented and LQH’s historical expenses may not be reflective of CorePoint Lodging’s consolidated results of operations, financial position and cash flows had it been a stand-alone company during the entirety of the periods discussed in the “Results of Operations” section below. Effective with the closing of the Spin-Off, the results of operations related to the hotel franchise and hotel management business are reported as discontinued operations. Wyndham Transition and Integration In connection with the agreements we entered into with LQH, our hotels became a part of the management and franchise platforms of Wyndham Worldwide, and we are pro-actively engaged in the related transition and integration. This includes: • accessing Wyndham Worldwide’s distribution network including Wyndham.com, contact centers and loyalty platform to potentially increase market share at a more cost-effective acquisition cost; • technology and system integrations for property management, reservation systems and revenue management, which could expand our asset management effectiveness; and • gross margin initiatives related to labor, procurement and other service deliveries. We are in regular communication with La Quinta and are actively monitoring our progress. We expect the technology components, which are a part of Wyndham Worldwide’s technology upgrade, to be completed in the first half of 2019. Accordingly, we believe the major components of this transition will be completed during 2019; however, given the dynamics of the lodging sector and ever-changing technology, marketing and revenue enhancing opportunities, the impact on our operations and the interaction with our property manager will continuously be evolving. Strategic Priorities Post Spin-Off, CorePoint is positioned as what we believe is the only publicly traded U.S. lodging REIT strategically focused on the ownership of mid-scale and upper mid-scale select-service hotels. Our strategic priorities include disciplined capital allocation, maintaining balance sheet strength, proactive asset management and enhancing the value of our properties. Following completion of our Spin-Off, the Company began a strategic real estate review in the fourth quarter of 2018 to improve operating performance and increase the Company’s net asset valuation. Our initial focus is on our lowest performing hotels, where we are evaluating opportunities to increase gross margin, net cash flow and return on investment. These include initiatives to increase revenue from access to the Wyndham Worldwide distribution platform as discussed above and to control variable expenses while still maintaining appropriate guest satisfaction levels. We will also consider repositioning these hotels through capital investment and renovation. However, concurrent with these initiatives, we will also evaluate whether the dispositions of certain hotels and reallocation of such capital could result in superior value creation over the long term. Such a capital reallocation could include new investments at a more attractive return, reducing leverage by paying down debt, either permanently or on a temporary basis, or returning capital to stockholders. Repositioning In 2016, LQH Parent identified 54 properties that, with the appropriate scope of capital investment and renovation, LQH Parent believed would have the opportunity to re-position within a market, capturing increased occupancy and additional rate while being measured against new, higher quality competitive sets. Compared to 2017, in 2018 these properties experienced an approximate increase in occupancy of 460 basis points and an approximate increase in RevPAR of 15%. Because certain of the properties were only operational for a portion of 2018 and others still trending toward fully stabilized performance levels by the end of 2018, we expect further increases in RevPAR during 2019, but at a slower rate of increase than during 2018. The capital expenditures related to the repositioning during 2018 were approximately $61 million. As of December 31, 2018, the construction phase of the repositioning effort had been completed for 53 of these hotels. As of December 31, 2018, we expect capital expenditures of approximately $5 million to occur during 2019. We expect to complete construction on the one remaining hotel in the first half of 2019. Hurricanes During the third quarter of 2017, two major hurricanes made landfall impacting areas serviced by our hotels. In August 2017, Hurricane Harvey lingered over Texas and parts of Louisiana causing widespread flooding and associated damage. In September 2017, Hurricane Irma made its way up Florida’s west coast causing widespread wind damage, flooding and power outages. At peak of impact, approximately three thousand rooms were out of service by the storms and during the resulting restoration period, including due to property damage, damage to infrastructure surrounding the hotels and business interruption. Hurricanes Harvey and Irma had a meaningful impact on our business in the third and fourth quarters of 2017, as well as the first half of 2018. In September 2018, Hurricane Florence made landfall on the coastal Carolina region of the United States. The impact of this hurricane had minimal effect on our operations. In October 2018, Hurricane Michael made landfall primarily in the Florida panhandle region. The hurricane caused us to close our hotel in Panama City, Florida with total damage estimated at approximately $10 to $15 million. As of December 31, 2018, all hotels impacted by the 2017 and 2018 Hurricanes, except for the hotel in Panama City, Florida, have reopened. Compared to 2017 and 2018 when, at peak of impact, up to an approximately 7% of our rooms were out of service due to hurricane damage; accordingly, we expect increased revenues in 2019 for the previously hurricane-impacted hotels. We also continue to work closely with our insurance adjusters, claims adjusters and construction staff to bring the affected rooms back online as quickly as possible. Property and business interruption insurance claims will be made as determined through the evaluation process; however, the timing and amount of insurance proceeds are uncertain and may not be sufficient to cover all losses. Capital expenditures will be made in order to restore these hotels to pre-hurricane condition and may be larger than normal due to the scope of the damage. Timing differences have existed and are likely to continue to exist between the capital expenditures and insurance proceeds reflected in our financial statements. Segment Our hotel investments have similar economic characteristics and our service offerings and delivery of services are provided in a similar manner, using the same types of facilities and similar technologies. Our chief operating decision maker, the Company’s Chief Executive Officer, reviews our financial information on an aggregated basis. As a result, we have concluded that we have one reportable business segment. Union Activity As of December 31, 2018, employees of our hotel manager at two of our hotels were represented by labor unions. In March 2019, the union ratified agreements with our hotel manager for both hotels. As a result, we expect labor and benefit costs to increase in 2019 and 2020 at the two hotels which now have union representation. Seasonality The lodging industry is seasonal in nature. Generally, our revenues are greater in the second and third quarters than in the first and fourth quarters. The timing of holidays, local special events and weekends can also impact our quarterly results. The periods during which our properties experience higher revenues vary from property to property and depend principally upon location. This seasonality can be expected to cause quarterly fluctuations in revenue, profit margins, net earnings and cash provided by operating activities. Additionally, our quarterly results may be adversely affected by the timing of certain of our marketing production and maintenance expenditures. Further, the timing of opening of newly constructed or renovated hotels and the timing of any hotel acquisitions or dispositions may cause a variation of revenue and earnings from quarter to quarter. Inflation We do not believe that inflation had a material effect on our business during the years ended December 31, 2018, 2017 and 2016 due to low national inflation rates and in the primary local markets of our hotels. Although we believe that increases in the rate of inflation will generally result in comparable increases in hotel room rates and operating expenses, severe inflation could contribute to a slowing of the U.S. economy. Such a slowdown could result in a reduction in room rates and occupancy levels, negatively impacting our revenues and net income. Further, to the extent that inflation is correlated with higher interest rates, our borrowing costs on our floating rate debt or new debt placements could be higher. Key components and factors affecting our results of operations Revenues Room revenues are primarily derived from room lease rentals at our hotels. We recognize room revenues on a daily basis, based on an agreed-upon daily rate, after the guest has stayed at one of our hotels. Customer incentive discounts, cash rebates, and refunds are recognized as a reduction of room revenues. Occupancy, hotel, and sales taxes collected from customers and remitted to the taxing authorities are excluded from revenues in our consolidated statements of operations. Principal Components of Revenues Rooms. These revenues represent room lease rentals at our hotels and account for a substantial majority of our total revenue. Other revenue. These revenues represent revenue generated by the incidental support of operations at our hotels, including charges to guests for vending commissions, meeting and banquet rooms, and other rental income from operating leases associated with leasing space for restaurants, billboards and cell towers. Factors Affecting our Revenues Customer demand. Our customer mix is approximately evenly divided between leisure travelers and business travelers. Customer demand for our products and services is closely linked to the performance of the general economy on both a national and regional basis and is sensitive to business and personal discretionary spending levels. Leading indicators of demand include gross domestic product, unemployment rates, wage growth, business spending and the consumer price index. Declines in customer demand due to adverse general economic conditions, reductions in travel patterns, severe weather and lower consumer confidence can lower the revenues and profitability of our hotels. As a result, changes in consumer demand and general business cycles have historically subjected, and could in the future subject, our revenues to significant volatility. See “Risk Factors-Risks Related to Our Business and Industry.” Supply. New room supply is an important factor that can affect the lodging industry’s performance. Room rates and occupancy, and thus RevPAR, tend to increase when demand growth exceeds supply growth. The addition of new competitive hotels affects the ability of existing hotels to sustain or grow RevPAR, and thus profits. Age and amenities. Newly constructed or remodeled hotels generally will drive higher room rates and occupancy than older properties with deferred maintenance. Similarly, hotels with greater and more current amenities, which are in demand by lodgers, will also be able to achieve higher room rates and occupancy. The average age of our hotels is approximately 31 years. We have recently completed or are in the final phases of our renovation and repositioning program for 54 hotels. We will continue to evaluate our hotels for other appropriate improvements. Expenses Principal Components of Expenses Rooms. These expenses include hotel operating expenses of housekeeping, reservation systems (per our franchise agreements), room and breakfast supplies and front desk costs. Other departmental and support. These expenses include labor and other expenses that constitute non-room operating expenses, including parking, telecommunications, on-site administrative departments, sales and marketing, recurring repairs and maintenance and utility expenses. Property tax, insurance and other. These expenses consist primarily of real and personal property taxes, other local taxes, ground rent, equipment rent and insurance. Management and royalty fees. Management fees represent fees paid to third parties and are computed as a percentage of gross revenue. Royalty fees are generally computed as a percentage of rooms revenues. In connection with the Spin-Off, we entered into new, long term, management and franchise agreements with significant early cancellation provisions (refer to Note 11 “Commitments and Contingencies” included in the notes to the consolidated financial statements elsewhere in this Annual Report on Form 10-K for additional information). Casualty (gain) loss and other, net. These expenses primarily include casualty losses incurred resulting from property damage or destruction caused by any sudden, unexpected or unusual event such as a hurricane or significant casualty in excess of related insurance proceeds. Factors Affecting our Costs and Expenses Variable expenses. Expenses associated with our room expenses are mainly affected by occupancy and correlate closely with their respective revenues. These expenses can increase based on increases in salaries and wages, occupancy levels, as well as on the level of service and amenities that are provided. Our management and royalty fees, which commenced effective with our Spin-Off, are also primarily driven by our level of gross or room revenues. For the period since our Spin-Off to December 31, 2018, management fees represent 5% of total gross revenue and royalty fees represent 5% of our room revenues. We are also subject to other brand and ancillary fees. Further, a large portion of our room revenues is commissions-based and depends on our revenue channel distribution mix. On a comparable hotel basis, for the year ended December 31, 2018, online travel agencies represented approximately 30% of our revenue channel mix. Fixed expenses. Many of the other expenses associated with our hotels are relatively fixed. These expenses include portions of rent expense, property taxes, insurance and utilities. Since we generally are unable to decrease these costs significantly or rapidly when demand for our hotels decreases, any resulting decline in our revenues can have a greater adverse effect on our net cash flow, margins and profits. This effect can be especially pronounced during periods of economic contraction or slow economic growth. The effectiveness of any cost-cutting efforts is limited by the amount of fixed costs inherent in our business. As a result, we may not be able to successfully offset revenue reductions through cost cutting. In addition, any efforts to reduce costs, or to defer or cancel capital improvements, could adversely affect the economic value of our hotels. We have taken steps to reduce our fixed costs to levels we believe are appropriate to maximize profitability and respond to market conditions without jeopardizing the overall customer experience or the value of our hotels. Changes in depreciation and amortization expense. Changes in depreciation expense are due to renovations of existing hotels, acquisition or development of new hotels, the disposition of existing hotels through sale or closure or changes in estimates of the useful lives of our assets. As we incur additions to our hotels or place new assets into service, we will be required to recognize additional depreciation expense on those assets. Age. As hotels age, maintenance expense tends to increase. These expenses include more frequent and higher costing repairs, higher utility expenses, increased supplies and higher labor costs. If these costs result in capitalized improvements, depreciation expense could increase over time as discussed above. For other factors affecting our costs and expenses, see “Risk Factors-Risks Related to Our Business and Industry.” Key indicators of financial condition and operating performance We use a variety of financial and other information in monitoring the financial condition and operating performance of our business. Some of this information is financial information that is prepared in accordance with GAAP, while other information may be financial in nature and may not be prepared in accordance with GAAP. Our management also uses other information that may not be financial in nature, including statistical information and comparative data that are commonly used within the lodging industry to evaluate hotel financial and operating performance. Our management uses this information to measure the performance of hotel properties and/or our business as a whole. Historical information is periodically compared to budgets, as well as against industry-wide information. We use this information for planning and monitoring our business, as well as in determining management and employee compensation. Average daily rate (“ADR”) represents hotel room revenues divided by total number of rooms rented in a given period. ADR measures the average room price attained by a hotel or group of hotels, and ADR trends provide useful information concerning pricing policies and the nature of the guest base of a hotel or group of hotels. Changes in room rates have an impact on overall revenues and profitability. Occupancy represents the total number of rooms rented in a given period divided by the total number of rooms available at a hotel or group of hotels. Occupancy measures the utilization of our hotels’ available capacity, which may be affected from time to time by our repositioning, property casualties and other activities. Management uses occupancy to gauge demand at a specific hotel or group of hotels in a given period. Occupancy levels also help us determine achievable ADR levels as demand for hotel rooms increases or decreases. Revenue per available room (“RevPAR”) is defined as the product of the ADR charged and the average daily occupancy achieved. RevPAR does not include other ancillary, non-room revenues, such as food and beverage revenues or parking, telephone or other guest service revenues generated by a hotel, which are not significant for the Company. RevPAR changes that are driven predominately by occupancy have different implications for overall revenue levels and incremental hotel operating profit than changes driven predominately by ADR. For example, increases in occupancy at a hotel would lead to increases in room and other revenues, as well as incremental operating costs (including, but not limited to, housekeeping services, utilities and room amenity costs). RevPAR increases due to higher ADR, however, would generally not result in additional operating costs, with the exception of those charged or incurred as a percentage of revenue, such as management and royalty fees, credit card fees and commissions. As a result, changes in RevPAR driven by increases or decreases in ADR generally have a greater effect on operating profitability at our hotels than changes in RevPAR driven by occupancy levels. Due to seasonality in our business, we review RevPAR by comparing current periods to budget and period-over-period. Comparable hotels are defined as hotels that were active and operating in our system for at least one full calendar year as of the end of the applicable reporting period and were active and operating as of January 1st of the previous year; except for: (i) hotels that sustained substantial property damage or other business interruption, (ii) hotels that become subject to a purchase and sale agreement, or (iii) hotels in which comparable results are otherwise not available. Management uses comparable hotels as the basis upon which to evaluate ADR, occupancy and RevPAR. We report variances in ADR, occupancy and RevPAR between periods for the set of comparable hotels existing at the reporting date versus the results of same set of hotels in the prior period. Of our 315 hotels as of December 31, 2018, 304 have been classified as comparable hotels. Non-GAAP Financial Measures We also evaluate the performance of our business through certain other financial measures that are not recognized under GAAP. Each of these non-GAAP financial measures should be considered by investors as supplemental measures to GAAP performance measures such as total revenues, operating profit and net income. These measurements are not to be considered more relevant or accurate than the measurements presented in accordance with GAAP. In compliance with SEC requirements, our non-GAAP measurements are reconciled to the most directly comparable GAAP performance measurement. For all non-GAAP measurements, neither the SEC nor any other regulatory body has passed judgement on these non-GAAP measurements. EBITDA, EBITDAre and Adjusted EBITDAre “EBITDA.” Earnings before interest, taxes, depreciation and amortization (“EBITDA”) is a commonly used measure in many REIT and non-REIT related industries. The Company believes EBITDA is useful in evaluating our operating performance because it provides an indication of our ability to incur and service debt, to satisfy general operating expenses, and to make capital expenditures. We calculate EBITDA excluding discontinued operations. “EBITDAre.” The Company presents EBITDAre in accordance with guidelines established by the National Association of Real Estate Investment Trusts (“NAREIT”). NAREIT defines EBITDAre as net income or loss, excluding interest expense, income tax expense, depreciation and amortization, gains or losses on the disposition of property, impairments, and adjustments to reflect the entity’s share of EBITDAre of unconsolidated affiliates. The Company believes EBITDAre is a useful performance measure to help investors evaluate and compare the results of the Company’s operations from period to period. EBITDAre is intended to be a supplemental non-GAAP financial measure that is independent of a company’s capital structure. “Adjusted EBITDAre.” The Company adjusts EBITDAre when evaluating its performance because the Company believes that the adjustment for certain items, such as restructuring and separation transaction expenses, acquisition and disposition transaction expenses, stock-based compensation expense, discontinued operations, and other items not indicative of ongoing operating performance, provides useful supplemental information to management and investors regarding our ongoing operating performance. The Company believes that EBITDAre and Adjusted EBITDAre provide useful information to investors about it and its financial condition and results of operations for the following reasons: (i) EBITDAre and Adjusted EBITDAre are among the measures used by the Company’s management to evaluate its operating performance and make day-to-day operating decisions; and (ii) EBITDAre and Adjusted EBITDAre are frequently used by securities analysts, investors, lenders and other interested parties as a common performance measure to compare results or estimate valuations across companies in and apart from the Company’s industry sector. EBITDA, EBITDAre and Adjusted EBITDAre are not recognized terms under GAAP, have limitations as analytical tools and should not be considered either in isolation or as a substitute for net income (loss), cash flow or other methods of analyzing the Company’s results as reported under GAAP. Some of these limitations are that these measures: • do not reflect changes in, or cash requirements for, the Company’s working capital needs; • do not reflect the Company’s interest expense, or the cash requirements necessary to service interest or principal payments, on its indebtedness; • do not reflect the Company’s tax expense or the cash requirements to pay its taxes; • do not reflect historical cash expenditures or future requirements for capital expenditures or contractual commitments; • do not reflect the impact on earnings or changes resulting from matters that the Company considers not to be indicative of our future operations, including but not limited to discontinued operations, impairment, acquisition and disposition activities and restructuring expenses; • although depreciation and amortization are non-cash charges, the assets being depreciated, amortized or impaired will often have to be replaced, upgraded or repositioned in the future, and EBITDA, EBITDAre and Adjusted EBITDAre do not reflect any cash requirements for such replacements; and • other companies in the Company’s industry may calculate EBITDA, EBITDAre and Adjusted EBITDAre differently, potentially limiting their usefulness as comparative measures. Because of these limitations, EBITDA, EBITDAre and Adjusted EBITDAre should not be considered as discretionary cash available to the Company to reinvest in the growth of its business or as measures of cash that will be available to the Company to meet its obligations. The following is a reconciliation of our GAAP net income (loss) to EBITDA, EBITDAre and Adjusted EBITDAre for the years ended December 31, 2018, and 2017 (in millions): (1) Other income, net primarily consists of business interruption insurance proceeds and non-recurring legal expenses. The decline in these non-GAAP financial measures for 2018 is primarily due to the hotel and franchise agreements we entered into in May 2018 in connection with the completion of our Spin-Off. During 2018, we incurred approximately $52 million in fee expense related to those agreements, with no similar expense in 2017. As the 2018 fee expenses were only for a partial period, we expect our hotel and franchise related expenses to increase in 2019. NAREIT FFO attributable to stockholders and Adjusted FFO attributable to stockholders We present NAREIT FFO attributable to stockholders and NAREIT FFO per diluted share (defined as set forth below) as non-GAAP measures of our performance. We calculate funds from operations (“FFO”) attributable to stockholders for a given operating period in accordance with standards established by NAREIT, as net income or loss attributable to stockholders (calculated in accordance with GAAP), excluding depreciation and amortization related to real estate, gains or losses on sales of certain real estate assets, impairment write-downs of real estate assets, discontinued operations, income taxes related to sales of certain real estate assets, and the cumulative effect of changes in accounting principles, plus adjustments for unconsolidated joint ventures. Adjustments for unconsolidated joint ventures are calculated to reflect our pro rata share of the FFO of those entities on the same basis. Since real estate values historically have risen or fallen with market conditions, many industry investors have considered presentation of operating results for real estate companies that use historical cost accounting to be insufficient by themselves. For these reasons, NAREIT adopted the FFO metric in order to promote an industry wide measure of REIT operating performance. We believe NAREIT FFO provides useful information to investors regarding our operating performance and can facilitate comparisons of operating performance between periods and between REITs. Our presentation may not be comparable to FFO reported by other REITs that do not define the terms in accordance with the current NAREIT definition, or that interpret the current NAREIT definition differently than we do. We calculate NAREIT FFO per diluted share as our NAREIT FFO divided by the number of fully diluted shares outstanding during a given operating period. We also present Adjusted FFO attributable to stockholders and Adjusted FFO per diluted share when evaluating our performance because we believe that the exclusion of certain additional items described below provides useful supplemental information to investors regarding our ongoing operating performance. Management historically has made the adjustments detailed below in evaluating our performance and in our annual budget process. We believe that the presentation of Adjusted FFO provides useful supplemental information that is beneficial to an investor’s complete understanding of our operating performance. We adjust NAREIT FFO attributable to stockholders for the following items, and refer to this measure as Adjusted FFO attributable to stockholders: transaction expense associated with the potential disposition of or acquisition of real estate or businesses, severance expense, share-based compensation expense, litigation gains and losses outside the ordinary course of business, amortization of deferred financing costs, reorganization costs and separation transaction expenses, loss on extinguishment of debt, straight-line ground lease expense, casualty losses, deferred tax expense and other items that we believe are not representative of our current or future operating performance. NAREIT FFO attributable to stockholders and Adjusted FFO attributable to stockholders are not recognized terms under GAAP, have limitations as analytical tools and should not be considered either in isolation or as a substitute for net income (loss), cash flow or other methods of analyzing our results as reported under GAAP. NAREIT FFO is not an indication of our liquidity, nor is it indicative of funds available to fund our cash needs, including our ability to fund dividends. NAREIT FFO is also not a useful measure in evaluating net asset value because impairments are taken into account in determining net asset value but not in determining NAREIT FFO. Investors are cautioned that we may not recover any impairment charges in the future. Accordingly, NAREIT FFO should be reviewed in connection with GAAP measurements. We believe our presentation of NAREIT FFO is in accordance with the NAREIT definition; however, our NAREIT FFO may not be comparable to amounts calculated by other REITs. The following table provides a reconciliation of net income (loss) attributable to stockholders to NAREIT FFO attributable to stockholders and Adjusted FFO attributable to stockholders for the years ended December 31, 2018, and 2017 (in millions): (1) Other income, net primarily consists of business interruption insurance proceeds and non-recurring legal expenses. (2) Share amounts are presented on a diluted basis assuming a positive non-GAAP financial measure. This presentation may differ from our GAAP diluted shares for the anti-dilutive effects when we report a GAAP net loss. See Note 16: “Earnings Per Share” included in the notes to the consolidated financial statements included in this Annual Report on Form 10-K. The decline in these non-GAAP financial measures for 2018 is primarily due to the hotel and franchise agreements we entered into in May 2018 in connection with the completion of our Spin-Off. During 2018, we incurred approximately $52 million in fee expense related to those agreements, with no similar expense in 2017. As the 2018 fee expenses were only for a partial period, we expect our hotel and franchise related expenses to increase in 2019. Results of operations Overview For the year ended December 31, 2018, we reported a loss from continuing operations before income taxes of $216 million, compared to income from continuing operations before income taxes of $44 million in 2017, a decrease of $260 million. The decrease was primarily due to increased impairment loss of $153 million and increased management and royalty fees and corporate general and administrative expenses related to our Spin-Off of approximately $61 million, only partially offset by increased revenues of $26 million. During 2018, we recognized impairment losses of $154 million compared to $1 million in 2017. Our 2018 impairment losses were primarily due to a strategic review of our hotels and their operations which resulted in shortened holding periods for many of our hotels. In connection with our Spin-Off, we entered into new franchise and management agreements effective May 30, 2018, incurring $52 million of management and royalty fee expenses during the remaining portion of 2018. Also related to the Spin-Off, we incurred certain reorganization expenses, including expenses related to becoming a stand-alone NYSE-listed REIT, of approximately $44 million. We would expect the transition related expenses to decrease for 2019, but as our franchise, management and public REIT expenses were only for a partial year, would expect a larger increase in expenses during the full year of 2019. Our reported revenue was primarily driven by our occupancy, ADR and RevPAR metrics, our capital initiatives and storm related operations as repairs were completed. For the year ended December 31, 2018, occupancy at our comparable hotels was 65.5%, an increase of 60 basis points from the year ended December 31, 2017 of 64.9%. ADR increased by 3.8% to $89.62 for the year ended December 31, 2018, from $86.33 at December 31, 2017. The net effect was an increase to RevPAR of 4.7% to $58.67 for the year ended December 31, 2018, up from December 31, 2017 of $56.05. Beginning in the second half of 2016, we began enacting several key initiatives designed to further improve our RevPAR performance, including taking steps to enhance consistency of product and guest experience and investing in points of differentiation to encourage engagement with the brand. These initiatives have led to higher capital expenditures during the last two years to reposition 54 hotels. For the years ended December 31, 2018 and 2017, we spent approximately $61 million and $146 million, respectively, on these initiatives. As of December 31, 2018, the construction phase of the repositioning effort had been completed for 53 of the 54 hotels. We expect to complete construction on the one remaining hotel in the first half of 2019. Our income tax expense from continuing operations increased $130 million from 2017 to 2018, primarily associated with changes related to the Tax Act rate changes, our 2018 Spin-Off and our REIT election. The Tax Act reduced corporate tax rates, resulting in remeasurement of our deferred tax assets and liabilities, resulting in a deferred tax benefit of $132 million in 2017. In 2018, we recognized total tax expense of $21 million, of which $12 million related to the tax impact of operations for the pre-transaction period and $9 million related to the operations post-transaction. Year ended December 31, 2018 compared with year ended December 31, 2017 The following tables present our overall operating performance for the years ended December 31, 2018 and 2017, including the amount and percentage change in these results between the periods (for additional information about quarterly periods, see Note 18: “Quarterly Results” in the consolidated financial statements included elsewhere in this Annual Report on Form 10-K), ($ in millions, non-meaningful percentage changes are noted as “NM”): Revenues As of December 31, 2018, we owned 315 hotels, comprising approximately 40,400 rooms, all located in the United States. Room revenues at our hotels for the years ended December 31, 2018 and 2017 totaled $845 million and $820 million, respectively. The increase of $25 million, or 3.0%, in room revenues was primarily as a result of an increase in RevPAR at our comparable hotels of 4.7% for the year ended December 31, 2018 over the prior year. The increase in RevPAR was driven by an increase in ADR of 3.8% and a 60 basis point increase in occupancy. Beginning in 2016 we began an over $200 million capital expenditure initiative to upgrade and reposition 54 hotels. These upgrades resulted in certain hotels being fully or partially taken off-line while the work was being completed. During 2017 and 2018, these upgrades were completed for 53 hotels, increasing 2018 RevPAR by approximately 15% as compared to 2017. We expect to complete construction on the one remaining hotel in the first half of 2019. We expect revenues to increase in 2019 as a higher proportion of these hotels will be operating for a full year. Our revenues were also impacted by significant hurricane damages in 2017. Hurricane Harvey (in August 2017) and Hurricane Irma (in September 2017), at peak of impact, removed from service approximately 3,000 rooms, either directly from property damage or damage to infrastructure surrounding the hotels. Additionally, in October 2018, our hotel in Panama City, Florida, was severely damaged by Hurricane Michael and as of December 31, 2018, was under repair and unopened. We expect the Panama City, Florida, hotel to open in the second quarter of 2019. As of December 31, 2018, all hotels impacted by the 2017 hurricanes have reopened. Compared to 2017 and 2018 when at peak of impact, up to an approximately 7% of our rooms were out of service due to hurricane damage; accordingly, we expect increased revenues in 2019 for the previously hurricane impacted hotels. These increases were partially offset by the sale of two hotels during 2018, which produced approximately $3 million of revenue in 2017. Excluding the effect of the hotels impacted by the hurricanes and those undergoing significant renovation as part of the repositioning effort, comparable RevPAR increased 2.2% for the year ended December 31, 2018. Other hotel revenues for each of the years ended December 31, 2018 and 2017 totaled $17 million and $16 million, respectively. These revenues represent revenue generated by the incidental support of operations at our hotels, including charges to guests for vending commissions, meeting and banquet room revenues, and other rental income from operating leases associated with leasing space for restaurants or other retail sites, billboards and cell towers. Operating expenses Rooms expense for our hotels totaled $385 million and $353 million for the years ended December 31, 2018 and 2017, respectively, resulting in an increase of $32 million. The variance in rooms expense was primarily caused by increases in payroll (including changes in staffing, both permanent and temporary, and wage increases) and benefits of approximately $17 million, third party reservation services expense of $3 million due to increased volume driven through third party online travel agencies, and supply expense of $2 million. These increases were partially offset by a decrease in expense caused by two fewer hotels in the hotel portfolio at December 31, 2018 in comparison to the hotels owned at December 31, 2017. We expect as labor markets tighten, we will experience further expense increases in attracting, hiring and retaining hotel staff. Management and royalty fees for our hotels totaled $52 million for the year ended December 31, 2018. We did not incur royalty fees prior to May 30, 2018. For 2017 and prior to May 30, 2018, expenses related to managing our hotels are included with in corporate general and administrative expenses. On May 30, 2018, in connection with the Spin-Off, we entered into management and franchise agreements for our hotels with LQM and LQ Franchising, respectively. Management fees are computed as 5% of total gross revenue and royalty fees are computed as 5% of gross rooms revenues. We expect these fees to be a significant variance to prior periods through 2019. Impairment expense was $154 million for 2018, compared to $1 million for 2017. The increase was due to a strategic review of our hotels and their operations which resulted in shortened holding periods for many of our hotels. Depreciation and amortization expense for our hotels totaled $156 million and $140 million for the years ended December 31, 2018 and 2017, respectively. The increase of $16 million was primarily the result of capital expenditures between December 31, 2018 and December 31, 2017 of approximately $151 million related to our investments in real estate. Other Income (Expenses) Interest expense totaled $64 million and $49 million for the years ended December 31, 2018 and 2017, respectively resulting in an increase of $15 million. On May 30, 2018, in connection with the Spin-Off, we borrowed an aggregate principal amount of $1.035 billion under the CMBS Facility (as defined below). The proceeds from the CMBS Facility were used to facilitate the repayment of existing debt. Accordingly, our total debt outstanding during 2018 was approximately $32 million higher than the similar period in 2017. Additionally, on May 30, 2018, we borrowed $25 million under our Revolving Facility (as defined below) at a rate of one-month LIBOR plus 4.5% per annum, which was repaid on August 2, 2018. The deferred financing costs related to the CMBS Facility and Revolving Facility each are being amortized over their initial term, which is a shorter period than the prior debt instruments, and accordingly are approximately $7 million higher than the same period in 2017. Additionally, in connection with the completion of the Spin-Off we issued $15 million of Cumulative Redeemable Series A Preferred Stock, par value $0.01 per share (the “Series A Preferred Stock”) at a current dividend rate of 13%. Distributions on our Series A Preferred Stock are classified as interest expense and were approximately $1 million for the year ended December 31, 2018. Further, as required by the CMBS Loan Agreement (as defined below), we entered into an interest rate cap on May 30, 2018 with a notional amount of $1.035 billion. As we did not designate the interest rate cap as a hedge, the change in fair value is recorded as interest expense. As of December 31, 2018, the fair value of our interest rate cap declined by $1 million primarily due to a change in expected interest rates and the relatively short duration of our interest rate cap. Other income, net, totaled $15 million and $1 million for the years ended December 31, 2018 and 2017, respectively. The increase of $14 million was primarily due to an increase in the amount of proceeds from business interruption insurance proceeds related to our hurricane damaged hotels, which are recorded as income as collected. As the business interruption claim process is currently ongoing, we expect additional business interruption proceeds in 2019. Accordingly, there is a gap between the timing of the lost revenue and recording of business interruption income. We also recognized a gain from the settlement of our prior interest rate swap in connection with the Spin-Off of $3 million. Loss on extinguishment of debt totaled $10 million for the year ended December 31, 2018 and was attributable to the early repayment of LQH’s term loans (the “Term Facility”). We did not have any debt extinguishment in 2017. Income tax (expense) benefit Our income tax expense from continuing operations totaled an expense of $21 million in 2018 and an income tax benefit of $109 million in 2017. The $130 million increase in income tax expense is primarily due to amounts recorded for the re-measurement of U.S. federal deferred tax assets and liabilities at lower enacted corporate tax rates due to the Tax Act primarily related to deferred tax liabilities on fixed assets, for the year ended December 31, 2017. The 2018 tax expense is primarily due to the tax impact pf pre-transaction operations of $12 million and post-transaction operations of $9 million. Loss from Discontinued Operations, net of tax Our reported discontinued operations relate to hotel franchise and hotel management operations which remained with La Quinta following the Spin-Off. The decrease in the reported loss is primarily due to the reported amounts only including a partial year of revenues with increased expenses related to completing the Spin-Off. Year ended December 31, 2017 compared with year ended December 31, 2016 The following table presents our overall operating performance for the year ended December 31, 2017 and 2016, including the amount and percentage change in these results between the periods ($ in millions, non-meaningful percentage changes are noted as “NM”): Revenues Room revenues at our hotels for the years ended December 31, 2017 and 2016 totaled $820 million and $855 million, respectively. The decrease of $35 million, or 4.1%, was primarily due to a decrease in the number of available rooms due to damage caused by hurricanes in the third quarter of 2017 and also driven by the sale of five hotels between the periods. RevPAR at our comparable hotels increased 0.2% for the year ended December 31, 2017 over the prior year period. The increase in RevPAR was driven by an increase in ADR of 1.1%, offset slightly by a decrease in occupancy of 58 basis points. Excluding the impact of the hotels impacted by the hurricanes and those undergoing significant renovation as part of the repositioning effort, comparable RevPAR increased 2.6% for the year ended December 31, 2017. Beginning in 2016 we began an over $200 million capital expenditure initiative to upgrade and reposition 54 hotels. These upgrades resulted in certain hotels being fully or partially taken off-line while the work was being completed. During 2017, these upgrades were completed for approximately 27 hotels. Our revenues were also impacted by 2017 hurricane damage. Hurricane Harvey (in August 2017) and Hurricane Irma (in September 2017), at peak of impact, removed from service approximately 3,000 rooms, either directly from property damage or damage to infrastructure surrounding the hotels. Operating expenses Rooms expense for our hotels totaled $353 million and $344 million for the years ended December 31, 2017 and 2016, respectively, resulting in an increase of $9 million. The variance in rooms expenses was primarily caused by a $8 million increase in payroll (including salaries and hourly wages), benefits, and contract labor due to difficulty in hiring. Additionally, travel agency commission costs increased by $3 million due to increased volume driven through third party online travel agencies. These increases were partially offset by a decrease in supply expenses and a decrease caused by five fewer hotels in the hotel portfolio at December 31, 2017 in comparison to the hotels owned at December 31, 2016 as a result of hotel sales. Corporate general and administrative expenses for our hotels totaled $76 million and $54 million, for the years ended December 31, 2017 and 2016, respectively, resulting in an increase of $22 million. The increase in corporate general and administrative expenses were primarily the result of increased transition costs and other non-recurring costs of $24 million in anticipation of establishing CorePoint as an independent, publicly traded company. Impairment loss for our hotels totaled $1 million and $104 million for the years ended December 31, 2017 and 2016, respectively. During 2017, we determined that one of our hotels was partially impaired due to economic conditions and we recorded a non-cash impairment charge of $1 million. During 2016, as part of a strategic review of our hotel portfolio, we identified approximately 50 hotels as possible candidates for sale and recorded a non-cash impairment charge of approximately $80 million after considering the reduced estimated holding period of these hotels. We also recorded a non-cash impairment charge of approximately $20 million in 2016 for the 8 hotels in held for sale during the year in order to reflect our expected sale price less transaction costs for these hotels. Additionally, during 2016 we determined that two of our hotels were partially impaired due to economic conditions and we recorded a non-cash impairment charge of $4 million. Income tax expense (benefit) Our income tax benefit from continuing operations totaled $109 million in 2017 and $2 million in 2016. The income tax benefit in 2017 is primarily due to $132 million recorded for the re-measurement of deferred tax assets and liabilities at lower enacted corporate tax rates due to the Tax Act, primarily related to our deferred tax liabilities on fixed assets. Significant Balance Sheet Fluctuations The discussion below relates to significant fluctuations in certain line items of our consolidated balances sheets from December 31, 2017 to December 31, 2018. Total real estate, net, decreased $158 million for the year ended December 31, 2018, primarily due to the $154 million impairment recorded in 2018 and to $154 million of 2018 depreciation expense, partially offset by approximately $139 million in additions to real estate. Other assets increased $22 million for the year ended December 31, 2018. The increase was primarily as a result of $15 million placed in lender escrow related to our CMBS Facility and $5 million related to escrow for general liability insurance claims. Assets and liabilities in discontinued operations as of December 31, 2017 were primarily composed of balance sheet items associated with our management and franchise businesses, which on May 30, 2018, was removed in connection with the completion of our Spin-Off. See Note 3 “Discontinued Operations” included in the notes to the consolidated financial statements included elsewhere in this Annual Report on Form 10-K. Debt, net increased $22 million for the year ended December 31, 2018. The increase was primarily a result of the refinancing of the Term Facility of $1.003 billion and placement of the new CMBS Facility of $1.035 billion, less applicable deferred finance costs related to the new placement. Mandatorily redeemable preferred shares increased $15 million for the year ended December 31, 2018 with the issuance in May 2018 of the Series A Preferred Stock. Dividends Payable increased $12 million for the year ended December 31, 2018. This increase is due to the Company’s commencement of quarterly common stock dividend payments subsequent to the Spin-Off. The Company declared a common stock dividend of $0.20 per share in the fourth quarter of 2018 which was paid on January 15, 2019. Deferred tax liabilities decreased $206 million during the year ended December 31, 2018. This is primarily due to our pre-Spin-Off deferred tax liabilities being written off as a result of the Company’s intent to be taxed as a REIT. Liquidity and Capital Resources Overview As of December 31, 2018, we had total cash and cash equivalents of $68 million and availability under our Revolving Facility of $150 million. Our known liquidity requirements primarily consist of funds necessary to pay for operating expenses associated with our hotels and other expenditures, including corporate expenses, legal costs, interest and scheduled principal payments on our outstanding indebtedness, potential payments related to our interest rate caps, capital expenditures for renovations and maintenance at our hotels, costs associated with our Spin-Off and the Merger, quarterly dividend payments and other purchase commitments. We finance our short-term business activities primarily with existing cash and cash generated from our operations. We believe that this cash will be adequate to meet anticipated requirements for operating expenses and other expenditures, including corporate expenses, payroll and related benefits, legal costs, and purchase commitments for the foreseeable future. We may also draw on our $150 million Revolving Facility to bridge any liquidity requirements. The objectives of our short-term cash management policy are to maintain the availability of liquidity and meet our recurring operational costs. In connection with the completion of the Spin-Off, the Company raised approximately $1 billion in long-term debt and preferred stock. These financings were used to retire debt incurred prior to the Spin-Off and to provide access to additional capital for our future operations. We believe that these long-term financings, plus our potential access to other debt and equity capital as a publicly traded REIT will allow us to fund our long-term strategic initiatives. As market conditions warrant and subject to liquidity requirements, contractual restrictions and other factors, we, our affiliates, and/or our major stockholders and their respective affiliates, may from time to time purchase our outstanding equity securities and/or debt through open market purchases, privately negotiated transactions or otherwise. We also review the operating performance of our hotel investments. Hotels that are not meeting our return and operating expectations are evaluated for opportunities to improve gross margins through operational improvements or capital investments to upgrade the property. If these initiatives are not successful, then we will consider dispositions of those hotels and reallocate the capital. Any amounts involved may be material. In connection with the Spin-Off and Merger, the parties agreed to set aside $240 million as a reserve amount to pay certain taxes that will be due as a result of the Spin-Off and related transaction. CorePoint and its tax advisors are continuing their work to finalize the calculations. We do not believe the eventual finalization will have a material effect on our liquidity. The following table summarizes our net cash flows for the years ended December 31, 2018, 2017, and 2016 ($ in millions, non-meaningful percentage changes are noted as “NM”): Operating activities Net cash provided by operating activities was $111 million for the year ended December 31, 2018, compared to $182 million for the year ended December 31, 2017. The $71 million decrease was primarily driven by higher hotel management and franchise royalty fees, increased corporate general and administration expenses related to the completion of the Spin-Off and the other operating results discussed above. This decrease also includes the effects of timing differences in our various working capital components including other assets, accrued payroll and employee benefits and other liabilities. Net cash provided by operating activities was $182 million for the year ended December 31, 2017, compared to $264 million for the year ended December 31, 2016. The $82 million decrease was primarily driven by decreased operating income, related to our hurricane damaged hotels and rooms temporarily out of service during our renovations as discussed above and increased general and administrative expenses of $22 million, primarily related to our Spin-Off. The change period over period also includes the effects of timing in our various working capital components including accounts receivable and accrued expenses and other liabilities. Investing activities Net cash used in investing activities during the year ended December 31, 2018 was $156 million, compared to net cash used in investing activities of $181 million during the year ended December 31, 2017. The $25 million decrease in cash used in investing activities was primarily attributable to a $27 million decrease in proceeds from the sale of real estate and a $51 million decrease in capital expenditures, partially offset by the $20 million lender escrows payments related to our new financings and insurance escrow with our hotel manager and a $19 million increase in insurance proceeds from casualty claims. The change in proceeds from the sale of real estate related to five hotel sales for the year ended December 31, 2017, compared to two smaller sales during the year ended December 31, 2018. Approximately $94 million of our capital expenditures for the year ended December 31, 2018 related to repositioning and casualty replacements. As these projects are completed, we expect our total capital expenditures to decrease. Net cash used in investing activities during the year ended December 31, 2017 was $181 million, compared to net cash used in investing activities of $70 million during the year ended December 31, 2016. The $111 million increase in cash used in investing activities was primarily due to an increase of $74 million of capital expenditures driven by increased renovations of our hotels and a decrease of $38 million in proceeds from hotel sales during 2017 as compared to 2016. Financing activities Net cash used in financing activities during the year ended December 31, 2018 was $28 million, compared to $21 million during the year ended December 31, 2017. The $7 million increase in cash used in financing activities was primarily attributable to the financing activity associated with the Spin-Off, including payment to LQH of $23 million related to the Spin-Off and issuance of the mandatorily redeemable preferred shares of $15 million less net payments. In 2017, our primary financing activity was the repayment of debt of $18 million. Net cash used in financing activities during the year ended December 31, 2017 was $21 million, compared to $120 million during the year ended December 31, 2016. The $99 million decrease in cash used in financing activities was primarily attributable to common stock repurchases of $102 million in 2016. Common stock repurchases were only $3 million in 2017. Discontinued Operations Effective with the closing of the Spin-Off on May 30, 2018, the results of operations related to the hotel franchise and hotel management business are reported as discontinued operations for all periods presented. In addition, the assets and liabilities of the hotel franchise and hotel management business have been segregated from the assets and liabilities related to the Company’s continuing operations and presented separately on the Company’s consolidated balance sheet as of December 31, 2017. In connection with the Spin-Off, CorePoint made a cash payment to LQH Parent of approximately $1 billion (the “Cash Payment”) immediately prior to and as a condition of the Spin-Off. The Cash Payment was to facilitate the repayment of part of LQH Parent’s existing debt. In addition, simultaneously with the closing of the merger, Wyndham Worldwide repaid, or caused to be repaid, on behalf of LQH Parent, LQH Parent’s Term Facility. Other than as specifically discussed in this section, we do not expect these discontinued operations to have a significant impact on our future liquidity. Capital expenditures Our capital expenditures are generally paid using cash on hand and cash flows from operations, although other sources discussed herein may also be used. During the years ended December 31, 2018 and 2017, we invested approximately $167 million and $218 million in capital expenditures, respectively (exclusive of discontinued operations). Approximately $94 million of these expenditures in 2018 related to our repositioning and casualty replacements. Approximately $57 million of our 2018 activity related to recurring hotel operations. As of December 31, 2018, we had outstanding commitments under capital expenditure contracts of approximately $25 million related to certain continuing redevelopment and renovation projects, casualty replacements and information technology enhancements. If cancellation of a contract occurred, our commitment would be any costs incurred up to the cancellation date, in addition to any costs associated with the discharge of the contract. In addition, our requirement to meet certain brand standards imposed by our franchisor includes requirements that we incur certain capital expenditures, generally ranging from $1,500 to $7,500 per hotel room (with various specific amounts within this range being applicable to different groups of our hotels) during a prescribed period generally ranging from two to eleven years. These amounts are over and above the capital expenditures we are required to make each year for recurring furniture, fixtures and equipment maintenance. However, these amounts that we are required to spend are subject to reduction, in varying degrees, by the amount of capital expenditures made for hotels in the applicable group over and above the capital expenditures required for the recurring maintenance in one or more years before receipt of the franchisor’s notice. The initial period during which the franchisor can notify us that we must make these capital expenditures is through 2028. At the franchisor’s discretion, subject to the franchise agreement provisions governing when such requirements may be imposed, the franchisor may provide a notice obligating us to meet those capital expenditure requirements generally within two to nine years of the notice. As of December 31, 2018, no such notices have been received; however, approximately 63% of our hotels are potentially eligible for such capital expenditure requirements. Through 2028, our remaining hotels will become eligible for such notices and capital expenditure requirements. We expect to meet these requirements primarily through our recurring capital expenditure program. As of December 31, 2018, $15 million was held in lender escrows that can be used to finance these requirements. We expect to meet all of these obligations from our operations, insurance claim reimbursements or other funds available to us. Financing Transactions in connection with the Spin-Off On May 30, 2018, certain indirect wholly-owned subsidiaries of CorePoint (collectively, the “CorePoint CMBS Borrower”) entered into a Loan Agreement (the “CMBS Loan Agreement”), pursuant to which the CorePoint CMBS Borrower borrowed an aggregate principal amount of $1.035 billion under a secured mortgage loan secured primarily by mortgages for 307 owned and ground leased hotels, an excess cash flow pledge for seven owned and ground leased hotels and other collateral customary for mortgage loans of this type (the “CMBS Facility”). The proceeds from the CMBS Facility were used to facilitate the repayment of part of LQH Parent’s existing debt. In addition, concurrently with the closing of the Merger, Wyndham repaid, or caused to be repaid, the Term Facility. Also on May 30, 2018, CorePoint Revolver Borrower and CorePoint OP entered into the Revolver Credit Agreement providing for the $150 million Revolving Facility (“Revolving Facility”). The Revolving Facility will mature on May 30, 2020, with an election to extend the maturity for one additional year subject to certain conditions, including that the maturity of the CMBS Facility be extended to a date no earlier than the maturity of the Revolving Facility. Upon consummation of the Spin-Off, $25 million was drawn on the Revolving Facility and repaid on August 3, 2018. We had no other Revolving Facility borrowings during 2018. In connection with LQH’s internal reorganization prior to the Spin-Off, the Company issued 15,000 shares of Series A Preferred Stock to a wholly-owned subsidiary of LQH Parent for a cash price of $15 million. LQH, through its subsidiary, privately sold all of the Series A Preferred Stock to an unrelated third-party investor immediately prior to the completion of the Spin-Off. As of December 31, 2018, we had cash and cash equivalents of $68 million and borrowing capacity under our Revolving Facility of $150 million, for a total availability of $218 million. We also believe we have access to other sources of debt and equity capital as a public company in addition to cash generated from our operations. The CMBS and Revolving Facility mature in 2020. The Revolving Facility provides for a one-year extension option and the CMBS Facility provides for five one-year extension options. We expect to exercise the extension options or refinance the related debt prior to the maturities of these facilities. There is no assurance that at those times we will be able to obtain financings at comparable interest rates or leverage levels or at all. Further, if we are unable to generate sufficient cash flow from operations in the future to service our debt, we may be required to reduce capital expenditures or refinance all or a portion of our existing debt. Our ability to make scheduled principal payments and to pay interest on our debt depends on the future performance of our operations, which is subject to general conditions in or affecting the hotel industry that are beyond our control. See “Risk Factors-Risks Related to our Business and Industry” and “Risk Factors-Risks Relating to Our Indebtedness” in this Annual Report on Form 10-K. Long-term liquidity and capital allocation The Company began a strategic real estate review in the fourth quarter of 2018 to improve operating performance and increase the Company’s net asset valuation. Our initial focus is on our lowest performing hotels, where we are evaluating opportunities to increase gross margin, net cash flow and return on investment. These include initiatives to increase revenue through access to the Wyndham platform and control of variable expenses per guest while still maintaining appropriate guest satisfaction levels. We will also consider repositioning these hotels, through capital investment and renovation. Concurrently with these initiatives we will consider dispositions of these hotels and reallocation of the capital. Such a capital reallocation could include new investments at a more attractive return, reducing leverage by paying down debt, either permanently or on a temporary basis, or returning capital to stockholders. The amounts involved in these activities could be material. Dividends Dividends are authorized at the discretion of our board of directors based on an analysis of our prior performance, market distribution rates of our industry peer group, expectations of performance for future periods, including actual and anticipated operating cash flow, changes in market capitalization rates for investments suitable for our portfolio, capital expenditure needs, dispositions, general financial condition and other factors that our board of directors deems relevant. The board’s decision will be influenced, in part, by our intent to maintain our status as a REIT. Beginning in August 2018 and effective for the second quarter of 2018, our board of directors authorized our first quarterly dividend. Such quarterly dividend was for a prorated amount of $0.067 per share, representing the period from the Spin-Off date to June 30, 2018, which represented an anticipated quarterly dividend rate of $0.20 per share of common stock. Our board of directors authorized additional quarterly dividends of $0.20 per share for the third and fourth quarter of 2018 in September 2018 and November 2018, respectively. Total dividends paid subsequent to the Spin-Off date was $16 million. Our fourth quarter dividend of $12 million in the aggregate was paid on January 15, 2019. The cash common stock dividends noted above represent a quarterly dividend payment of approximately $12 million, or an annual dividend payout of approximately $48 million. Cash flow from operating activities for the year ended December 31, 2018 was $111 million. Such cash flow from operating activities includes payments for our Series A Preferred Stock. Further, our NAREIT FFO for the year ended December 31, 2018 was $69 million. Accordingly, we believe our cash flow from operating activities and NAREIT FFO are in excess of our dividends. However, as dividends are at the sole discretion of our board of directors, there is no assurance of the amount of any future dividends, if any. (See “Non-GAAP Financial Measures” above for additional information regarding our calculation of funds from operations and a reconciliation to GAAP net income). Contractual obligations The following table summarizes our significant contractual obligations for the next five years and thereafter, as of December 31, 2018 (in millions): (1) Debt obligation excludes the deduction of debt issuance costs of $21 million. (2) Includes interest on debt outstanding as of December 31, 2018, all of which is floating rate debt. For presentation purposes, amounts included in the table are interest rates effective at December 31, 2018, which is 5.21% for the CMBS Facility, our only debt then outstanding. (3) Purchase commitments include outstanding commitments under contracts for capital expenditures at our hotels and for information technology enhancements. (4) These amounts do not include capital expenditures which our franchisor may require to meet brand standards. Such amounts are effective upon notice from the franchisor, primarily during the periods through 2028. As of December 31, 2018, no such notices have been received. Based on our franchise agreement, our franchisor may currently provide notices for approximately $80 million, where we would have up to nine years to meet the requirements. The franchisor would be eligible to provide notices for approximately $5 million in 2020, approximately $90 million in 2021 and approximately $75 million thereafter to 2028. For these years, the Company generally has two to eleven years to meet the capital expenditure requirements, which may be offset to various degrees by prior year capital expenditures. Accordingly, actual amounts and the timing of such amounts may differ from those described. We expect to generally meet these requirements from our ordinary capital expenditure programs, funded from cash flow from operating activities or the other sources described herein. Off-balance sheet arrangements We currently have no off-balance sheet arrangements that have or are reasonably likely to have a current or future material effect on our financial condition, revenues or expenses, results of operations, liquidity, capital expenditures or capital resources. Critical accounting policies and estimates The preparation of our financial statements in accordance with GAAP requires us to make estimates and assumptions that affect the reported amounts of assets and liabilities as of the date of the consolidated financial statements, the reported amounts of revenues and expenses during the reporting periods and the related disclosures in the consolidated financial statements and accompanying footnotes. We believe that of our significant accounting policies, which are described in Note 2: “Significant Accounting Policies and Recently Issued Accounting Standards” in the audited consolidated financial statements included elsewhere in this Annual Report on Form 10-K, the following accounting policies are critical because they involve a higher degree of judgment, and the estimates required to be made were based on assumptions that are inherently uncertain. As a result, these accounting policies could materially affect our financial position, results of operations and related disclosures. On an ongoing basis, we evaluate these estimates and judgments based on historical experiences and various other factors that are believed to reflect the current circumstances. While we believe our estimates, assumptions and judgments are reasonable, they are based on information presently available. Actual results may differ significantly from these estimates due to changes in judgments, assumptions and conditions as a result of unforeseen events or otherwise, which could have a material impact on financial position or results of operations. Impairment of long-lived assets We review our long-lived assets, such as property and equipment and intangible assets, for impairment, whenever events or changes in circumstances indicate that the carrying amount of an asset may not be recoverable. When such circumstances are identified as an impairment indicator for a long-lived asset, we compare the sum of the expected future cash flows (undiscounted and without interest charges) generated by the asset or group of assets during the asset’s estimated holding period with its associated net carrying value. If the net carrying value of the asset or group of assets exceeds expected future cash flows, the excess of the net book value over estimated fair value is charged to impairment loss in the statements of operations. Properties held for sale are reported at the lower of their carrying amount of their estimated sales price, less estimated costs to sell. We estimate fair value for our hotels primarily using unobservable inputs related to common valuation methods and metrics used by market participants, which include multiples of hotel revenues, capitalization rates applied to the properties’ net operating income and per room valuations. In the event our estimate of fair value of the asset using these unobservable inputs becomes the new basis of the asset or group of assets, this new basis is then depreciated over the asset’s remaining useful life. We incurred non-cash impairment charges in each of the three years ended December 31, 2018, and we may be subject to impairment charges in the future. Triggering events for future impairment charges include, but are not limited to, situations where individual hotel operations are materially different from its forecasts, fair values of our hotels change, the economy or the lodging industry weakens, or the estimated holding period of a hotel is shortened. Insurance programs From our hotel operations, we are exposed to liability claims from our hotel guests, employees of our hotel management company and other third parties. We manage these liabilities either through insurance directly purchased by us or indirectly from insurance purchased by our third-party hotel management company. These insurance programs are primarily related to workers’ compensation, general liability and automobile liability. These policies contain deductibles and retention limits on a primary and excess limits basis, where the Company retains and is therefore exposed to first dollar claim liability. Case loss reserves are established for losses within the insurance programs. These individual case reserves are estimates of amounts necessary to settle the claims as of the reporting date. These individual case estimates are based on known facts and interpretations of circumstances and legal standards and include the claims representatives’ expertise and experience with similar cases. These individual estimates change over time as additional facts and information become known. Periodically, we perform a formal review of estimates of the ultimate liability for losses and associated expenses for each coverage component of the casualty insurance program within the deductible and self-insured retention. These loss claims may require an extended period for the claim to be asserted and to reach a final settlement. Accordingly, we, and/or our hotel management company, engage outside actuaries who perform an analysis of historical development trends of loss frequency and severity in order to project the ultimate liability for losses, including incurred but not reported claims. We revise our reserve amounts periodically based upon recognized changes in the development factors and trends that affect loss costs and their impact on the actuarial calculation. These estimates are influenced by external factors, including inflation, changes in law, court decisions and changes to regulatory requirements, economic conditions and public attitudes. Income taxes Subsequent to the Spin-Off, we intend to elect to be taxed as a REIT under the Code, which will be effective with the filing of our U.S. federal tax return for the year ended December 31, 2018. To qualify as a REIT, we must meet a number of organizational and operational requirements, including a requirement that we distribute at least 90% of our REIT taxable income to our stockholders. These Code provisions also include that the Company cannot operate or manage its hotels. Therefore, the REIT leases the hotel properties to the TRS, where the TRS is subject to federal, state and local income taxes. Accordingly, other than with respect to our TRS operations, we generally will not be subject to federal income tax at the corporate level. We are organized and operate in such a manner as to qualify for taxation as a REIT under the Code, and we intend to continue to operate in such a manner, but no assurance can be given that we will operate in a manner so as to remain qualified as a REIT. In determining our tax expense for financial statement reporting purposes, we must evaluate our compliance with the Code, including the transfer pricing determinations used in establishing rental payments between the REIT and the TRS. GAAP accounting for income taxes requires, among others, interpretation of the Code, estimated tax effects of transactions, and evaluation of probabilities of sustaining tax positions, including realization of tax benefits. We recognize tax positions only after determining that the relevant tax authority would more likely than not sustain the position following the audit. The final resolution of those assessments may subject us to additional taxes. In addition, we may incur expenses defending our positions during IRS tax examinations, even if we are able to eventually sustain our position with the tax authorities. As more fully discussed in Note 11. “Commitments and Contingencies” in the audited consolidated financial statements included elsewhere in this report, LQH is under two audits by the IRS covering periods from 2010 to 2013 related to tax deductions made by the LQH predecessor TRS during those periods. These IRS tax claims total approximately $158 million, not including penalties and interest and the possible loss of certain tax operating loss carryforwards arising from those years. Based on our review of these IRS claims, and the advice of our tax professional firms, the methodologies applied in the tax audits are flawed and the IRS proposed tax and other adjustments are inconsistent with U.S. federal tax laws related to REITs. Accordingly, we have concluded that the positions reported on the tax returns under audit by the IRS are, based on their technical merits, more-likely-than-not to be sustained upon examination. Accordingly, as of December 31, 2018, we have not established any reserves related to these IRS audits. However, if we are unsuccessful in challenging the IRS, we would be responsible for additional income taxes, interest and penalties in amounts that could be material to our financial position and results of operations. Also, as more fully discussed in Note 11. “Commitments and Contingencies,” the Spin-Off is treated as a taxable transaction and Wyndham Worldwide reserved $240 million for these potential income tax expenses. Any amount remaining from the amount reserved would be remitted to the Company. Any related tax payment in excess of the reserve is the responsibility of Wyndham Worldwide and the Company is obligated to deliver to Wyndham Worldwide either cash or common stock in an amount equal to the amount of the excess. As the calculations of the tax due has not been completed, the final determination of the reserve amount is not known. Any adjustment related to the settlement of the reserve, including the issuance of the Company’s common stock, would result in an adjustment to stockholders’ equity. As of December 31, 2018, no adjustment related to the settlement of this reserve has been recorded in the consolidated financial statements. Legal contingencies We are subject to various legal proceedings and claims, the outcomes of which are subject to significant uncertainty. We accrue an estimated amount for a loss contingency if it is probable and the amount of the loss can be reasonably estimated. Significant judgment is required when we evaluate, among other factors, the degree of probability of an unfavorable outcome and the ability to make a reasonable estimate of the amount of loss. Changes in these factors could materially impact our consolidated financial statements. New Accounting Pronouncements See Note 2 of the notes to our consolidated financial statements in this Annual Report on Form 10-K for a comprehensive list of new accounting pronouncements.

<s>[INST] This Management’s Discussion and Analysis of Financial Condition and Results of Operations (“MD&A”) is intended to help provide an understanding of our business and results of operations. This MD&A should be read in conjunction with our consolidated financial statements and the notes thereto included in this Annual Report on Form 10K. This report, including the following MD&A, contains forwardlooking statements regarding future events or trends that should be read in conjunction with the factors described under “ForwardLooking Statements.” Actual results or developments could differ materially from those projected in such statements as a result of the factors described under “ForwardLooking Statements” as well as the risk factors described in Part I, Item 1A, “Risk Factors,” of this Annual Report on Form 10K. For purposes of the following discussion and unless otherwise indicated or the context otherwise requires, “we,” “our,” “us,” “CorePoint” and “CorePoint Lodging” refer to CorePoint Lodging Inc. and its consolidated subsidiaries in each case, after giving effect to the SpinOff, including the internal reorganization and Distribution; “LQH” refers to La Quinta Holdings Inc. and its consolidated subsidiaries; references to “LQH Parent” refer only to La Quinta Holdings Inc. exclusive of its subsidiaries, in each case before giving effect to the SpinOff; “La Quinta” refers to La Quinta Holdings Inc and its consolidated subsidiaries; and references to “La Quinta Parent” refer only to La Quinta Holdings Inc., exclusive of its subsidiaries, in each case after giving effect to the SpinOff. See “Overview” below. Overview Our Business CorePoint is a leading owner in the midscale and upper midscale select service hotel segments, primarily under the La Quinta brand. Our portfolio, as of December 31, 2018, consisted of 315 hotels representing approximately 40,400 rooms across 41 states in attractive locations in or near employment centers, airports, and major travel thoroughfares. All but one of our hotels is whollyowned. We primarily derive our revenues from our hotel operations. SpinOff from LQH On May 30, 2018, LQH Parent spun off its hotel ownership business as an independent, publicly traded company as part of a plan approved by LQH Parent’s board of directors prior to the Merger of LQH Parent with a whollyowned subsidiary of Wyndham Worldwide. CorePoint Parent entered into a Separation and Distribution Agreement in January 2018 and several other agreements with LQH Parent prior to consummation of the SpinOff. These agreements set forth the principal transactions required to effect CorePoint Lodging’s separation from LQH and provide for the allocation between CorePoint Parent and La Quinta Parent of various assets, liabilities, rights and obligations (including employee benefits, intellectual property, insurance and taxrelated assets and liabilities) and govern the relationship between CorePoint Lodging and La Quinta after completion of the SpinOff. These agreements also include arrangements with respect to transitional services to be provided by La Quinta to CorePoint Lodging. In addition, prior to the SpinOff, CorePoint Lodging entered into agreements, including longterm hotel management and franchise agreements for each of its hotels, with LQH that have either not existed historically, or that may be on different terms than the terms of the arrangement or agreements that existed prior to the SpinOff. The consolidated financial statements of CorePoint included herein do not reflect the effect of these new or revised agreements for the entirety of the periods presented and LQH’s historical expenses may not be reflective of CorePoint Lodging’s consolidated results of operations, financial position and cash flows had it been a standalone company during the entirety of the periods discussed in the “Results of Operations” section below. Effective with the closing of the SpinOff, the results of operations related to the hotel franchise and hotel management business are reported as discontinued operations. Wyndham Transition and Integration In connection with the agreements we entered into with LQH, our hotels became a part of the management and franchise platforms of Wyndham Worldwide, and we are proactively engaged in the related transition and [/INST] Negative. </s>

CorePoint Lodging Inc.

2020-03-13

2019-12-31

Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations The following discussion and analysis is intended to help provide an understanding of our business and results of operations and should be read in conjunction with the accompanying consolidated financial statements and the notes thereto. This discussion and analysis deals with comparisons of material changes in the consolidated financial statements for the years ended December 31, 2019 and 2018. For a discussion and analysis of our financial condition and results of operations for the year ended December 31, 2017, see the Management’s Discussion and Analysis of Financial Condition and Results of Operations in Part II, Item 7 of our Annual Report on Form 10-K for the year ended December 31, 2018, filed with the Securities and Exchange Commission on March 22, 2019 which specific discussion is incorporated herein by reference. Overview CorePoint is a leading owner in the midscale and upper midscale select service hotel segments, all under the La Quinta brand. Our portfolio, as of December 31, 2019, consisted of 271 hotels representing approximately 35,000 rooms across 41 states in locations in or near employment centers, airports, and major travel thoroughfares. All but one of our hotels is wholly owned. We primarily derive our revenues from our hotel operations. Wyndham Transition and Integration In connection with the agreements entered into with subsidiaries of La Quinta Holdings Inc. (“LQH Parent” and, together with its consolidated subsidiaries, “LQH”), our hotels became a part of the management and franchise platforms of Wyndham. This related transition and integration, which is ongoing, includes: • transitioning to Wyndham’s distribution network, including Wyndham.com, contact centers and loyalty platform; • technology and system integrations for property management, reservation systems and revenue management; and • gross margin initiatives related to operating expenses and other service delivery management. We are in regular communication with Wyndham and are actively monitoring their progress in transitioning and integrating our hotels to their platform, much of which LQM completed during the second quarter of 2019. As part of these platform initiatives, modifications were made to the revenue management software and tools, the call center customer interface technology and the administration of corporate and group bookings. We believe these modifications, and other problems relating to implementation of the transition of our hotels to their platform, contributed to lower occupancy and rental rates and consequently adversely affected our business. In addition, we were not always receiving timely and adequate books of account and other accounting records as required by the management agreements. As a result, on July 30, 2019 and August 14, 2019, we gave notice to LQM that we believed there were several events of default under the management agreements relating to all of our wholly owned properties. On October 18, 2019, the Company and CorePoint TRS L.L.C. (“CorePoint TRS”), an indirect subsidiary of the Company, on the one hand, and LQM, LQ Franchising and Wyndham Hotel Group, LLC (“Wyndham Hotel” and, collectively with the Company, CorePoint TRS, LQ Franchising and LQM, the “Parties”), on the other hand, entered into a settlement agreement relating to (a) the management, franchising, operation and sales of the Company’s portfolio of hotels pursuant to the (1) Management Agreements between CorePoint TRS and Manager, dated May 30, 2018 (“Management Agreements”), and (2) Franchise Agreements between CorePoint TRS and Franchisor, dated May 30, 2018 (“Franchise Agreements”), and (b) the Tax Matters Agreement, dated as of May 30, 2018, by and between LQH Parent and the Company (the “Tax Matters Agreement”) (the “Wyndham Settlement”). Pursuant to the Wyndham Settlement, with respect to certain revenue management matters: • LQM agreed to develop, install and implement at its expense a fully functional enhanced dynamic best available rate-setting tool providing functionality at least reasonably equivalent to the legacy rate-setting tool used for the Company’s hotels (the “DBAR Replacement Tool”); the fully functional implementation is to be accomplished by December 31, 2020, subject to certain extensions; • LQM agreed to deploy at its expense an enhanced direct billing system for corporate group clients at least reasonably equivalent to the legacy direct billing system used for the Company’s hotels; the fully functional implementation of such direct billing system is to be made by June 30, 2020, subject to certain extensions; and • LQM agreed to deploy at its expense certain enhanced legacy booking tools used for the Company’s hotels. The implementations and deployments are underway and on schedule. As of the date of this filing, we are unable to assess the effectiveness of the tools and systems on our future operations. With respect to certain financial reporting and accounting matters, the Wyndham Settlement amends the Parties’ respective obligations concerning financial deliverables within specified time frames. In addition, LQM agreed to provide, at its sole cost and expense, an annual System and Organization Control Report prepared by a “Big Four” accounting firm or other firm mutually agreed upon by the Parties by no later than February 1, 2021 and February 1 of each year thereafter. Wyndham also agreed to pay $20 million to resolve all actual and potential claims between the Parties, including but not limited to our alleged loss of revenue. Wyndham paid $11 million during 2019, with the remainder to be made in cash payments over time and satisfied in full by June 30, 2021. The full $20 million was recorded to income in 2019. As of the date of this filing, Wyndham has made aggregate payments of $13 million. Pursuant to the Wyndham Settlement, the Parties amended the Franchise Agreements to limit the criteria for LQ Franchising’s approval of asset sales, including the adoption of certain objective criteria with respect to liquidity, net worth and operating experience of the proposed buyer. As discussed in “Part I-Item. 1 Business,” this amendment was a significant factor in the development of our hotel disposition strategy. In addition, Wyndham made a cash payment to us of $17 million in connection with the Tax Matters Agreement. As the payment related to income tax attributable to the Spin-Off, the transaction was recorded to equity in 2019 and not as a component of our 2019 income. Pursuant to the Wyndham Settlement, the Company and CorePoint TRS agreed to a release of all claims against LQM, LQ Franchising, Wyndham Hotel or any of their affiliates arising out of or relating to (a) any alleged violation or breach of the Management Agreements, the Franchise Agreements, and specified provisions of the Tax Matters Agreement or any other agreements between the Parties, up to and including the date of the Wyndham Settlement, (b) the transition to the Wyndham platform in the second quarter of 2019 and (c) once the Company has given its final approval of the DBAR Replacement Tool, the development, installation, implementation, or operation of the DBAR Replacement Tool. Wyndham Hotel, LQM and LQ Franchising agreed to a release of all claims against the Company and CorePoint TRS or any of their affiliates arising out of or relating to any violation or breach of the Management Agreements, the Franchise Agreements, and specified provisions of the Tax Matters Agreement or any other agreements between the Parties, up to and including the date of the Wyndham Settlement. Non-Core Hotel Disposition Strategy In 2019, after the finalization of the Wyndham Settlement, our strategy has primarily focused on opportunities to dispose of our lower performing hotels, identifying as of December 31, 2019, 166 non-core hotels. These hotels are generally older and have lower RevPAR and higher capital expenditure requirements. We will seek to sell those assets generally over the next two years. There can be no assurance as to the timing of any future sales, whether any approvals required under applicable franchise agreements will be obtained or upon what terms, whether such sales will be completed at all, or, if completed, their effect on our future results. During 2019, we sold 42 operating hotels, for gross consideration of $173 million and two non-operating hotels for gross consideration of $4 million. Subsequent to December 31, 2019, an additional 17 operating hotels were sold, for gross consideration of $74 million. As these hotels were among our lowest performing hotels, we believe these dispositions will positively impact portfolio RevPAR and gross margin. Further, as the net sales proceeds were substantially used to retire portions of our existing debt, these dispositions will reduce interest expense. We expect to also benefit from no longer incurring capital expenditures for the disposed hotels, increasing the availability of liquidity for other uses. See “Part I-Item 1A. Risk Factors - Risks Related to Our Business and Industry - We face various risk posed by our disposition activities as well as our acquisition, redevelopment, repositioning, renovation and re-branding activities.” Certain historical information related to the 42 operating hotels sold during 2019 is presented in the table below (amounts in millions, except for RevPAR): ____________________ (1) Hotel Adjusted EBITDAre and FFO are non-GAAP financial measures. See “Non-GAAP Financial Measures” below for definitions and limitations of these terms. The related “Sales Metrics,” which are common in the lodging industry in evaluating dispositions, as further defined below, are referred to as the revenue multiple, EBITDAre multiple and FFO yield. Amounts presented are the aggregated amounts and for Sales Metrics are based on a weighted average for each category using unrounded dollar amounts. (2) Revenues represent the revenues for the trailing twelve-month period from the calendar quarter end date preceding the particular hotel’s disposition. The Sales Metric referred to as the revenue multiple is calculated as the gross sales price divided by such revenues. Closing costs and other costs due from the sale have averaged approximately 10% of the gross sales price. (3) RevPAR represents the weighted average RevPAR for the trailing twelve-month period. Our weighted average Comparable Hotel RevPAR for the year ended December 31, 2019 is $58.75. (4) Hotel Adjusted EBITDAre represents Hotel Adjusted EBITDAre for the trailing twelve-month period from the calendar quarter end date preceding the particular hotel’s disposition. The Sales Metric referred to as the Hotel Adjusted EBITDAre multiple is calculated as gross sales price divided by such calculated Hotel Adjusted EBITDAre. (5) FFO represents the FFO for the trailing twelve-month period from the calendar quarter end date preceding the particular hotel’s disposition. The FFO amount includes the related annualized interest expense based on the actual debt principal paid down for each hotel sale using the December 31, 2019 interest rate of 4.51%. The FFO amount includes only directly associated hotel expenses and does not include any allocated general and administrative or other corporate expenses. The Sales Metric referred to as FFO yield is calculated as such calculated FFO divided by the gross sales price less the actual debt principal paid down. (6) Capital expenditures represent capital expenditures for the trailing twelve-month period from the calendar quarter end date preceding the particular hotel’s disposition. Hotel Capital Investment During 2019, we invested approximately $74 million in capital investments in our hotels. Approximately $10 million related to repositioning expenditures which were a part of our 54-hotel renovation program started in 2016 and completed in 2019. In addition, approximately $20 million related to hurricane restoration costs from recent storms and other casualties. We anticipate an additional $14 million during 2020 for the completion of the hurricane repair work. We expect a substantial portion of these costs to be reimbursed by insurance. Compared to 2018, during 2019, the properties impacted by the renovation program and hurricanes experienced an approximate increase in occupancy of 136 basis points and an approximate increase in RevPAR of 0.4%. The remaining capital investments during 2019 related to recurring maintenance and upgrade capital expenditures to our hotel properties. These represent approximately 5% of 2019 revenues. We generally expect these capital expenditures to fall within a range of 5% to 10% of annual revenues, with quarterly variances due to seasonality of revenues and timing of capital expenditures. To the extent we are able to complete the dispositions of other hotels, we anticipate that our total recurring maintenance and upgrade capital expenditures will decline on an absolute basis. We currently anticipate funding these capital investments from cash flows from operating activities, insurance proceeds, hotel sales, proceeds from the Wyndham Settlement and other potential sources. Segment Reporting Our hotel investments have similar economic characteristics and our service offerings and delivery of services are provided in a similar manner, using the same types of facilities and similar technologies. Our chief operating decision maker reviews our financial information on an aggregated basis. As a result, we have concluded that we have one reportable business segment. Inflation We do not believe that inflation had a material effect on our business during the years ended December 31, 2019 and 2018 due to low inflation rates, both nationally and in the primary local markets of our hotels. Although we believe that increases in the rate of inflation will generally result in comparable increases in hotel room rates and operating expenses, severe inflation could contribute to a slowing of the U.S. economy. Such a slowdown could result in a reduction in room rates and occupancy levels, negatively impacting our revenues and net income. Further, to the extent that inflation is correlated with higher interest rates, our borrowing costs on our floating rate debt or new debt placements could be higher. Other factors that may affect our results of operations Due to the recent outbreak of coronavirus disease 2019 (COVID-19) reported in many countries worldwide, major companies have begun to cancel conferences and travel plans and require employees to work from home. Local and federal governments have issued travel advisories, canceled large scale public events and closed schools. Beginning in late February 2020, we have experienced lost revenue due to slowdowns in transient travel and reservation bookings. Although group travel does not constitute a material part of our overall revenue mix, we have also noted group and conference cancellations. The impact of coronavirus (COVID-19) on our future results could be significant and will largely depend on future developments, which we cannot accurately predict, including new information which may emerge concerning the severity of coronavirus (COVID-19), the success of actions taken to contain or treat coronavirus (COVID-19), and reactions by consumers, companies, governmental entities and capital markets. Key components and factors affecting our results of operations Revenues Room revenues are primarily derived from room lease rentals at our hotels. We recognize room revenues on a daily basis, based on an agreed-upon daily rate, after the guest has stayed at one of our hotels. Customer incentive discounts, cash rebates, and refunds are recognized as a reduction of room revenues. Occupancy, hotel, and sales taxes collected from customers and remitted to the taxing authorities are excluded from revenues in our consolidated statements of operations. Principal Components of Revenues Rooms. These revenues represent room lease rentals at our hotels and account for a substantial majority of our total revenue. Other revenue. These revenues represent revenue generated by the incidental support of operations at our hotels, including charges to guests for vending commissions, meeting and banquet rooms, and other rental income from operating leases associated with leasing space for restaurants, billboards and cell towers. Factors Affecting our Revenues Hotel dispositions. As discussed above, we continue to evaluate dispositions of our non-core hotels. As these hotels are sold, our revenues will decrease. We sold 42 operating hotels during the year ended December 31, 2019, and we sold two operating hotels in 2018. These sold hotels generated revenue of $49 million and $72 million, for the years ended December 31, 2019 and 2018, respectively. Customer demand. Our customer mix includes both leisure travelers and business travelers. Customer demand for our products and services is closely linked to the performance of the general economy on both a national and regional basis and is sensitive to business and personal discretionary spending levels. Leading indicators of demand include gross domestic product, unemployment rates, wage growth, business spending and the consumer price index. Declines in customer demand due to adverse general economic conditions, reductions in travel patterns, severe weather, lower consumer confidence, outbreaks of pandemic or contagious diseases, and adverse political conditions can lower the revenues and profitability of our hotels. As a result, changes in consumer demand and general business cycles have historically subjected, and could in the future subject, our revenues to significant volatility. See “Item 1A. Risk Factors-Risks Related to Our Business and Industry.” Supply. New room supply is an important factor that can affect the lodging industry’s performance. Room rates and occupancy, and thus RevPAR, tend to increase when demand growth exceeds supply growth. The addition of new competitive hotels affects the ability of existing hotels to sustain or grow RevPAR, and thus profits. Age and amenities. Newly constructed or remodeled hotels generally will drive higher room rates and occupancy than older properties with deferred maintenance. Similarly, hotels with greater and more current amenities, which are in demand by lodgers, will also be able to achieve higher room rates and occupancy. The average age of our hotels is approximately 31 years. We have recently completed a renovation and repositioning program for 54 hotels. We will continue to evaluate our hotels for other appropriate improvements, where we can upgrade the hotels and increase our competitiveness in the market. Expenses Principal Components of Certain Expenses Rooms. These expenses include hotel operating expenses of housekeeping, reservation systems (per our franchise agreements), room and breakfast supplies and front desk costs. Other departmental and support. These expenses include expenses that constitute non-room operating expenses, including parking, telecommunications, on-site administrative labor, sales and marketing, loyalty program, recurring repairs and maintenance and utility expenses. Property tax, insurance and other. These expenses consist primarily of real and personal property taxes, other local taxes, ground rent, equipment rent and insurance. Management and royalty fees. Management and royalty fees represent fees paid to third parties and are computed as a percentage of revenues. Factors Affecting our Costs and Expenses Variable expenses. Expenses associated with our room expenses are mainly affected by occupancy and correlate closely with their respective revenues. These expenses can increase based on increases in housekeeping salaries, occupancy levels, as well as on the level of service and amenities that are provided. Our management and royalty fees are also primarily driven by our level of gross or room revenues. For the year ended December 31, 2019, management fees represent 5% of total gross revenues and royalty fees represent 5% of our room revenues. We are also subject to other brand and ancillary fees. Further, a large portion of our room revenues is commissions-based and depends on our revenue channel distribution mix. On a comparable hotel basis, for the year ended December 31, 2019, online travel agencies represented approximately 34% of our revenue channel mix. Fixed expenses. Many of the other expenses associated with our hotels are relatively fixed. These expenses include portions of administrative field staff salaries, rent expense, property taxes, insurance and utilities. Since we generally are unable to decrease these costs significantly or rapidly when demand for our hotels decreases, any resulting decline in our revenues can have a greater adverse effect on our net cash flow, margins and profits. This effect can be especially pronounced during periods of economic contraction or slow economic growth. The effectiveness of any cost-cutting efforts is limited by the amount of fixed costs inherent in our business. As a result, we may not be able to successfully offset revenue reductions through cost cutting. Individuals employed at certain of our hotels are party to collective bargaining agreements with our hotel managers that may also limit the manager’s ability to make timely staffing or labor changes in response to declining revenues. In addition, any efforts to reduce costs, or to defer or cancel capital improvements, could adversely affect the economic value of our hotels. We have taken steps to reduce our fixed costs to levels we believe are appropriate to maximize profitability and respond to market conditions without jeopardizing the overall customer experience or the value of our hotels. Changes in depreciation and amortization expense. Changes in depreciation expense are due to renovations of existing hotels, acquisition or development of new hotels, the disposition of existing hotels through sale or closure or changes in estimates of the useful lives of our assets. As we incur additions to our hotels or place new assets into service, we will be required to recognize additional depreciation expense on those assets. Conversely, impairment losses, which are effectively accelerated depreciation, will reduce future depreciation expenses at these hotels. Age. As hotels age, maintenance expense tends to increase. These expenses include more frequent and higher costing repairs, higher utility and insurance expenses, increased supplies and higher labor costs. If these costs result in capitalized improvements, depreciation expense could increase over time as discussed above. Renovations and other hotel improvements can mitigate the maintenance expenses of older properties. For other factors affecting our costs and expenses, see “Item 1A. Risk Factors-Risks Related to Our Business and Industry.” Key indicators of financial condition and operating performance We use a variety of financial and other information in monitoring the financial condition and operating performance of our business. Some of this information is financial information that is prepared in accordance with GAAP, while other information may be financial in nature and may not be prepared in accordance with GAAP. Our management also uses other information that may not be financial in nature, including statistical information and comparative data that are commonly used within the lodging industry to evaluate hotel financial and operating performance. Our management uses this information to measure the performance of hotel properties and/or our business as a whole. Historical information is periodically compared to budgets, as well as against industry-wide information. We use this information for planning and monitoring our business, as well as in determining management and employee compensation. Average daily rate (“ADR”) represents hotel room revenues divided by total number of rooms rented in a given period. ADR measures the average room price attained by a hotel or group of hotels, and ADR trends provide useful information concerning pricing policies and the nature of the guest base of a hotel or group of hotels. Changes in room rates have an impact on overall revenues and profitability. Occupancy represents the total number of rooms rented in a given period divided by the total number of rooms available at a hotel or group of hotels. Occupancy measures the utilization of our hotels’ available capacity, which may be affected from time to time by our repositioning, property casualties and other activities. Management uses occupancy to gauge demand at a specific hotel or group of hotels in a given period. Occupancy levels also help us determine achievable ADR levels as demand for hotel rooms increases or decreases. Revenue per available room (“RevPAR”) is defined as the product of the ADR charged and the average daily occupancy achieved. RevPAR does not include bad debt expense or other ancillary, non-room revenues, such as food and beverage revenues or parking, telephone or other guest service revenues generated by a hotel, which are not significant for us. RevPAR changes that are driven predominately by occupancy have different implications for overall revenue levels and incremental hotel operating profit than changes driven predominately by ADR. For example, increases in occupancy at a hotel would lead to increases in room and other revenues, as well as incremental operating costs (including, but not limited to, housekeeping services, utilities and room amenity costs). RevPAR increases due to higher ADR, however, would generally not result in additional operating costs, with the exception of those charged or incurred as a percentage of revenue, such as management and royalty fees, credit card fees and commissions. As a result, changes in RevPAR driven by increases or decreases in ADR generally have a greater effect on operating profitability at our hotels than changes in RevPAR driven by occupancy levels. Due to seasonality in our business, we review RevPAR by comparing current periods to budget and period-over-period. Comparable Hotels are defined as hotels that were active and operating in our system for at least one full calendar year as of the end of the applicable reporting period and were active and operating as of January 1st of the previous year. Comparable Hotels exclude: (i) hotels that sustained substantial property damage or other business interruption; (ii) hotels that are sold or classified as held for sale; or (iii) hotels in which comparable results are otherwise not available. Management uses Comparable Hotels as the basis upon which to evaluate ADR, occupancy, and RevPAR. Management calculates comparable ADR, Occupancy, and RevPAR using the same set of Comparable Hotels as defined above. Further, we report variances in comparable ADR, occupancy, and RevPAR between periods for the set of Comparable Hotels existing at the reporting date versus the results of the same set of hotels in the prior period. Of the 271 hotels in our portfolio as of December 31, 2019, 257 have been classified as Comparable Hotels. Non-GAAP Financial Measures We also evaluate the performance of our business through certain other financial measures that are not recognized under GAAP. Each of these non-GAAP financial measures should be considered by investors as supplemental measures to GAAP performance measures such as total revenues, operating profit and net income. These measurements are not to be considered more relevant or accurate than the measurements presented in accordance with GAAP. In compliance with SEC requirements, our non-GAAP measurements are reconciled to the most directly comparable GAAP performance measurement. For all non-GAAP measurements, neither the SEC nor any other regulatory body has passed judgment on these non-GAAP measurements. EBITDA, EBITDAre, Adjusted EBITDAre and Hotel Adjusted EBITDAre “EBITDA.” Earnings before interest, income taxes, depreciation and amortization (“EBITDA”) is a commonly used measure in many REIT and non-REIT related industries. We believe EBITDA is useful in evaluating our operating performance because it provides an indication of our ability to incur and service debt, to satisfy general operating expenses, and to make capital expenditures. We calculate EBITDA excluding discontinued operations. EBITDA is intended to be a supplemental non-GAAP financial measure that is independent of a company’s capital structure. “EBITDAre.” We present EBITDAre in accordance with guidelines established by the National Association of Real Estate Investment Trusts (“Nareit”). Nareit defines EBITDAre as EBITDA adjusted for gains or losses on the disposition of properties, impairments, and adjustments to reflect the entity’s share of EBITDAre of unconsolidated affiliates. We believe EBITDAre is a useful performance measure to help investors evaluate and compare the results of our operations from period to period. “Adjusted EBITDAre.” Adjusted EBITDAre is calculated as EBITDAre adjusted for certain items, such as restructuring and separation transaction expenses, acquisition transaction expenses, stock-based compensation expense, severance expense, and other items not indicative of ongoing operating performance. “Hotel Adjusted EBITDAre.” measures property-level results at our hotels before corporate-level expenses and is a key measure of a hotel’s profitability. We present Hotel Adjusted EBITDAre to assist us and our investors in evaluating the ongoing operating performance of our properties. We believe that EBITDA, EBITDAre, Adjusted EBITDAre and Hotel Adjusted EBITDAre provide useful information to investors about our financial condition and results of operations for the following reasons: (i) EBITDA, EBITDAre, Adjusted EBITDAre and Hotel Adjusted EBITDAre are among the measures used by our management to evaluate its operating performance and make day-to-day operating decisions; and (ii) EBITDA, EBITDAre, Adjusted EBITDAre and Hotel Adjusted EBITDAre are frequently used by securities analysts, investors, lenders and other interested parties as a common performance measure to compare results or estimate valuations across companies in and apart from our industry sector. EBITDA, EBITDAre, Adjusted EBITDAre, and Hotel Adjusted EBITDAre have limitations as analytical tools and should not be considered either in isolation or as a substitute for net income (loss), cash flow or other methods of analyzing our results as reported under GAAP. Some of these limitations are that these measures: • do not reflect changes in, or cash requirements for, our working capital needs; • do not reflect our interest expense, or the cash requirements necessary to service interest or principal payments, on its indebtedness; • do not reflect our tax expense or the cash requirements to pay its taxes; • do not reflect historical cash expenditures or future requirements for capital expenditures or contractual commitments; • EBITDAre, Adjusted EBITDAre and Hotel Adjusted EBITDAre do not include gains or losses on the disposition of properties which may be material to our operating performance and cash flow; • Adjusted EBITDAre and Hotel Adjusted EBITDAre do not reflect the impact on earnings or changes resulting from matters that we consider not to be indicative of our future operations, including but not limited to impairment, acquisition and disposition activities and restructuring expenses; • although depreciation, amortization and impairment are non-cash charges, the assets being depreciated, amortized or impaired will often have to be replaced, upgraded or repositioned in the future, and EBITDA, EBITDAre, Adjusted EBITDAre, and Hotel Adjusted EBITDAre do not reflect any cash requirements for such replacements; and • other companies in our industry may calculate EBITDA, EBITDAre, Adjusted EBITDAre, and Hotel Adjusted EBITDAre differently, limiting their usefulness as comparative measures. Because of these limitations, EBITDA, EBITDAre, Adjusted EBITDAre and Hotel Adjusted EBITDAre should not be considered as a replacement to net income presented in accordance with GAAP, discretionary cash available to us to reinvest in the growth of our business or as measures of cash that will be available to us to meet our obligations. The following is a reconciliation of our net loss to EBITDA, EBITDAre, Adjusted EBITDAre and Hotel Adjusted EBITDAre for the years ended December 31, 2019, and 2018 (in millions): Additional Information: • During the year ended December 31, 2019 we recorded $20 million in other income as part of the Wyndham Settlement to offset declines incurred due to the disruptions related to changes in revenue management and other booking tools and processes by our manager in 2019. We have collected $11 million of this amount as of December 31, 2019. The Wyndham Settlement amount shown above is net of associated legal costs. • We also collected $17 million as part of the Wyndham Settlement related to final settlement of income tax matters, which was adjusted to retained earnings and is not reflected above. • Other, net for the years ended December 31, 2019 and 2018 includes adjustments to exclude business interruption insurance proceeds collected of $11 million and $12 million, respectively. These proceeds are offset by $7 million and $4 million, respectively, for other expenses that are not representative of our current or future operating performance. • Corporate general and administrative expenses includes the additional corporate-level expenses not already adjusted in calculating Adjusted EBITDAre. • Significant drivers for the decline in Hotel Adjusted EBITDAre from 2018 to 2019 are increases in management and royalty fees and the effects of hotel sales. Effective with the Spin-Off closing in May 2018, we began incurring management and royalty fees. Accordingly, our results in 2019 include a full year of management and royalty fees, while 2018 results only include expenses for a partial year. Our hotel sales also resulted in a decrease in Hotel Adjusted EBITDAre. Nareit FFO attributable to stockholders and Adjusted FFO attributable to stockholders We present Nareit FFO attributable to common stockholders (as defined below) as non-GAAP measures of our performance. We calculate funds from operations (“FFO”) attributable to common stockholders for a given operating period in accordance with standards established by Nareit, as net income or loss (calculated in accordance with GAAP), excluding depreciation and amortization related to real estate, gains or losses on sales of certain real estate assets, impairment write-downs of real estate assets, discontinued operations, income taxes related to sales of certain real estate assets, and the cumulative effect of changes in accounting principles, plus similar adjustments for unconsolidated joint ventures. Adjustments for unconsolidated joint ventures are calculated to reflect our pro rata share of the FFO of those entities on the same basis. Since real estate values historically have risen or fallen with market conditions, many industry investors have considered presentation of operating results for real estate companies that use historical cost accounting to be insufficient by themselves. For these reasons, Nareit adopted the FFO metric in order to promote an industry wide measure of REIT operating performance. We believe Nareit FFO provides useful information to investors regarding our operating performance and can facilitate comparisons of operating performance between periods and between REITs. We also present Adjusted FFO attributable to common stockholders when evaluating our performance because we believe that the exclusion of certain additional items described below provides useful supplemental information to investors regarding our ongoing operating performance. Management historically has made the adjustments detailed below in evaluating our performance and in our annual budget process. We believe that the presentation of Adjusted FFO provides useful supplemental information that is beneficial to an investor’s complete understanding of our operating performance. We adjust Nareit FFO attributable to common stockholders for the following items, and refer to this measure as Adjusted FFO attributable to common stockholders: transaction expense associated with the potential disposition of or acquisition of real estate or businesses, severance expense, share-based compensation expense, litigation gains and losses outside the ordinary course of business, amortization of deferred financing costs, reorganization costs and separation transaction expenses, loss on early extinguishment of debt, straight-line ground lease expense, casualty losses, deferred tax expense and other items that we believe are not representative of our current or future operating performance. Nareit FFO attributable to common stockholders and Adjusted FFO attributable to common stockholders have limitations as analytical tools and should not be considered either in isolation or as a substitute for net income (loss), cash flow or other methods of analyzing our results as reported under GAAP. Nareit FFO is not an indication of our liquidity, nor is it indicative of funds available to fund our cash needs, including our ability to fund dividends. Nareit FFO is also not a useful measure in evaluating net asset value because impairments are taken into account in determining net asset value but not in determining Nareit FFO. Investors are cautioned that we may not recover any impairment charges in the future. Accordingly, Nareit FFO should be reviewed in connection with GAAP measurements. We believe our presentation of Nareit FFO is in accordance with the Nareit definition; however, our Nareit FFO may not be comparable to amounts calculated by other REITs. The following table provides a reconciliation of net loss attributable to stockholders to Nareit FFO attributable to stockholders and Adjusted FFO attributable to stockholders for the years ended December 31, 2019, and 2018 (in millions): Additional Information: • During the year ended December 31, 2019, we recorded $20 million in other income as part of the Wyndham Settlement to offset declines incurred due to the disruptions related to changes in revenue management and other booking tools and processes by our manager in 2019. We have collected $11 million of this amount, as of December 31, 2019. The Wyndham Settlement amount shown above is net of associated legal costs. • We also collected $17 million as part of the Wyndham Settlement related to final settlement of income tax matters, which was adjusted to retained earnings and is not reflected above. • Other, net for the years ended December 31, 2019 and 2018 includes adjustments to exclude business interruption insurance proceeds collected of $11 million and $12 million, respectively. These proceeds are offset by $7 million and $4 million, respectively, for other expenses that are not representative of our current or future operating performance. • The income tax effect of adjustments is primarily related to the Wyndham Settlement deduction. • Weighted average number of shares outstanding, diluted presented above may differ from weighted average number of shares outstanding, diluted presented for GAAP purposes when there is a net loss and all potentially dilutive securities are anti-dilutive. • Significant drivers for the decline in Adjusted FFO attributable to stockholders from 2018 to 2019 are increases in management and royalty fees and the effects of hotel sales. Effective with the Spin-Off closing in May 2018, we began incurring management and royalty fees. Accordingly, our results in 2019 include a full year of management and royalty fees, while 2018 results only include expenses for a partial year. Our hotel sales also resulted in a decrease in Adjusted FFO attributable to stockholders. Operational Overview The following discussion provides an overview of our operations and transactions for the year ended December 31, 2019 and should be read in conjunction with the full discussion of our operating results, liquidity, capital resources and risk factors included elsewhere in this Annual Report on Form 10-K. For the year ended December 31, 2019, we reported a net loss from continuing operations, net of tax of $212 million, as compared to a net loss from continuing operations, net of tax of $237 million for the year ended December 31, 2018, an improvement of $25 million. Revenue declined $50 million in 2019 as compared to 2018. Revenue at our Comparable Hotels decreased $35 million, primarily as a result of modifications made to the revenue property management systems by our hotel manager beginning in the second quarter of 2019 and revenue from our non-comparable hotels decreased $15 million, primarily related to the 2019 sale of 44 hotels. These revenue declines were offset by $20 million of other income recognized in connection with the Wyndham Settlement and a gain on hotel sales of $32 million. Corporate general and administrative expenses decreased $44 million due primarily to expenses incurred in 2018 in connection with our Spin-Off. Those improvements were partially offset by an increase in our management and royalty fees of $28 million primarily because our 2018 fees were only for a partial year subsequent to the Spin-Off. Our decision to initiate a disposition strategy resulted in a decrease in our estimated holding periods for our non-core hotels, resulting in impairment charges and increased depreciation expenses in 2019 of approximately $12 million over 2018 combined amounts. As we execute our disposition strategy, we expect to have further declines derived from our Comparable Hotel operations with a greater proportion of our operations related to non-comparable hotels. As of December 31, 2019, we have 166 hotels identified as non-core with the intent to dispose of these hotels generally over the next two years. Subsequent to December 31, 2019, 17 of these non-core hotels were sold and over 40 additional hotels are under contract to sell. Our ability to close these sale contracts, as well as the dispositions of the other non-core hotels, could be affected by the uncertainties related to the COVID-19 outbreak. The following table provides additional information about Comparable Hotels and non-comparable hotels for the year ended December 31, 2019 (in millions): _____________ (1) Non-comparable hotels includes sold hotels and hotels that were not operational due to substantial property damage or other business interruption due to hurricane, fire or other natural disasters. Of the 271 hotels in our portfolio as of December 31, 2019, 257 have been classified as Comparable Hotels. We sold 42 operating hotels and two non-operating hotels during in 2019. As of December 31, 2019, 14 of our hotels were classified as non-operational. Year ended December 31, 2019 as compared to year ended December 31, 2018 Revenues Room revenues for the year ended December 31, 2019 were $795 million as compared to $845 million for the year ended December 31, 2018, a decrease of $50 million or 5.9%. The decrease was primarily driven by lower RevPAR at our Comparable Hotels of 4.5% for the year ended December 31, 2019 as compared to the prior year period. The decrease in RevPAR was driven by a decrease in occupancy of 110bps and a decrease in ADR of 2.9%, primarily attributable to the modifications made by LQM to the revenue property management systems for our hotels as described above. As a part of the Wyndham Settlement, Wyndham agreed to pay us $20 million, which is recognized in other income, net. Also contributing to the decline were revenues related to our properties in oil markets, primarily in West Texas. RevPAR in our oil markets was down 31%, due to a decrease in ADR of 25% and a decrease in occupancy of 500bps. Excluding the hotels impacted by the hurricanes and those undergoing significant renovation as part of the repositioning effort, comparable RevPAR decreased approximately 7.4% for the year ended December 31, 2019 as compared to the year ended December 31, 2018. Hotel properties concentrated in the oil markets (primarily West Texas) experienced the largest RevPAR declines. Excluding oil market hotels and the repositioned and storm impacted hotels, comparable RevPAR over the comparable prior period decreased approximately 5.4%. During the year ended December 31, 2019, we sold 42 operating hotels classified as investments in real estate which produced approximately $49 million in revenue during that period, as compared to $72 million in the year ended December 31, 2018. The following table summarizes our key operating statistics for our Comparable Hotels for the year ended December 31, 2019 and 2018: Operating expenses Rooms expense was $383 million for the year ended December 31, 2019 as compared to $385 million for the year ended December 31, 2018, a decrease of $2 million. The decrease was primarily as a result of fewer operating hotels in the hotel portfolio in 2019 as compared to 2018, partially offset by an increase in supply expense of $10 million and increased third-party travel agency reservation service expenses of approximately $3 million due to increased volume driven through third-party online travel agencies. Management and royalty fees were $80 million for the year ended December 31, 2019 as compared to $52 million for the year ended December 31, 2018, an increase of $28 million. We did not incur any management and royalty fees prior to the Spin-Off in 2018. Our management fees are computed as 5% of total gross revenues and royalty fees are computed as 5% of total gross rooms revenues. Corporate general and administrative expenses were $41 million for the year ended December 31, 2019 as compared to $85 million for the year ended December 31, 2018, a decrease of $44 million. The decrease was primarily the result of costs in 2018 associated with the Spin-Off and the separation of our real estate business from our franchise and management business. In addition, one-time expenses were incurred in 2018 to establish CorePoint as an independent, publicly traded company that were not incurred in 2019. Depreciation and amortization expenses were $181 million for the year ended December 31, 2019 as compared to $156 million for the year ended December 31, 2018, an increase of $25 million. The increase was primarily the result of capital expenditures for 2019 and 2018 of $74 million and $167 million respectively, related to our investments in real estate, primarily in connection with our renovation program and restoration costs related to hurricane damage, which had a partial year or full year offset on 2019 depreciation and amortization expenses. The effects were partially offset by 2019 hotel sales and 2018 impairment cost basis adjustments, which combined reduced our gross operating real estate by $312 million. The 2019 impairment charge and hotel sales will reduce future depreciation and amortization expenses. Impairment loss was $141 million for the year ended December 31, 2019 as compared to $154 million for the year ended December 31, 2018, a decrease of $13 million. In each year the impairment losses were primarily due to changes in management’s expected holding period. Gain on sales of real estate was $32 million for the year ended December 31, 2019 as a result of the sale of 44 hotels (42 operating and two non-operating). We had no gain on sales of real estate for the year ended December 31, 2018. Similar to revenues, as the full period effects of previously sold hotels are realized, as well as the effect of future hotel sales, we anticipate further decreases in most operating expenses. Other Income (Expenses) Other income, net was $33 million for the year ended December 31, 2019 as compared to $15 million for the year ended December 31, 2018, an increase of $18 million primarily due to the $20 million of other income recognized in connection with the Wyndham Settlement. The $20 million benefit from the Wyndham Settlement was related to changes in the revenue management and other booking tools and processes that occurred during 2019 and was to offset the declines incurred. As we do not expect implementation of the new tools and systems until later in 2020, at the earliest, we expect to incur further net declines in our operating results until the new tools and systems are restored and are operationally effective. We did not incur significant expenses related to early debt repayments during 2019. Loss on extinguishment of debt totaled $10 million for the year ended December 31, 2018 and was attributable to the early repayment of LQH’s Term Facility. Cash Flow Analysis Year ended December 31, 2019 as compared to year ended December 31, 2018 Operating activities Net cash provided by operating activities was $116 million for the year ended December 31, 2019, as compared to $111 million for the year ended December 31, 2018. The $5 million increase was primarily attributable to the $11 million of cash collected from the Wyndham Settlement, offset primarily by $7 million in decreased cash inflows from working capital assets and liabilities in 2019 as compared to 2018. Investing activities Net cash provided by investing activities for the year ended December 31, 2019 was $103 million, as compared to $156 million net cash used in investing activities for the year ended December 31, 2018. The $259 million increase was primarily attributable to an increase of $155 million of proceeds from the sale of real estate and a $93 million decrease in capital expenditures due to decreased expenditures related to repositioning and casualty replacements. As these projects and other hotel sales are completed, we expect our future total capital expenditures to further decrease. Financing activities Net cash used in financing activities for the year ended December 31, 2019 was $186 million as compared to $28 million for the year ended December 31, 2018. The $158 million increase was primarily due to $114 million of debt repayments in 2019 primarily related to use of real estate sale proceeds used to partially retire our debt, as compared to $15 million in proceeds from issuance of mandatorily redeemable preferred shares, net of debt repayments and debt issuance costs, primarily related to the CMBS and Revolving Facilities we entered into in 2018. To the extent we continue disposing of real estate assets as a part of our property disposition strategy, we expect debt repayments to be a significant use of cash flow in financing activities. In addition, we had an increase in common stock dividends of $30 million and an increase of $25 million related to the purchase of our common stock, primarily due to the share repurchase program which we began in 2019. These increases in cash used in financing activities were partially offset by $23 million incurred in 2018 related to the Spin-Off. For the year ended December 31, 2019, we acquired 2.6 million shares of common stock at a total cost of $29 million, a weighted average cost of $11.34 per share under the share repurchase program. The repurchased shares represent approximately 5% of our outstanding shares as of December 31, 2019. The share purchases were primarily funded from cash on hand and cash flow from operating activities. Liquidity and Capital Resources Overview As of December 31, 2019, we had total cash and cash equivalents of $101 million and $100 million, respectively, available to be drawn under our Revolving Facility. Our known liquidity requirements primarily consist of funds necessary to pay for operating expenses associated with our hotels and other expenditures, including corporate expenses, legal costs, interest and scheduled principal payments on our outstanding indebtedness, potential payments related to our interest rate caps, capital expenditures for renovations and maintenance at our hotels, quarterly dividend payments and other purchase commitments. We finance our short-term business activities primarily with existing cash and cash generated from our operations. We believe that this cash will be adequate to meet anticipated requirements for operating expenses and other expenditures, including corporate expenses, payroll and related benefits, legal costs, and purchase commitments for the foreseeable future. From time to time, we may also draw on our Revolving Facility, in part or in full, to bridge our liquidity requirements or as a precautionary measure to preserve financial flexibility in light of uncertainty in the global markets or otherwise. On March 12, 2020, we provided notice to the lenders to borrow substantially all of our current availability under the Revolving Facility. See”Part II- Item 9B. Other Information.” The objectives of our short-term cash management policy are to maintain the availability of liquidity and meet our recurring operational costs. We believe our long-term financings, plus our potential access to other debt and equity capital as a publicly traded REIT, will allow us to fund our long-term strategic initiatives. We are currently evaluating plans to extend or refinance the CMBS Facility and Revolving Facility, each of which matures in 2020, with extension options exercisable at our election, provided there is no event of default existing. As we execute our disposition strategy, we intend to utilize a significant portion of the net sales proceeds to retire our debt. During 2019, we reduced our outstanding debt by $114 million. Also, as market conditions warrant and subject to liquidity requirements, contractual restrictions and other factors, we, our affiliates, and/or our major stockholders and their respective affiliates, may from time to time purchase our outstanding equity securities and/or debt through open market purchases, privately negotiated transactions or otherwise. In March 2019, our board of directors authorized a $50 million share repurchase program. During 2019, we acquired approximately 2.6 million shares of common stock at a total cost of $29 million, a weighted average cost of $11.34 per share. Hotel Sales In the execution of our disposition strategy as discussed above, during 2019, we sold 42 operating hotels for gross consideration of $173 million and two non-operating hotel for gross consideration of $4 million. Subsequent to December 31, 2019, an additional 17 operating hotels were sold for gross consideration of $74 million. The net sales proceeds were primarily used to pay down our CMBS Facility by $114 million during 2019, with an additional $41 million paid down subsequent to December 31, 2019, and the remainder available for other uses. These properties produced approximately $5 million of annualized levels of Hotel Adjusted EBITDAre; however, these disposed hotels also incurred approximately $5 million of capital expenditures during the prior twelve months. In addition, the annual interest savings from the partial debt repayments, based on interest rates as of December 31, 2019, is estimated at $5 million. Accordingly, we believe the dispositions will be accretive to our overall future net cash flows. As of December 31, 2019, we have identified 166 non-core hotels. These hotels, similar to the disposed hotels in 2019, are older, have lower RevPAR and higher capital expenditures. We will seek to sell those assets generally over the next two years. The provisions of our CMBS Facility require that a portion of, and in certain instances all, net proceeds from a secured hotel sale be applied to the outstanding principal balance. However, as the principal balance is reduced and other financial metric factors change over time, our required debt repayments may reduce. Accordingly, once these required repayment requirements are reduced, we plan to continue to use a substantial portion of the proceeds from these sales to repay our outstanding debt to reduce our overall net debt (total debt less cash and cash equivalents) to Adjusted EBITDAre leverage ratio to less than 5.0x. We believe the completion of our disposition strategy will reposition our hotel portfolio to be more focused on our key markets with younger hotels, higher RevPAR and less capital requirements. However, as we dispose of the non-core hotels we would expect to report decreased revenue and Hotel Adjusted EBITDAre. For the year ended December 31, 2019, these 166 non-core hotels contributed revenue and Hotel Adjusted EBITDAre of $354 million and $58 million, respectively. Capital Expenditures Our capital expenditures are generally paid using cash on hand and cash flows from operations, although other sources discussed herein may also be used. During the year ended December 31, 2019, we invested approximately $74 million in capital expenditures. Approximately $30 million of these expenditures related to our repositioning and casualty replacements and the remainder primarily related to recurring hotel operations. Capital expenditures related to the 42 hotels classified as investments in real estate that were sold during the twelve months ended December 31, 2019, were $5 million. During the year ended December 31, 2018, we invested $167 million in capital expenditures (inclusive of discontinued operations). As we execute our disposition strategy, we expect to benefit from lower capital expenditures due to fewer hotels with less capital expenditure requirements on the remaining core portfolio. As of December 31, 2019, we had outstanding commitments under capital expenditure contracts of $29 million primarily related to certain hotel improvement projects, casualty replacements, information technology enhancements and other hotel service contracts in the ordinary course of business. If cancellation of a contract occurred, our commitment would be any costs incurred up to the cancellation date, in addition to any costs associated with the discharge of the contract. In addition, our requirement to meet certain brand standards imposed by our franchisor includes requirements that we incur certain capital expenditures, generally ranging from $1,500 to $7,500 per hotel room (with various specific amounts within this range being applicable to different groups of our hotels) during a prescribed period generally ranging from two to eleven years. These amounts are over and above the capital expenditures we are required to make each year for recurring furniture, fixtures and equipment maintenance. However, these amounts that we are required to spend are subject to reduction, in varying degrees, by the amount of capital expenditures made for hotels in the applicable group over and above the capital expenditures required for the recurring maintenance in one or more years before receipt of the franchisor’s notice. The initial period during which the franchisor can notify us that we must make these capital expenditures is through 2028. At the franchisor’s discretion, subject to the franchise agreement provisions governing when such requirements may be imposed, the franchisor may provide a notice obligating us to meet those capital expenditure requirements generally within two to nine years of the notice. As of December 31, 2019, no such notices have been received; however, approximately 62% of our hotels are potentially eligible for such capital expenditure requirements. Through 2028, our remaining hotels will become eligible for such notices and capital expenditure requirements. We expect to meet these requirements primarily through our recurring capital expenditure program. As of December 31, 2019, $15 million was held in lender escrows that can be used to finance these requirements. We expect to meet all of these obligations from our operations, insurance claim reimbursements, the payments to us pursuant to the Wyndham Settlement or other funds available to us. However, as we continue our disposition strategy, which in part focuses on hotels with disproportionately high capital expenditure requirements, we expect our recurring capital expenditures to decrease in future periods. Long-term Liquidity As of December 31, 2019, we had total cash and cash equivalents of $101 million and $100 million, respectively, available to be drawn under our Revolving Facility. Availability is subject to meeting certain financial thresholds, including debt yield, leverage ratio, and minimum interest coverage, which have been adversely affected by our decline in operations and only partially offset by pay downs in our debt from hotel sales. A major source of long-term liquidity will be the monetization of our non-core hotels generally over the next two years. As of December 31, 2019, we identified 166 non-core hotels with a net real estate carrying value of $861 million. We believe we will be able to realize net proceeds at or in excess of our carrying value. We intend to use a substantial portion of these net proceeds to reduce our outstanding debt principal balances. Excess proceeds, if any, may be used to re-invest in our core hotels, acquire new hotels or other corporate uses. There is no assurance that we will be able to achieve this or any level of proceeds from the sale of our hotels. Our CMBS and Revolving Facilities mature in 2020. As of December 31, 2019, the outstanding principal related to these debt obligations is $921 million. The CMBS Facility provides for, at our option, five one-year extension options, and the Revolving Facility provides for a one-year extension option, provided there is no event of default existing as of the commencement of the applicable extension period. We anticipate exercising the extension options or refinancing the related debt prior to the maturities of these facilities. There is no assurance that at those times we will be able to obtain financings at comparable interest rates or leverage levels or at all. As of December 31, 2019, our gross debt (total debt before deduction for deferred financing costs) to total assets ratio was 44% and net debt to Adjusted EBITDAre was 5.6x. Our CMBS and Revolving Facilities use London Interbank Offering Rate (“LIBOR”) as a benchmark for establishing the interest rate. LIBOR is the subject of recent regulatory guidance and proposals for reform expected in 2021. As a result, we expect that LIBOR will no longer be provided after 2021. In addition, LIBOR may perform differently during the transition period to new benchmark rates than it has in the past. If LIBOR is no longer widely available, our CMBS and Revolving Facilities provide for alternate interest rate calculations. There is no assurance that such alternative interest rate calculations will not increase our cost of borrowing under the CMBS and Revolving Facilities or their refinanced debt. Further, if we are unable to generate sufficient cash flow from operations in the future to service our debt, we may be required to reduce capital expenditures or refinance all or a portion of our existing debt. Our ability to refinance or extend the maturities of our existing debt, to make scheduled principal payments and to pay interest on our debt depends on the future performance of our operations, which is further subject to general conditions in or affecting the lodging industry that are beyond our control. Dividends Dividends are authorized at the discretion of our board of directors based on an analysis of our prior performance, market distribution rates of our industry peer group, our desire to minimize our income tax liability, expectations of performance for future periods, including actual and anticipated operating cash flow, changes in market capitalization rates for investments suitable for our portfolio, capital expenditure needs, dispositions, general financial condition and other factors that our board of directors deems relevant. The board’s decision will be influenced, in part, by its obligation to ensure that we maintain our status as a REIT. To date, capital gains have not been a significant factor in our taxable income. However, as we execute our disposition strategy, we may recognize increased capital gains, which may result in additional regular or special distributions. Such distributions are not required in order to maintain REIT status and are at the discretion of our board of directors. During 2019, our board of directors authorized and we have declared a cash dividend of $0.20 per share of common stock with respect to each quarter, all of which was classified as a return of capital for tax purposes. None of the dividends were classified as ordinary income or capital gains taxable income in 2019. There is no assurance that future distributions will be similarly classified. The dividends have generally been paid on or about the 15th day of the month following each quarter end. We paid cash common stock dividends for the year ended December 31, 2019 of $46 million. Cash flow provided by operating activities for the year ended December 31, 2019 was $116 million. Further, our Nareit FFO attributable to common stockholders for the year ended December 31, 2019 was $76 million. Accordingly, we believe our cash flow from operating activities and Nareit FFO attributable to common stockholders are in excess of our dividends. However, as these measurements are before capital expenditures, we may require additional liquidity sources as discussed above, which may include proceeds from sales of real estate assets. In addition, as dividends are at the sole discretion of our board of directors, there is no assurance of the amount of any future dividends, if any. (See “Non-GAAP Financial Measures” above for additional information regarding our calculation of Nareit FFO attributable to common stockholders and a reconciliation to net loss). Share Repurchase Program On March 21, 2019, our board of directors authorized a $50 million share repurchase program. Under the program, we may purchase common stock in the open market, in privately negotiated transactions or in such other manner as determined by it, including through repurchase plans complying with the rules and regulations of the SEC. The amount and timing of any repurchases made under the share repurchase program will depend on a variety of factors, including available liquidity, cash flow and market conditions. The share repurchase program does not obligate us to repurchase any dollar amount or number of shares of common stock and the program may be suspended or discontinued at any time. During 2019, we acquired 2.6 million shares at a weighted average cost per share of $11.34. Contractual obligations The following table summarizes our significant contractual obligations for the next five years and thereafter, as of December 31, 2019 (in millions): ____________________ (1) Debt obligations exclude the deduction of debt issuance costs of $6 million and are included in the table based on contractual maturities, before extension options. We intend to extend the maturity date or refinance the obligations prior to the maturity date. (2) Includes interest on debt outstanding as of December 31, 2019, all of which is floating rate debt. For presentation purposes, amounts included in the table are interest rates effective at December 31, 2019, which is 4.51% for the CMBS Facility, our only outstanding debt. Interest payments are presented in the table consistent with note (1) above, which includes interest payments through the contractual maturity date, with no extension of the maturity assumed. (3) Purchase commitments include outstanding commitments under contracts for capital expenditures at our hotels and for information technology enhancements. (4) These amounts do not include capital expenditures which our franchisor may require to meet brand standards. The initial period during which the franchisor can notify us that we must make these capital expenditures is through 2028. As of December 31, 2019, no such notices have been received. The franchisor would be eligible to provide notices for approximately $70 million in both 2020 and 2021 and approximately an additional $70 million thereafter to 2028. We generally have two to eleven years from the notice to meet the capital expenditure requirements, which may be offset to various degrees by prior year capital expenditures. Accordingly, actual amounts and the timing of such amounts may differ from those described. We expect to generally meet these requirements from our ordinary capital expenditure programs, funded from cash flow from operating activities or the other sources described herein. Off-balance sheet arrangements We currently have no off-balance sheet arrangements that have or are reasonably likely to have a current or future material effect on our financial condition, revenues or expenses, results of operations, liquidity, capital expenditures or capital resources. Critical accounting policies and estimates The preparation of our financial statements in accordance with GAAP requires us to make estimates and assumptions that affect the reported amounts of assets and liabilities as of the date of the consolidated financial statements, the reported amounts of revenues and expenses during the reporting periods and the related disclosures in the consolidated financial statements and accompanying footnotes. We believe that of our significant accounting policies, which are described in Note 2 “Significant Accounting Policies and Recently Issued Accounting Standards” in the audited consolidated financial statements included elsewhere in this Annual Report on Form 10-K, the following accounting policies are critical because they involve a higher degree of judgment, and the estimates required to be made were based on assumptions that are inherently uncertain. As a result, these accounting policies could materially affect our financial position, results of operations and related disclosures. On an ongoing basis, we evaluate these estimates and judgments based on historical experiences and various other factors that are believed to reflect the current circumstances. While we believe our estimates, assumptions and judgments are reasonable, they are based on information presently available. Actual results may differ significantly from these estimates due to changes in judgments, assumptions and conditions as a result of unforeseen events or otherwise, which could have a material impact on financial position or results of operations. Impairment of Real Estate Related Assets For our investments in real estate, we monitor events and changes in circumstances indicating that the carrying amounts of the real estate assets may not be recoverable. When such events or changes are present, we make an assessment of the property’s recoverability by comparing the carrying amount of the asset to our estimate of the aggregate undiscounted future operating cash flows expected to be generated over the holding period of the asset including its eventual disposition. If the carrying amount exceeds the aggregate undiscounted future operating cash flows, we recognize an impairment loss to the extent the carrying amount exceeds the estimated fair value of the property. Any such impairment is treated for accounting purposes similar to an asset acquisition at the estimated fair value, which includes establishing a new cost basis and the elimination of the asset’s accumulated depreciation and amortization. In evaluating our investments for impairment, we undergo continuous evaluations of property level performance and real estate trends, and management makes several estimates and assumptions, including, but not limited to, the projected date of disposition, estimated sales price and future cash flows of each property during our estimated holding period. If our analysis or assumptions regarding the projected cash flows expected to result from the use and eventual disposition of our properties change, we incur additional costs and expenses during the holding period, or our expected hold periods decrease, we may incur future impairment losses. Income Taxes We are organized in conformity with and operate in a manner that allows us to be taxed as a REIT for U.S. federal income tax purposes. To the extent we continue to qualify as a REIT, we generally will not be subject to U.S. federal income tax on taxable income generated by our REIT activities that we distribute to our stockholders. Accordingly, no provision for U.S. federal income tax expense has been included in our consolidated financial statements for the years ended December 31, 2019 or 2018 related to our REIT operations; however, CorePoint TRS, our wholly owned taxable REIT subsidiary, is subject to U.S. federal, state and local income taxes, and we may be subject to state and local taxes. We were subject to U.S. federal, state and local taxes prior to the Spin-Off and our REIT election. We use the asset and liability method of accounting for income taxes. Under this method, current income tax expense represents the amounts expected to be reported on our income tax returns, and deferred tax assets and liabilities are recognized for the future tax consequences attributable to differences between the financial statement carrying amounts of existing assets and liabilities and their respective tax basis. The deferred tax assets and liabilities are measured using the enacted tax rates that are expected to be applied to taxable income in the years in which those temporary differences are expected to reverse. In determining our tax expense for financial statement reporting purposes, we must evaluate our compliance with the Code, including the transfer pricing determinations used in establishing rental payments between the REIT and CorePoint TRS. Accounting for income taxes requires, among others, interpretation of the Code, estimated tax effects of transactions, and evaluation of probabilities of sustaining tax positions, including realization of tax benefits. We recognize tax positions only after determining that the relevant tax authority would more likely than not sustain the position following the audit. The final resolution of those assessments may subject us to additional taxes. In addition, we may incur expenses defending our positions during IRS tax examinations, even if we are able to eventually sustain our position with the tax authorities. We are subject to or are contractually responsible for audits by federal and state tax authorities related to prior periods, which may result in additional tax liabilities. We have concluded that the positions reported on our tax returns under audit by the IRS are, based on their technical merits, more-likely-than-not to be sustained upon conclusion of the examination. Accordingly, as of December 31, 2019, we have not established any reserves related to this proposed adjustment or any other issues reflected on the returns under examination. If, however, we are unsuccessful in challenging the IRS, an excise tax would be imposed on the REIT related to the excess rent and we would be responsible for additional income taxes, interest and penalties, which could adversely affect our financial condition, results of operations and cash flow and the trading price of our common stock. Such adjustments could also give rise to additional state income taxes. New Accounting Pronouncements See Note 2 “Significant Accounting Policies and Recently Issued Accounting Standards” to our consolidated financial statements included elsewhere in this Annual Report on Form 10-K for a description of recently adopted accounting pronouncements.

<s>[INST] Overview CorePoint is a leading owner in the midscale and upper midscale select service hotel segments, all under the La Quinta brand. Our portfolio, as of December 31, 2019, consisted of 271 hotels representing approximately 35,000 rooms across 41 states in locations in or near employment centers, airports, and major travel thoroughfares. All but one of our hotels is wholly owned. We primarily derive our revenues from our hotel operations. Wyndham Transition and Integration In connection with the agreements entered into with subsidiaries of La Quinta Holdings Inc. (“LQH Parent” and, together with its consolidated subsidiaries, “LQH”), our hotels became a part of the management and franchise platforms of Wyndham. This related transition and integration, which is ongoing, includes: transitioning to Wyndham’s distribution network, including Wyndham.com, contact centers and loyalty platform; technology and system integrations for property management, reservation systems and revenue management; and gross margin initiatives related to operating expenses and other service delivery management. We are in regular communication with Wyndham and are actively monitoring their progress in transitioning and integrating our hotels to their platform, much of which LQM completed during the second quarter of 2019. As part of these platform initiatives, modifications were made to the revenue management software and tools, the call center customer interface technology and the administration of corporate and group bookings. We believe these modifications, and other problems relating to implementation of the transition of our hotels to their platform, contributed to lower occupancy and rental rates and consequently adversely affected our business. In addition, we were not always receiving timely and adequate books of account and other accounting records as required by the management agreements. As a result, on July 30, 2019 and August 14, 2019, we gave notice to LQM that we believed there were several events of default under the management agreements relating to all of our wholly owned properties. On October 18, 2019, the Company and CorePoint TRS L.L.C. (“CorePoint TRS”), an indirect subsidiary of the Company, on the one hand, and LQM, LQ Franchising and Wyndham Hotel Group, LLC (“Wyndham Hotel” and, collectively with the Company, CorePoint TRS, LQ Franchising and LQM, the “Parties”), on the other hand, entered into a settlement agreement relating to (a) the management, franchising, operation and sales of the Company’s portfolio of hotels pursuant to the (1) Management Agreements between CorePoint TRS and Manager, dated May 30, 2018 (“Management Agreements”), and (2) Franchise Agreements between CorePoint TRS and Franchisor, dated May 30, 2018 (“Franchise Agreements”), and (b) the Tax Matters Agreement, dated as of May 30, 2018, by and between LQH Parent and the Company (the “Tax Matters Agreement”) (the “Wyndham Settlement”). Pursuant to the Wyndham Settlement, with respect to certain revenue management matters: LQM agreed to develop, install and implement at its expense a fully functional enhanced dynamic best available ratesetting tool providing functionality at least reasonably equivalent to the legacy ratesetting tool used for the Company’s hotels (the “DBAR Replacement Tool”); the fully functional implementation is to be accomplished by December 31, 2020, subject to certain extensions; LQM agreed to deploy at its expense an enhanced direct billing system for corporate group clients at least reasonably equivalent to the legacy direct billing system used for the Company’s hotels; the fully functional implementation of such direct billing system is to be made by June 30, 2020, subject to certain extensions; and LQM agreed to deploy at its expense certain enhanced legacy booking tools used for the Company’s hotels. The implementations and deployments are underway and on schedule. As of the date of this filing, we are unable to assess the effectiveness of the tools and systems on our future operations. [/INST] Positive. </s>

Principia Biopharma Inc.

2019-03-19

2018-12-31

Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations. You should read the following discussion and analysis of our financial condition and results of operations together with our consolidated financial statements and the related notes to those statements included elsewhere in this report. This discussion and analysis and other parts of this report contain forward-looking statements based upon current beliefs, plans and expectations related to future events and our future financial performance that involve risks, uncertainties and assumptions, such as statements regarding our intentions, plans, objectives, expectations, forecasts and projections. Our actual results and the timing of selected events could differ materially from those anticipated in these forward-looking statements as a result of several factors, including those set forth under the section titled “Risk Factors” and elsewhere in this report. Overview We are a late-stage biopharmaceutical company dedicated to bringing transformative oral therapies to patients with significant unmet medical needs in immunology and oncology. Our proprietary Tailored Covalency® platform enables us to design and develop reversible covalent and irreversible covalent, small molecule inhibitors with potencies and selectivities that we believe will rival those of injectable biologics, but with the convenience of a pill. We have produced three new drug candidates from our platform, resulting in four clinical programs. In November 2018, we initiated a pivotal Phase 3 trial of PRN1008, a wholly owned Bruton’s Tyrosine Kinase, or BTK, inhibitor for the treatment of pemphigus. We retain full, worldwide rights to PRN1008, PRN1371 and our oral immunoproteasome inhibitor program, and have established an ongoing collaboration with Sanofi for PRN2246/SAR442168. Since commencing operations in 2011, we have devoted substantially all of our resources to identifying and developing our drug candidates, including conducting preclinical studies and clinical trials and providing general and administrative support for these operations. Our clinical pipeline programs include PRN1008, a reversible BTK inhibitor for the treatment of PV; PRN1008 for the treatment of immune thrombocytopenic purpura, also known as immune thrombocytopenia, or ITP; PRN2246/SAR442168, an irreversible BTK inhibitor that was designed to cross the blood-brain barrier, for the treatment of multiple sclerosis, or MS, and other central nervous system, or CNS, disorders; and PRN1371, an irreversible inhibitor of Fibroblast Growth Factor Receptor, or FGFR, for the treatment of bladder cancer. • Based on the interim results from our Phase 2 trial in pemphigus, we initiated a pivotal Phase 3 trial of PRN1008 in pemphigus (PV & PF) in November 2018. In parallel, we have initiated a Phase 2 trial of PRN1008 in ITP, and anticipate announcing topline results in the fourth quarter of 2019. We intend to assess one or more additional immunological indications for PRN1008 for future clinical development. We expect to commercialize PRN1008, if approved, by developing our own sales organization targeting dermatologists and hematologists at specialized centers in the United States. • In November 2017, we entered an exclusive licensing agreement with Sanofi. We believe that this collaboration maximizes the potential of PRN2246/SAR442168 to address target indications affecting larger populations of patients with CNS diseases. We have completed our development efforts under the early development plan and Sanofi is responsible for further clinical development of this compound in patients suffering from MS. Prior to the initiation of the Phase 3 clinical trials for PRN2246/SAR442168, we will decide whether to exercise our option to fund a portion of the development costs of these trials in exchange for additional economic rights. • We have initiated the expansion cohort of our Phase 1 trial of PRN1371 in patients with metastatic urothelial carcinoma having FGFR 1, 2, 3, or 4 genetic alterations and are planning another study for treatment of non-muscle invasive bladder cancer, an early bladder cancer, which has a high rate of FGFR expression. • We are expanding our wholly owned pipeline by continuing to innovate and discover differentiated oral small molecules with the potential to be best-in-class, and we intend to keep our programs at the forefront of covalent inhibitor drug discovery by investing in new technologies that will broaden the target space of our Tailored Covalency platform. In addition, we plan to explore the new biology discovered with our oral immunoproteasome inhibitors and to select the optimal development path for these highly differentiated assets. • As we have done with our collaboration with Sanofi, we plan to selectively use collaborations and partnerships as strategic tools to maximize the value of our drug candidates, particularly in indications with large target patient populations. As of December 31, 2018, we have financed our operations primarily with proceeds totaling $299.5 million from our initial public offering (“IPO”), private placements of our convertible preferred stock and convertible notes and with payments from license and research collaborations totaling $80.0 million. In 2017, we received non-refundable upfront payments of $40.0 million and $15.0 million from our collaboration agreements with Sanofi and AbbVie, respectively. In 2018, we received total payments of $25.0 million from Sanofi, for achieving various milestones pursuant to the early development plan. In August 2018, we sold 3,474,668 shares of Series C convertible preferred stock at a price of $14.3898 per share for net proceeds of $49.8 million. As of December 31, 2018, we held cash, cash equivalents and marketable securities totaling $180.6 million. On September 13, 2018, our Registration Statement on Form S-1 filed in connection with our IPO was declared effective by the SEC. In connection with our IPO, we issued and sold an aggregate of 7,187,500 shares of common stock, including 937,500 shares issued and sold pursuant to the underwriters’ full exercise of their over-allotment option to purchase additional shares, at an offering price to the public of $17.00 per share. Proceeds from the IPO, net of underwriting discounts and commissions, were $113.6 million. In connection with the completion of our IPO in September 2018, all then outstanding shares of convertible preferred stock were converted into 15,760,102 shares of common stock. In addition, all of our convertible preferred stock warrants were converted into warrants to purchase shares of common stock. We do not have any products for sale and have not generated any product revenue since our inception. As of December 31, 2018, all of our revenue has been generated from the upfront and milestone payments received from our agreements with Sanofi and AbbVie. For the years ended December 31, 2018, 2017 and 2016, we recorded net income of $18.2 million, net loss of $28.7 million and net loss of $30.6 million, respectively. As of December 31, 2018, we have an accumulated deficit of $132.4 million, and we do not expect positive cash flows from operations in the foreseeable future. We expect to continue to incur significant expenses and net operating losses as we advance our clinical drug candidates and expand our pipeline, seek regulatory approval and, if successful, proceed to commercial launch activities. Furthermore, we expect to incur additional costs associated with operating as a public company. In addition, we do not yet have a sales organization or commercial infrastructure. Accordingly, we will incur significant expenses to develop a sales organization or commercial infrastructure in advance of generating any commercial product sales. As a result, we will need substantial additional capital to support our operating activities. We currently anticipate that we will seek to fund our operations through equity or debt financings or other sources, such as potential collaboration agreements with third parties. Adequate funding may not be available to us on acceptable terms, or at all. If sufficient funds on acceptable terms are not available when needed, we could be required to significantly reduce our operating expenses and delay, reduce the scope of or eliminate one or more of our development programs. Based on our planned operations, we believe our cash, cash equivalents and marketable securities at December 31, 2018, which include the net proceeds generated from our IPO in September 2018, are sufficient to fund our operations for at least the next 12 months from the issuance date of this report. Sanofi Agreement In November 2017, we entered into the Sanofi Agreement for an exclusive license to PRN2246/SAR442168 and backup molecules for development in MS and other CNS diseases. Under the Sanofi Agreement, we have completed the Phase 1 trials and Sanofi is taking on all further development activities. We and Sanofi are each responsible for certain early development costs, and Sanofi is responsible for all further development and commercialization costs, subject to our Phase 3 option described below. Sanofi has an exclusive license for PRN2246/SAR442168 and its backups for the CNS field, which includes indications of the central nervous system, retina and ophthalmic nerve. We have agreed not to develop other BTK inhibitors within the CNS field, and Sanofi has agreed not to develop PRN2246/SAR442168 or its backups for any indications outside the CNS field. In the event that we cease all development and commercialization of our other BTK inhibitors or unilaterally decide to offer Sanofi a field expansion, Sanofi could expand its field upon payment to us of a field expansion payment as well as potential milestones payments and royalties within the expanded field. In December 2017, we received a $40.0 million upfront payment. Under the Sanofi Agreement, our deliverables are (i) granting a license of rights to PRN2246/SAR442168, (ii) transfer of technology (know-how) related to PRN2246/SAR442168, and (iii) performance of research and development services related to our responsibilities under the early development plan. In May 2018, we amended the Sanofi Agreement to include additional activities under the early development plan and to modify the definition of one of the milestone payments. Pursuant to the amendment, we received a $10.0 million payment in July 2018 for the completion of a major part of the Phase 1 trial. In August 2018, we received a $5.0 million payment for the successful completion of preclinical toxicology studies. In November 2018, we received $10.0 million in additional payments from Sanofi for successful development activities of PRN2246/SAR442168 related to the early development plan. Under the amended Sanofi Agreement, we may receive development, regulatory and commercial milestone payments of up to an aggregate of $765.0 million, as well as royalties up to the mid-teens. As we have satisfied all deliverables under the Sanofi Agreement, as of December 31, 2018, any future milestones achieved will be recognized as revenue, if and when earned. We have an option to fund a portion of Phase 3 development costs in return for, at our option, either a profit and loss sharing arrangement within the United States, or an additional worldwide royalty that would result in royalties up to the high-teens. Only the additional royalty option would be available if we develop PRN1008 for major enumerated indications overseen by the FDA’s Division of Pulmonary, Allergy and Rheumatology Products or if we experience a change in control involving certain Sanofi competitors. Royalties are subject to specified reductions and are payable, on a product-by-product and country-by-country basis until the later of the date that all of our patent rights that claim a composition of matter of such product expire in such country, the date of expiration of regulatory exclusivity for such product in such country, or the date that is ten years from the first commercial sale of such product in such country. AbbVie Agreement In June 2017, we entered into a collaboration agreement with AbbVie to research and develop oral immunoproteasome inhibitors and received an upfront payment of $15.0 million. Under the AbbVie Agreement, our deliverables are (i) to grant a license of rights to certain licensed compounds to develop and commercialize oral immunoproteasome inhibitors, (ii) to transfer of technology (know-how) related to the oral immunoproteasome inhibitors program, and (iii) to provide research and development services during the two-year research period, which can be extended for up to six months. As of December 31, 2018, approximately $9.4 million of this upfront payment has been recognized as revenue. In March 2019, we announced a mutual agreement with AbbVie to end our collaboration and to reacquire rights to the program, following an assessment by AbbVie that there is no longer a strategic fit of our highly selective inhibitors’ biologic profiles relative to AbbVie’s desired disease areas of focus. We and AbbVie have agreed to conclude the collaboration effective March 8, 2019 and there are no further financial obligations between us, as of the date of the termination. University of California License Agreements In November 2009, we entered into a license agreement, or the First Agreement, with the Regents of the University of California, or the Regents, which was amended in October 2010, February 2011, and amended and restated in May 2012. In September 2011, we entered into a separate license agreement, or the Second Agreement, with the Regents which was amended and restated in December 2013. We refer to the First Agreement and the Second Agreement together as the UC Agreements. Under the UC Agreements, the Regents have granted to us exclusive, worldwide licenses, with the right to grant sublicenses, under the Regents’ patent rights in certain patent applications to make, use, sell, offer for sale, and import products and services and practice methods covered by such patent applications in all fields of use. We have paid the Regents license fees of $30,000 and $10,000 under the First Agreement and the Second Agreement, respectively, and we are required to pay the Regents annual license maintenance fees equal to $30,000 and $10,000 for the First Agreement and Second Agreement, respectively, prior to launching any licensed product. We may be obligated to make one-time regulatory and development milestone payments under the First Agreement or the Second Agreement, for future drug candidates. We are obligated to pay the Regents tiered royalty payments in the low single digits on net sales of the licensed products. The royalty is payable under the First Agreement or the Second Agreement, but not both. For licensed products under the First Agreement, we have to make a minimum annual royalty payment of $50,000 beginning in the calendar year after the first commercial sale of a licensed product occurs. The royalties are subject to standard reductions and are payable until the patents upon which such royalties are based expire or are held invalid. The patents issuing under the First Agreement will expire between 2024 and 2030 and those under the Second Agreement will expire in 2033, subject to any potential patent term extensions. Additionally, we are obligated to pay the Regents payments on non-royalty licensing revenue we receive from our sub-licensees for products covered by UC patents. The UC Agreements require us to make IPO milestone payments under each of the First Agreement and Second Agreement upon the closing of an IPO. Pursuant to the UC agreements, we made IPO milestone payments totaling approximately $140,000 to the Regents in early October 2018. Under the UC Agreements, we are required to diligently proceed with the development, manufacture, regulatory approval, and sale of licensed products which include obligations to meet certain development-stage milestones within specified periods of time and to market the resulting licensed products in sufficient quantity to meet market demand. We have the right and option to extend the date by which we must meet any milestone in one year extensions by paying an extension fee for second and subsequent extension, provided we can demonstrate we made diligent efforts to meet the milestone. Components of Operating Results Revenue To date, all of our revenue has been generated from payments pursuant to our collaboration arrangements with Sanofi and AbbVie. In connection with the Sanofi Agreement, we received a $40.0 million non-refundable upfront payment in December 2017 and additional payments of $25.0 million in 2018 for successful development activities under the early development plan. We considered the provisions of the revenue recognition multiple-element arrangement guidance and concluded that the delivered license does not have standalone value at the inception of the arrangement due to our proprietary expertise with respect to the licensed compound and related ongoing developmental participation under the agreement, which is required for Sanofi to fully realize the value from the delivered license. Therefore, the aggregate $65.0 million received, prior to December 31, 2018, related to this combined unit of accounting is recognized as revenue ratably over the performance period, which has concluded as of December 31, 2018. For the years ended December 31, 2018 and 2017, we recognized $63.1 million and $1.9 million, respectively, in revenue from Sanofi. There was no deferred revenue related to the Sanofi Agreement at December 31, 2018. Deferred revenue related to the Sanofi Agreement was $38.1 million at December 31, 2017. Amounts for certain early development plan costs subject to reimbursement from Sanofi, recorded as a reduction of research and development expense, totaled $2.4 million and $0.2 million for the years ended December 31, 2018 and 2017. In connection with the AbbVie Agreement, we received a $15.0 million non-refundable upfront payment in June 2017. We considered the provisions of the revenue recognition multiple-element arrangement guidance and concluded that the delivered license does not have standalone value at the inception of the arrangement due to our proprietary expertise with respect to the licensed compounds and related ongoing developmental participation under the AbbVie Agreement, which is required for AbbVie to fully realize the value from the licensed compound. Therefore, the $15.0 million received related to this combined unit of accounting is recognized as revenue over the estimated performance period, which as of December 31, 2018 was estimated to continue through the fourth quarter of 2019. Revenue related to AbbVie for the years ended December 31, 2018 and 2017, was approximately $6.0 million and $3.4 million, respectively. Deferred revenue related to the AbbVie Agreement was $5.6 million and $11.6 million at December 31, 2018 and December 31, 2017, respectively. In March 2019, we announced a mutual agreement with AbbVie to end our collaboration and to reacquire rights to the program. We and AbbVie have agreed to conclude the collaboration effective March 2019 and there are no further financial obligations between us, as of the date of the termination. We expect to recognize the remaining balance of the up-front payment as revenue upon termination of the agreement in March 2019, after considering any amounts recorded as an adjustment to opening retained earnings on January 1, 2019, upon adoption of ASU 2014-09. Operating Expenses We classify our operating expenses into two categories: research and development and general and administrative. Research and Development Our research and development expenses account for a significant portion of our operating expenses and relate to expenses incurred in connection with research and development activities, including the preclinical and clinical development of our drug candidates. These expenses primarily consist of preclinical and clinical expenses; payroll and personnel expenses, including stock-based compensation, for our research and development employees; consulting costs, laboratory supplies and facilities costs. We expense both internal and external research and development costs as they are incurred. Non-refundable advance payments for services that will be used or rendered for future research and development activities are recorded as prepaid expenses and recognized as an expense as the related services are performed. Our external research and development expenses consist primarily of: • expenses incurred under contract research organizations, investigative clinical trial sites and other vendors involved in conducting our clinical trials; • expenses incurred with contract manufacturing organizations for manufacturing process development, scale up and both substance and manufacturing for our drug candidates; • expenses incurred with third party vendors for performing preclinical testing on our behalf; and • consulting fees and certain laboratory supply costs related to the execution of preclinical studies and clinical trials. With respect to internal costs, several of our departments support multiple clinical programs, and we do not allocate those costs by clinical program. Internal research and development expenses consist primarily of personnel-related costs, facilities and infrastructure costs and certain laboratory supplies and non-capitalized equipment used for internal research and development activities. We expect our research and development expenses to increase over the next several years as we continue to execute on our business strategy, advance our current programs and expand our research and development efforts, and pursue regulatory approvals of any of our drug candidates that successfully complete clinical trials. General and Administrative General and administrative expenses consist primarily of payroll and personnel related expenses, including stock-based compensation, for our personnel in finance, human resources, business and corporate development and other administrative functions, professional consulting fees for legal and accounting services, costs related to our intellectual property and other allocated costs, such as facility expenses not otherwise allocated to research and development, and infrastructure costs. We expect our general and administrative expenses to increase as a result of operating as a public company. Additional expenses include those related to compliance with the rules and regulations of the SEC and the Nasdaq Global Select Market, additional insurance expenses, investor relations activities and other administrative and professional services. Other Income, Net Other income, net, consists primarily of changes in fair value related to the outstanding convertible preferred stock warrant liability and the convertible notes redemption features liability. Interest Income Interest income is primarily related to interest earned on our marketable securities. Interest Expense Interest expense consists primarily of interest expense related to our debt obligation, and the accretion of non-cash debt discounts related to the beneficial conversion features of our convertible notes, the convertible notes redemption features and the convertible preferred stock warrants. Results of Operations Comparison of the Years Ended December 31, 2018 and 2017 The following table summarizes our results of operations for the years ended December 31, 2018 and 2017 (dollars in thousands): * Percentage not meaningful Revenue Revenue for the year ended December 31, 2018 was $69.1 million, consisting of a portion of the upfront payment received in connection with the AbbVie Agreement and a portion of the upfront and additional payments we received in connection with the Sanofi Agreement. Revenue for the year ended December 31, 2017 was $5.2 million, consisting of portions of the upfront payments received in connection with the AbbVie Agreement and Sanofi Agreement, which were signed in June and November 2017, respectively. The aggregate payments of $65.0 million under the Sanofi Agreement were recognized ratably over the performance period, and we recorded approximately $63.1 million and $1.9 million in revenue related to the Sanofi Agreement for the year ended December 31, 2018 and 2017, respectively. The nonrefundable upfront payment under the AbbVie Agreement is being recognized ratably over the estimated performance period and we recorded approximately $6.0 million and $3.4 million in revenue related to the AbbVie Agreement for each of the years ended December 31, 2018 and 2017, respectively. Research and Development Expenses Research and development expenses were $40.5 million for the year ended December 31, 2018, an increase of $15.1 million or 60%, compared to $25.4 million for the year ended December 31, 2017. The increase was primarily driven by a $9.9 million increase in external PRN1008 program costs, a $4.9 million increase in personnel related expenses, and a $1.2 million increase in other unallocated research and development costs, partially offset by a decrease of $0.8 million in costs related to PRN2246/SAR442168. The increase in PRN1008 program costs was mainly due to various manufacturing campaigns to supply drug products for our PRN1008 clinical trials and the initiation of a global Phase 3 trial in pemphigus in November 2018. The increase in personnel related expenses was mainly due to our R&D headcount increase as we build out our R&D team. The following table summarizes research and development expenses (in thousands): (1) Personnel related expenses include stock-based compensation expense of $1.4 million and $0.5 million for the years ended December 31, 2018 and 2017, respectively. As our research and development personnel generally support several of our programs and a significant amount of our internal development activities broadly support all of our programs, we do not separately track or allocate our personnel related expenses by program. General and Administrative Expenses General and administrative expenses were $11.5 million for the year ended December 31, 2018, an increase of $5.0 million or 78%, compared to $6.4 million for the year ended December 31, 2017. The increase was primarily driven by an increase in personnel and facility expenses. The increase in personnel costs was related to increased headcount during 2018 as we build out our organization. The increase in facility costs was due to certain rent expense recognition starting from August 1, 2018, the date when we gained access to our new leased premises, which we commenced occupancy in February 2019 Other Income (Expense), Net Other expense, net, for the year ended December 31, 2018 was $0.7 million compared to other income, net, of $5.1 million for the year ended December 31, 2017. Other expense, net, for the year ended December 31, 2018 included $0.7 million of expense related to the conversion of our preferred stock warrants upon IPO. Other income, net, for the year ended December 31, 2017 was primarily due to a net change of $5.1 million in 2017 for the fair values of the convertible note redemption features and the fair values of the outstanding convertible preferred stock warrants. Interest Income Interest income for the year ended December 31, 2018 was $1.7 million related to our investments in marketable securities. Interest income for the year ended December 31, 2017 was insignificant. Interest Expense No interest expense was recorded for the year ended December 31, 2018. Interest expense for the year ended December 31, 2017 was $7.2 million, comprised of $5.5 million debt discounts and $1.7 million accrued interest expense on the convertible notes, which were converted into preferred stock in December 2017. Comparison of the Years Ended December 31, 2017 and 2016 The following table summarizes our results of operations for the years ended December 31, 2017 and 2016 (dollars in thousands): * Percentage not meaningful. Revenue Revenue for the year ended December 31, 2017 was $5.2 million consisting of a portion of the upfront payments received in connection with the Sanofi Agreement and the AbbVie Agreement. No revenue was recognized for the year ended December 31, 2016. The nonrefundable upfront payment under the Sanofi Agreement is being recognized ratably over the estimated performance period and we recorded approximately $1.9 million in revenue related to the Sanofi Agreement for the year ended December 31, 2017. The nonrefundable upfront payment under the AbbVie Agreement is being recognized ratably over the estimated performance period and we recorded approximately $3.4 million in revenue related to the AbbVie Agreement for the year ended December 31, 2017. Research and Development Expenses Research and development expenses were $25.4 million for the year ended December 31, 2017, an increase of $3.1 million or 14%, compared to $22.3 million for the year ended December 31, 2016. The increase was primarily driven by a $3.1 million increase in external PRN1008 program costs due to the advancement of Phase 2 trials for the treatment of PV during 2017. The following table summarizes research and development expenses (in thousands): (1) Personnel related expenses include stock-based compensation expense of $0.5 million for each of the years ended December 31, 2016 and 2017, respectively. As our research and development personnel generally support several of our programs and a significant amount of our internal development activities broadly support all of our programs, we do not separately track or allocate our personnel-related expenses by program. General and Administrative Expenses General and administrative expenses were $6.4 million for the year ended December 31, 2017, an increase of $1.7 million or 35%, compared to $4.8 million for the year ended December 31, 2016. The increase was primarily driven by an increase of $0.7 million in personnel-related costs, an increase of $0.6 million in legal expenses associated with pharmaceutical company collaboration agreements, and other transactions, and an increase of $0.2 million related to consulting and outside services. Other Income, Net Other income, net, for the year ended December 31, 2017 was $5.1 million, an increase of $4.8 million, compared to $0.3 million for the year ended December 31, 2016. The increase was driven by a net change of $5.1 million in the fair values of the convertible note redemption features liability and the outstanding convertible preferred stock warrant liability during 2017, partially offset by a $0.5 million decrease related to an Australian research and development tax credit. Interest Expense Interest expense was $7.2 million for the year ended December 31, 2017, compared to $3.9 million for the year ended December 31, 2016. The increase was driven by the increased interest and debt discounts related to the convertible notes, which were issued during the second half of 2016 and in the beginning of 2017 with aggregate principal amounts of $13.4 million and $8.1 million, respectively. Debt discounts included in interest expense relate to the beneficial conversion features from our convertible notes, the convertible notes redemption features liability and the convertible preferred stock warrant liability. For the year ended December 31, 2017, interest expense included $5.5 million of accretion of debt discounts and $1.7 million of accrued interest expense on the convertible notes which were converted into preferred stock in December 2017. For the year ended December 31, 2016, interest expense included $3.5 million of accretion of debt discounts and $0.4 million of accrued interest expense on the convertible notes. Liquidity and Capital Resources To date, we have financed our operations primarily through our IPO, private placements of our convertible preferred stock and convertible notes and payments from license and research collaborations. In 2017, we entered into the Sanofi Agreement and the AbbVie Agreement, pursuant to which we have received non-refundable upfront payments. From inception to date, we have received $299.5 million in aggregate proceeds through our IPO and private placements and $80.0 million from license and research collaborations. As of December 31, 2018 and 2017, we held cash, cash equivalents and marketable securities totaling $180.6 million and $41.1 million respectively. We do not have any products for sale and have not generated any product revenue since our inception. To date, all of our revenue has been generated from payments received from our agreements with Sanofi and AbbVie. We have incurred significant operating losses since the commencement of our operations. As of December 31, 2018, we have an accumulated deficit of $132.4 million. We expect to continue to incur significant expenses as we advance our drug candidates and expand our pipeline through clinical development, the regulatory approval process and, if successful, commercial launch activities. If after reviewing the Phase 2 data, we elect to exercise our option to fund a portion of Phase 3 development under the Sanofi Agreement, we will be required to share in certain development costs. Furthermore, we expect to incur additional costs associated with operating as a public company. We believe our cash, cash equivalents, marketable securities at December 31, 2018, which include the net proceeds generated from our IPO in September 2018, are sufficient to fund our operations for at least the next 12 months from the issuance date of this report. We have based our projections of operating capital requirements on assumptions that may prove to be incorrect and we may use all of our available capital resources sooner than we expect. Because of the numerous risks and uncertainties associated with research, development and commercialization of pharmaceutical products, we are unable to estimate the exact amount of our operating capital requirements. Our future funding requirements will depend on many factors, including, but not limited to: • the scope, rate of progress, results and costs of research and development activities, conducting preclinical studies, laboratory testing and clinical trials for our drug candidates; • the number and scope of clinical programs we decide to pursue; • the cost, timing and outcome of regulatory review of our drug candidates; • the scope and cost of manufacturing development and commercial manufacturing activities; • the timing and amount of milestone payments, if any, we receive under the Sanofi Agreement; • our ability to maintain existing and establish new, strategic collaborations, licensing or other arrangements on favorable terms, if at all; • the costs of preparing, filing, prosecuting, maintaining, defending and enforcing our intellectual property portfolio; • our efforts to enhance operational systems and our ability to attract, hire and retain qualified personnel, including personnel to support the development of our drug candidates; • the costs associated with being a public company; and • the costs associated with commercialization activities if any of our drug candidates are approved for sale. See our “Risk Factors” elsewhere in this report for a description of additional risks associated with our substantial capital requirements. Cash Flows The following table summarizes cash flows for each of the periods presented below (in thousands): Cash used in operating activities During the year ended December 31, 2018, cash used in operating activities was $21.2 million, which resulted from net income of $18.2 million adjusted for changes in operating assets and liabilities and non-cash charges. Our net income was adjusted for non-cash charges of $2.8 million for stock-based compensation, $0.6 million related to the change in fair value of the convertible preferred stock warrant liability, $0.7 million for deferred rent and $0.2 million for depreciation and amortization. Changes in operating assets and liabilities included a decrease of $44.1 million in deferred revenue, an increase of $2.2 million in prepaid expenses and other assets, an increase of $1.0 million in accounts payable and an increase of $1.9 million in accrued liabilities. During the year ended December 31, 2017, cash provided by operating activities was $26.8 million, which resulted from net loss of $28.7 million adjusted for changes in operating assets and liabilities and non-cash charges. We received nonrefundable upfront payments of $40.0 million and $15.0 million from the Sanofi Agreement and the AbbVie Agreement, respectively. We recorded revenues of approximately $1.9 million and $3.4 million related to Sanofi and AbbVie, respectively, for the year ended December 31, 2017. The remaining $49.8 million is recorded as deferred revenue at December 31, 2017. Other changes in operating assets and liabilities included increases of $1.3 million and $2.0 million in accounts payable and accrued liabilities, respectively, partially offset by a decrease of $0.8 million in prepaid expenses and other current assets. Non-cash charges included debt discount amortization of $5.5 million, the conversion of accrued interest expense of $1.7 million into preferred stock, stock-based compensation and depreciation expenses of $1.0 million and $0.2 million, respectively, partially offset by a $5.1 million net gain related to changes in the fair values of the redemption features liability and convertible preferred stock warrant liability. During the year ended December 31, 2016, cash used in operating activities was $24.8 million, which resulted from net loss of $30.6 million adjusted for non-cash charges and changes in operating assets and liabilities. Non-cash charges included debt discount amortization of $3.5 million, stock-based compensation and depreciation expenses of $1.0 million and $0.2 million, respectively, a net charge of $0.2 million related to changes in the fair values of the loan redemption features liability and the convertible preferred stock warrant liability, offset by $0.2 million in convertible loan issuance costs. Cash used in investing activities During the year ended December 31, 2018, cash used in investing activities was $146.9 million and is primarily the result of purchases in excess of maturities of marketable securities of $145.8 million and purchases of laboratory and computer equipment of $1.1 million. During the year ended December 31, 2017, cash used in investing activities was $90,000 for the purchase of laboratory and computer equipment. During the year ended December 31, 2016, cash used in investing activities was not significant. Cash provided by financing activities During the year ended December 31, 2018, cash provided by financing activities was $161.9 million and includes $110.6 million of net proceeds, after deducting underwriting discounts, commissions and offering costs, from our IPO of our common stock, $49.8 million of proceeds from our Series C preferred stock issuance and $1.5 million from the issuance of common stock pursuant to our equity incentive plans. During the year ended December 31, 2017, cash provided by financing activities was $8.4 million consisting of $8.1 million of proceeds from the issuance of convertible notes and $0.3 million of proceeds from the issuance of common stock. During the year ended December 31, 2016, cash provided by financing activities was $13.4 million consisting primarily of proceeds from the issuance of convertible notes. Off-Balance Sheet Arrangements We currently do not have, and did not have during the periods presented, any off-balance sheet arrangements, as defined under SEC rules. Contractual Obligations and Commitments The following table summarizes our contractual obligation as of December 31, 2018 (in thousands): Our corporate headquarters are located in South San Francisco, California, where we lease approximately 30,000 square feet of office, research and development, and laboratory space pursuant to a lease agreement that expired on January 31, 2019. In April 2018, we signed a new lease for approximately 47,500 square feet of office, research and development and laboratory space. We began occupancy in the first quarter of 2019 for a seven-year period with an option to extend for another seven-year period, subject to certain conditions. JOBS Act The JOBS Act permits an “emerging growth company” such as ours to take advantage of an extended transition time to comply with new or revised accounting standards as applicable to public companies. We are choosing to elect the extended transition period for complying with new or revised accounting standards applicable to public companies. We have elected the extended transition period for complying with new or revised accounting standards pursuant to Section 107(b) of the JOBS Act until the earlier of the date we (i) are no longer an emerging growth company or (ii) affirmatively and irrevocably opt out of the extended transition period provided in the JOBS Act. As a result, our financial statements may not be comparable to companies that comply with new or revised accounting pronouncements as of public company effective dates. We will remain an emerging growth company until the earliest of (i) the last day of our first fiscal year (a) following the fifth anniversary of the completion of our IPO, (b) in which we have total annual gross revenues of at least $1.07 billion, or (ii) in which we are deemed to be a large accelerated filer, which means (a) the market value of our common stock that is held by non-affiliates exceeds $700.0 million of the prior September 30th and (b) the date on which we have issued more than $1.0 billion in non-convertible debt securities during the prior three-year period. Critical Accounting Policies, Significant Judgments and Use of Estimates Our management’s discussion and analysis of our financial condition and results of operations is based on our financial statements, which have been prepared in accordance with generally accepted accounting principles in the United States (“U.S. GAAP”). The preparation of our financial statements requires us to make estimates and assumptions that affect the reported amounts of assets and liabilities and the disclosure of contingent assets and liabilities at the date of the financial statements, as well as the reported expenses incurred during the reporting periods. Our estimates are based on our historical experience and on various other factors that we believe are reasonable under the circumstances, the results of which form the basis for making judgments about the carrying value of assets and liabilities that are not readily apparent from other sources. Actual results may differ from these estimates under different assumptions or conditions. Revenue Recognition We generate revenue from the Sanofi Agreement and the AbbVie Agreement. Revenue is recognized when the four revenue recognition criteria are met: (1) persuasive evidence of an arrangement exists; (2) delivery has occurred or services have been rendered; (3) the fee is fixed or determinable; and (4) collectability is reasonably assured. We account for multiple element arrangements, in which we may provide several deliverables, in accordance with Financial Accounting Standards Board, or FASB, Accounting Standards Codification, or ASC, Subtopic 605-25, Multiple Element Arrangements. Revenue from non-refundable upfront fees that are not dependent on any future performance by us is recognized when such amounts are earned. If we have continuing obligations to perform under the arrangement, such fees are recognized over the estimated period of the continuing performance obligation. Where a portion of non-refundable upfront fees or other payments received is allocated to continuing performance obligations under the terms of the agreement, it is recorded as deferred revenue and recognized as revenue ratably over the term of our estimated performance period under the agreement. We determine the estimated performance periods and review them periodically based on the progress of the related program. The effect of any change made to an estimated performance period and, therefore revenue recognized, would occur on a prospective basis in the period that the change was made. We have received reimbursements for a portion of our research and development costs. Such reimbursements are recorded as a reduction to research and development expenses on our consolidated statements of operations. Our collaboration agreement with Sanofi contains milestone payments that may become due upon the achievement of certain milestones. We apply ASC Subtopic 605-28, Milestone Method. Under the milestone method, payments that are contingent upon achievement of a substantive milestone are recognized in the period in which the milestone is achieved. A milestone is defined as an event that can only be achieved based on our performance and there is substantive uncertainty at the inception of the arrangement about whether the event will be achieved. Events that are contingent only on the passage of time or only on counterparty performance are not considered milestones subject to this guidance. Further, for the milestone to be considered substantive, (a) the consideration earned from the milestone must relate solely to our performance, (b) the consideration must be reasonable relative to all of the deliverables, and (c) the consideration must be commensurate with (i) our performance to achieve the milestone or (ii) the enhancement of the value of the item delivered as a result of a specific outcome resulting from our performance to achieve the milestone. Non-substantive milestone or contingent payments are recognized as revenue over the estimated period of any remaining performance obligations or when earned as a result of counterparty performance in accordance with contractual terms and when such payments can be reasonably estimated and collectability of such payments is reasonably assured. Research and Development Expense Accruals We accrue and expense research and development expense related to services performed by third parties based upon actual work completed in accordance with agreements established with such third parties. This process involves identifying services that have been performed and estimating the level of service performed and the associated contractual cost incurred for the service when we have not yet been invoiced or otherwise notified of actual cost. If timelines or contracts are modified based upon changes in the clinical trial protocol or scope of work to be performed, we modify our estimates of clinical trial accruals accordingly on a prospective basis. The financial terms of these agreements are subject to negotiation, vary from contract to contract and may result in uneven timing of payments. To date, we have not experienced any material differences between the accrued clinical trial expenses and actual clinical trial expenses. Fair Value of Convertible Preferred Stock Warrant Liability Freestanding warrants to purchase our convertible preferred stock were recorded as a liability on the consolidated balance sheets because the underlying shares of convertible preferred stock were contingently redeemable, which, therefore, may have obligated us to transfer assets at some point in the past to settle these warrants. The warrants were subject to revaluation at each balance sheet date, with changes in fair value recognized as a component of other income, net, on the consolidated statements of operations. The fair value of the preferred stock warrants was determined using a hybrid approach that takes into account the probability of an IPO and non-IPO liquidity events. The non-IPO liquidity event scenario uses an option pricing model to allocate the total enterprise value to the various securities within our capital structure based on future expectations. The IPO scenario also uses an option pricing model to estimate the value of the warrant in the case of an IPO. See Note 8, Debt Obligation, to our consolidated financial statements included elsewhere in this report. In September 2018, upon our IPO, all convertible preferred stock warrants were converted into common stock warrants. Fair Value of Convertible Notes Redemption Features Liability We recorded a derivative liability related to certain redemption features embedded within our outstanding convertible notes. The convertible notes issued in 2017 and 2016 included features that were determined to be an embedded derivative requiring bifurcation and separate accounting. This bifurcated redemption feature was initially recorded at fair value and is subject to revaluation at each balance sheet date. Changes in fair value were recognized as a component of other income, net, on the consolidated statements of operations. In December 2017, the convertible notes and interest payable were converted into shares of our Series B-3 preferred stock and the convertible notes redemption features liability was determined to have a fair value of $0. The fair value of our convertible notes redemption features was $0 as of December 31, 2018 and 2017. We determined the fair value of the convertible notes redemption features liability based on a lattice model that utilizes projected outcomes and the probability of those outcomes. The inputs used to determine the estimated fair value of the derivative instrument include the probability of an underlying event triggering the exercise of the redemption features and its timing. The fair value measurement was based upon significant inputs not observable in the market at each valuation date. The inputs included our evaluation of the likelihood of various settlement scenarios for the convertible notes, including the probabilities of (a) subsequent preferred stock sales at various price ranges, (b) the completion of an IPO, (c) a change in control of the company, (d) conversion of the convertible notes upon maturity, and (e) repayment of the convertible notes upon maturity. The settlement scenarios that would have triggered payments under the redemption features included the conversion to a future round of financing at a discounted price and a change in control prior to the conversion or repayment of the convertible notes. The other scenarios would not have triggered payment under the redemption features. These assumptions were inherently subjective and involved significant management judgment. See Note 8, Debt Obligation, to our consolidated financial statements included elsewhere in this Annual Report on Form 10-K Stock-based Compensation We use the Black-Scholes valuation model to estimate the grant date fair value of stock option awards with time-based vesting terms. Stock-based compensation expense is recognized based on the grant date fair value on a straight-line basis over the requisite service period and is reduced for forfeitures as they occur. The determination of fair value for stock-based awards on the date of grant using an option-pricing model requires us to make certain assumptions that represent our best estimates of volatility, risk-free interest rate, expected life and dividend yield. Changes in the assumptions can materially affect the fair value and ultimately how much stock-based compensation expense is recognized. These assumptions include: • Risk-Free Interest Rate: We base the risk-free interest rate on the interest rate payable on U.S. Treasury securities in effect at the time of grant, for a period that is commensurate with the assumed expected option term. • Expected Term of Options: The expected term of options represents the period of time options are expected to be outstanding. The expected term of the options granted is derived from the “simplified” method (that is, estimating the expected term as the mid-point between the vesting date and the end of the contractual term for each option). • Expected Stock Price Volatility: The expected volatility used is based on historical volatilities of similar entities within our industry for a period that is commensurate with our expected term assumption. • Expected Dividend Yield: The estimate for annual dividends is zero because we have not historically paid and do not expect for the foreseeable future to pay a dividend. Options granted to non-employee consultants are re-measured at the current fair value at the end of each reporting period until the underlying equity instruments vest. Stock-based compensation expense for non-employee consultants was insignificant for all periods presented. Determination of the estimated fair value of our common stock on grant dates prior to our IPO Prior to the IPO, the estimated fair value of our common stock was determined by our board of directors, with input from management, considering our most recently available third-party valuations of common stock and our board of directors’ assessment of additional objective and subjective factors that it believed were relevant, including factors that may have changed from the date of the most recent valuation through the date of the grant. The factors considered by our board of directors include, but are not limited to: the prices at which we sold shares of our convertible preferred stock to outside investors in arms-length transactions; the rights, preferences and privileges of our convertible preferred stock relative to those of our common stock; our results of operations, financial position and capital resources; current business conditions and projections; the lack of marketability of our common stock; the hiring of key personnel and the experience of management, progress of our research and development activities; our stage of development and material risks related to its business; the fact that the option grants involve illiquid securities in a private company; and the likelihood of achieving a liquidity event, such as an IPO or sale, in light of prevailing market conditions. Subsequent to the IPO, we estimate at the date of grant the fair value of the option to buy our underlying common stock, which is traded publicly on the Nasdaq Global Select Market. We have periodically determined the estimated fair value of our common stock at various dates using contemporaneous valuations performed in accordance with the guidance outlined in the American Institute of Certified Public Accountant’s Accounting and Valuation Guide, Valuation of Privately-Held Company Equity Securities Issued as Compensation ,or the Practice Aid. The Practice Aid identifies various available methods for allocating enterprise value across classes and series of capital stock to determine the estimated fair value of common stock at each valuation date. In accordance with the Practice Aid, our board of directors considered the following methods: • Option Pricing Method. Under the option pricing method, or OPM, shares are valued by creating a series of call options with exercise prices based on the liquidation preferences and conversion terms of each equity class. The estimated fair values of the preferred and common stock are inferred by analyzing these options. • Probability-Weighted Expected Return Method. The probability-weighted expected return method, or PWERM, is a scenario-based analysis that estimates value per share based on the probability-weighted present value of expected future investment returns, considering each of the possible outcomes available to us, as well as the economic and control rights of each share class. For the valuations of our common stock performed in August 2016, August 2017, December 2017, March 2018, June 2018 and July 2018, we used a hybrid of the OPM and PWERM methods to determine the estimated fair value of our common stock. Our board of directors and management develop best estimates based on application of these approaches and the assumptions underlying these valuations, giving careful consideration to the advice from our third-party valuation specialist. Such estimates involve inherent uncertainties and the application of significant judgment. As a result, if factors or expected outcomes change and we use significantly different assumptions or estimates, our stock-based compensation expense could be materially different. In determining the estimated fair value of our common stock, our board of directors also considered the fact that our stockholders could not freely trade our common stock in the public markets. Accordingly, we applied discounts to reflect the lack of marketability of our common stock based on the weighted-average expected time to liquidity. Determination of the fair value of our common stock on grant dates following our IPO The fair values of each granted option to buy underlying common stock is estimated, based on the price of our common stock as reported by the Nasdaq Global Select Market, at the date of grant. Stock-based compensation expense was $2.8 million, $1.0 million and $1.0 million for the years ended December 31, 2018, 2017, and 2016, respectively. As of December 31, 2018, we had $15.6 million of total unrecognized stock-based compensation expenses which we expect to recognize over a weighted-average period of 3.3 years. We have not recognized, and we do not expect to recognize in the near future, any tax benefit related to employee stock-based compensation expense as a result of the full valuation allowance on our deferred tax assets including deferred tax assets related to our net operating loss carryforwards. Income Taxes We account for income taxes under the asset and liability method. Deferred tax assets and liabilities are recognized for future tax consequences attributable to the differences between the financial statement carrying amounts of existing assets and liabilities and their respective tax bases and net operating loss and tax credit carryforwards. Valuation allowances are established when necessary to reduce deferred tax assets to the amount expected to be realized. Deferred tax assets and liabilities are measured at the balance sheet date using the enacted tax rates expected to apply to taxable income in the years in which those temporary differences are expected to be recovered or settled. The effect on deferred tax assets and liabilities of a change in tax rates is recognized in the period such tax rate changes are enacted. We record uncertain tax positions on the basis of a two-step process in which (1) we determine whether it is more likely than not that the tax positions will be sustained on the basis of the technical merits of the position and (2) for those tax positions that meet the more-likely-than-not recognition threshold, we recognize the largest amount of tax benefit that is more than 50 percent likely to be realized upon ultimate settlement with the related tax authority. Our policy is to recognize interest and penalties related to the underpayment of income taxes as a component of income tax expense or benefit. To date, there have been no interest or penalties charged in relation to the underpayment of income taxes. As of December 31, 2018, our total deferred tax assets were $32.7 million. The realization of deferred tax assets is dependent upon future earnings, if any, the timing and amount of which are uncertain. Accordingly, we have provided for a full valuation allowance against our deferred tax assets. Recent Accounting Pronouncements The information required by this item is included in Note 2, Significant Accounting Policies, to the Consolidated Financial Statements included elsewhere in Part II, Item 8, of this Annual Report on Form 10-K.

<s>[INST] Overview We are a latestage biopharmaceutical company dedicated to bringing transformative oral therapies to patients with significant unmet medical needs in immunology and oncology. Our proprietary Tailored Covalency® platform enables us to design and develop reversible covalent and irreversible covalent, small molecule inhibitors with potencies and selectivities that we believe will rival those of injectable biologics, but with the convenience of a pill. We have produced three new drug candidates from our platform, resulting in four clinical programs. In November 2018, we initiated a pivotal Phase 3 trial of PRN1008, a wholly owned Bruton’s Tyrosine Kinase, or BTK, inhibitor for the treatment of pemphigus. We retain full, worldwide rights to PRN1008, PRN1371 and our oral immunoproteasome inhibitor program, and have established an ongoing collaboration with Sanofi for PRN2246/SAR442168. Since commencing operations in 2011, we have devoted substantially all of our resources to identifying and developing our drug candidates, including conducting preclinical studies and clinical trials and providing general and administrative support for these operations. Our clinical pipeline programs include PRN1008, a reversible BTK inhibitor for the treatment of PV; PRN1008 for the treatment of immune thrombocytopenic purpura, also known as immune thrombocytopenia, or ITP; PRN2246/SAR442168, an irreversible BTK inhibitor that was designed to cross the bloodbrain barrier, for the treatment of multiple sclerosis, or MS, and other central nervous system, or CNS, disorders; and PRN1371, an irreversible inhibitor of Fibroblast Growth Factor Receptor, or FGFR, for the treatment of bladder cancer. Based on the interim results from our Phase 2 trial in pemphigus, we initiated a pivotal Phase 3 trial of PRN1008 in pemphigus (PV & PF) in November 2018. In parallel, we have initiated a Phase 2 trial of PRN1008 in ITP, and anticipate announcing topline results in the fourth quarter of 2019. We intend to assess one or more additional immunological indications for PRN1008 for future clinical development. We expect to commercialize PRN1008, if approved, by developing our own sales organization targeting dermatologists and hematologists at specialized centers in the United States. In November 2017, we entered an exclusive licensing agreement with Sanofi. We believe that this collaboration maximizes the potential of PRN2246/SAR442168 to address target indications affecting larger populations of patients with CNS diseases. We have completed our development efforts under the early development plan and Sanofi is responsible for further clinical development of this compound in patients suffering from MS. Prior to the initiation of the Phase 3 clinical trials for PRN2246/SAR442168, we will decide whether to exercise our option to fund a portion of the development costs of these trials in exchange for additional economic rights. We have initiated the expansion cohort of our Phase 1 trial of PRN1371 in patients with metastatic urothelial carcinoma having FGFR 1, 2, 3, or 4 genetic alterations and are planning another study for treatment of nonmuscle invasive bladder cancer, an early bladder cancer, which has a high rate of FGFR expression. We are expanding our wholly owned pipeline by continuing to innovate and discover differentiated oral small molecules with the potential to be bestinclass, and we intend to keep our programs at the forefront of covalent inhibitor drug discovery by investing in new technologies that will broaden the target space of our Tailored Covalency platform. In addition, we plan to explore the new biology discovered with our oral immunoproteasome inhibitors and to select the optimal development path for [/INST] Negative. </s>

Principia Biopharma Inc.

2020-03-10

2019-12-31

Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations. You should read the following discussion and analysis of our financial condition and results of operations together with our consolidated financial statements and the related notes to those statements included elsewhere in this report. This discussion and analysis and other parts of this report contain forward-looking statements based upon current beliefs, plans and expectations related to future events and our future financial performance that involve risks, uncertainties and assumptions, such as statements regarding our intentions, plans, objectives, expectations, forecasts and projections. Our actual results and the timing of selected events could differ materially from those anticipated in these forward-looking statements as a result of several factors, including those set forth under the section titled “Risk Factors” and elsewhere in this report. Overview We are a late-stage biopharmaceutical company focused on developing potential treatments for immune-mediated diseases. Our proprietary Tailored Covalency® platform enables us to design and develop reversible covalent and irreversible covalent, small molecule inhibitors with potencies and selectivities that we believe will rival those of injectable biologics, but with the convenience of an oral or topical treatment. We retain full, worldwide rights to rilzabrutinib, PRN473 Topical, PRN1371 and our oral immunoproteasome inhibitor program, and have established an ongoing collaboration with Sanofi for PRN2246/SAR442168. Since commencing operations in 2011, we have devoted substantially all our resources to identifying and developing our drug candidates, including conducting preclinical studies and clinical trials and providing general and administrative support for these operations. Our clinical pipeline programs include rilzabrutinib for the treatment of pemphigus (pemphigus vulgaris (PV) and pemphigus foliaceus (PF)); rilzabrutinib for the treatment of immune thrombocytopenia (ITP); rilzabrutinib for the treatment of IgG4-Related Disease (RD); PRN473 Topical, a reversible covalent BTK inhibitor being developed for immune-mediated diseases that could benefit from localized application to the skin; and PRN2246/SAR442168, an irreversible BTK inhibitor which crosses the blood-brain barrier, for the treatment of multiple sclerosis (MS) and other central nervous system (CNS) diseases. In January 2020, we announced suspension of PRN1371, an inhibitor of Fibroblast Growth Factor Receptor (FGFR) designed for the treatment of solid tumors, to focus our portfolio on immune-mediated diseases. • Based on results from our Phase 2 clinical trial in pemphigus, we initiated a global Phase 3 pivotal clinical trial of rilzabrutinib in pemphigus in November 2018. This Phase 3 clinical trial is evaluating rilzabrutinib in PV patients, and a smaller number of PF patients. We anticipate Phase 3 data in the second half of 2021, which has been accelerated from the original first half of 2022 timeline. In March 2019, we presented the Phase 2 Part A data at the 2019 AAD Annual Meeting as a late-breaking presentation. In December 2019, we announced CDA and CR rates from our Phase 2 Part B trial. Final data from the Phase 2 Part B trial will be submitted for presentation at an upcoming medical conference in the first half of 2020. In parallel, we are evaluating rilzabrutinib in a Phase 1/2 clinical trial in ITP, and recently amended the clinical trial protocol to add a long-term extension cohort for responders and to allow for the flexibility to enroll additional patients if we determine additional data would help inform the Phase 3 design. We presented positive data from our Phase 1/2 trial at the 61st ASH Annual Meeting in December 2019. We anticipate reporting Phase 2 data for rilzabrutinib in ITP in the second half of 2020. In January 2020, we announced an expansion in the development of rilzabrutinib into IgG4-RD, an immune-mediated disease of chronic inflammation and fibrosis that, if left untreated, can lead to severe morbidity including organ dysfunction and organ failure. We anticipate initiating a Phase 2 clinical trial for rilzabrutinib in IgG4-RD in the first half of 2020. Beyond pemphigus, ITP, and IgG4-RD, we believe there are numerous immune-mediated diseases for which rilzabrutinib may have therapeutic benefit. We anticipate commercializing rilzabrutinib, if approved, by developing our own sales organization targeting dermatologists, hematologists and rheumatologists at specialized centers in the United States. • In November 2017, we entered an exclusive licensing agreement with Sanofi. We believe that this collaboration maximizes the potential of PRN2246/SAR442168 to address target indications affecting larger populations of patients with CNS diseases. We have completed our development efforts under the early development plan and Sanofi is responsible for further clinical development of this compound in patients suffering from MS. In February 2020, Sanofi announced data for its Phase 2b clinical trial in relapsing MS. Specifically, Sanofi announced that PRN2246/SAR442168 met its primary endpoint, significantly reduced disease activity associated with MS as measured by MRI and was well tolerated in the Phase 2b trial with no new safety findings. Sanofi also announced that it anticipates initiating four Phase 3 clinical trials in relapsing and progressive forms of MS in the middle of 2020. We hold an option to fund a portion of Phase 3 development costs in return for, at our discretion, either a profit and loss sharing arrangement within the United States, or an additional worldwide royalty that would result in rates up to the high-teens. • In January 2020, we announced an expansion of our BTK franchise with PRN473 Topical, which is being developed for immune-mediated diseases that could benefit from localized application to the skin. In March 2020, we initiated a Phase 1 clinical trial of PRN473 Topical, which is anticipated to be completed in 2020. PRN473 Topical is our third BTK inhibitor in the clinic, joining rilzabrutinib and PRN2246/SAR442168. • We are expanding our wholly owned pipeline by continuing to innovate and discover differentiated oral or topical small molecules with the potential to be best-in-class, and we intend to keep our programs at the forefront of covalent inhibitor drug discovery by investing in new technologies that will broaden the target space of our Tailored Covalency platform. In addition, we plan to explore the new biology discovered with our oral immunoproteasome inhibitors and to select the optimal development path for these highly differentiated assets. • As we have done with our collaboration with Sanofi, we plan to selectively use collaborations and partnerships as strategic tools to maximize the value of our drug candidates, particularly in indications with large target patient populations. Since inception and through December 31, 2019, we have financed our operations primarily with proceeds totaling $541.0 million from our initial public offering (“IPO”) and a subsequent equity offering in October 2019, private placements of our convertible preferred stock and convertible notes and with payments totaling $110.0 million from license and research collaborations. We received a $30.0 million milestone payment in 2019 and milestone payments totaling $25.0 million in 2018 from our collaboration agreement with Sanofi. In 2017, we received non-refundable upfront payments of $40.0 million and $15.0 million from our collaboration agreements with Sanofi and AbbVie, respectively. In October 2019, we completed an equity offering of 8,625,000 shares of our common stock (which included 1,125,000 shares of our common stock issued and sold pursuant to the underwriters’ option to purchase additional shares) at a price to the public of $28.00 per share. We received net proceeds of approximately $226.5 million after deducting underwriting discounts and commissions and estimated offering expenses payable by us. On September 13, 2018, our Registration Statement on Form S-1 filed in connection with our IPO was declared effective by the SEC. In connection with our IPO, we issued and sold an aggregate of 7,187,500 shares of common stock, including 937,500 shares issued and sold pursuant to the underwriters’ full exercise of their overallotment option to purchase additional shares, at an offering price to the public of $17.00 per share. Proceeds from the IPO, net of underwriting discounts and commissions, were $113.6 million. In connection with the completion of our IPO in September 2018, all then outstanding shares of convertible preferred stock were converted into 15,760,102 shares of common stock. In addition, warrants to purchase 12,285,434 shares of our convertible preferred stock were converted into warrants to purchase shares of common stock. In August 2018, we sold 3,474,668 shares of Series C convertible preferred stock at a price of $14.3898 per share for net proceeds of $49.8 million. As of December 31, 2019, we held cash, cash equivalents and marketable securities totaling $367.8 million. We do not have any products for sale and have not generated any product revenue since our inception. To date, all our revenue has been generated from payments received from our agreements with Sanofi and AbbVie. We have incurred significant operating losses since the commencement of our operations. As of December 31, 2019, we have an accumulated deficit of $185.7 million. We expect to continue to incur significant expenses as we advance our drug candidates and expand our pipeline through clinical development, the regulatory approval process and, if successful, commercial launch activities. If after reviewing the Phase 2 data, we elect to exercise our option to fund a portion of Phase 3 development under the Sanofi Agreement, we will be required to share in certain development costs. Furthermore, we expect to incur additional costs associated with operating as a public company. Based on our planned operations, we believe our cash, cash equivalents and marketable securities at December 31, 2019 are sufficient to fund our operations for at least the next 12 months from the issuance date of these financial statements. Sanofi Agreement In November 2017, we entered into a strategic collaboration agreement with Sanofi, or the Sanofi Agreement, for an exclusive license to PRN2246/SAR442168 and backup molecules for development in MS and other CNS diseases. Under the Sanofi Agreement, we have completed the Phase 1 trials and Sanofi is taking on all further development activities. We and Sanofi are each responsible for certain early development costs, and Sanofi is responsible for all further development and commercialization costs, subject to our Phase 3 option described below. Sanofi has an exclusive license for PRN2246/SAR442168 and its backups for the CNS field, which includes indications of the central nervous system, retina and ophthalmic nerve. We have agreed not to develop other BTK inhibitors within the CNS field, and Sanofi has agreed not to develop PRN2246/SAR442168 or its backups for any indications outside the CNS field. In the event we cease all development and commercialization of our other BTK inhibitors or unilaterally decide to offer Sanofi a field expansion, Sanofi could expand its field upon a field expansion payment to us, as well as potential milestones payments and royalties within the expanded field. Under the amended Sanofi Agreement, we may receive development, regulatory and commercial milestone payments of up to an aggregate of $765.0 million, as well as royalties up to the mid-teens. We have an option to fund a portion of Phase 3 development costs in return for, at our option, either a profit and loss sharing arrangement within the United States, or an additional worldwide royalty that would result in royalties up to the high-teens. Only the additional royalty option would be available if we develop rilzabrutinib for major enumerated indications overseen by the FDA’s Division of Pulmonary, Allergy and Rheumatology Products or if we experience a change in control involving certain Sanofi competitors. Royalties are subject to specified reductions and are payable, on a product-by-product and country-by-country basis until the later of the date that all of our patent rights that claim a composition of matter of such product expire in such country, the date of expiration of regulatory exclusivity for such product in such country, or the date that is ten years from the first commercial sale of such product in such country. AbbVie Agreement In June 2017, we entered into a collaboration agreement with AbbVie, or the AbbVie Agreement, to research and develop oral immunoproteasome inhibitors and received an upfront payment of $15.0 million. In March 2019, we announced a mutual agreement with AbbVie to end our collaboration and to reacquire rights to the program following an assessment by AbbVie that there was no longer a strategic fit of our highly selective oral immunoproteasome inhibitors’ biologic profiles relative to AbbVie’s desired disease areas of focus. We and AbbVie agreed to conclude the collaboration effective March 2019. There are no further financial obligations between AbbVie and us. University of California License Agreements In November 2009 and September 2011, we entered into license agreements with the Regents of the University of California, or the Regents, which were subsequently amended and restated at various dates (the “UC Agreements”). Under the UC Agreements, the Regents have granted to us exclusive, worldwide licenses, with the right to grant sublicenses, under the Regents’ patent rights in certain patent applications to make, use, sell, offer for sale, and import products and services and practice methods covered by such patent applications in all fields of use. We have paid the Regents license fees of $40,000 in total under the UC Agreements and are required to pay annual license maintenance fees totaling $40,000 prior to launching any licensed product. We may be obligated to make one-time regulatory and development milestone payments under the UC Agreements for future drug candidates and are obligated to pay tiered royalty payments in the low single digits on net sales of the licensed products. Additionally, we are obligated to pay the Regents payments on non-royalty licensing revenue we receive from our sub-licensees for products covered by UC patents. Pursuant to the UC Agreements, we also made IPO milestone payments to the Regents totaling approximately $140,000 in October 2018. Under the UC Agreements, we are required to diligently proceed with the development, manufacture, regulatory approval, and sale of licensed products which include obligations to meet certain development-stage milestones within specified periods of time and to market the resulting licensed products in sufficient quantity to meet market demand. We have the right and option to extend the date by which we must meet any milestone in one year extensions by paying an extension fee for second and subsequent extension, provided we can demonstrate we made diligent efforts to meet the milestone. Components of Operating Results Revenue To date, all our revenue has been generated from payments pursuant to our collaboration arrangements with Sanofi and AbbVie. In connection with the Sanofi Agreement, we received a $40.0 million non-refundable upfront payment in December 2017, additional milestone payments totaling $25.0 million in 2018 for successful development activities under the early development plan, and a $30.0 million clinical development milestone payment in 2019 for the initiation of Sanofi’s Phase 2b clinical trial of PRN2246/SAR442168. We identified the following performance obligations under our Sanofi Agreement: (i) granting a license of rights to PRN2246/SAR442168, (ii) transferring of technology (know-how) related to PRN2246/SAR442168, and (iii) performance of research and development services related to our responsibilities under the early development plan. We concluded that the delivered license was not distinct at the inception of the arrangement due to our proprietary expertise with respect to the licensed compound and related developmental participation under the agreement, which was required for Sanofi to fully realize the value from the delivered license. Therefore, we combined these performance obligations as one unit of accounting and recognized the $40.0 million upfront payment and the aggregate of $25.0 million in milestone payments ratably over the performance period, which ended as of December 31, 2018. On January 1, 2019, we adopted Accounting Standards Codification (“ASC”) No. 2014-09, Revenue from Contracts with Customers, or ASC 606, using the modified retrospective approach. We concluded upon analysis that there is no adjustment necessary to revenue recognized through December 31, 2018 under ASC 606 for the Sanofi Agreement. All deliverables under ASC 605 and all performance obligations under ASC 606 had been completed as of December 31, 2018. In June 2019, we received a $30.0 million milestone payment from Sanofi for achieving a clinical development milestone and recognized the full payment as revenue. For the years ended December 31, 2019, 2018 and 2017, we recognized $30.0 million, $63.1 million and $1.9 million in revenue from Sanofi, respectively. There was no deferred revenue related to the Sanofi Agreement at December 31, 2019 and 2018. In connection with the AbbVie Agreement, we received a $15.0 million non-refundable upfront payment in June 2017. Prior to the adoption of ASC 606, we concluded under ASC 605 that the delivered license was not distinct at the inception of the arrangement due to our proprietary expertise with respect to the licensed compounds and related ongoing research participation under the AbbVie Agreement, which was required for AbbVie to fully realize the value from the licensed compound. Therefore, the $15.0 million received related to this combined unit of accounting was recognized as revenue ratably over the performance period, which as of December 31, 2018, was estimated to continue through the fourth quarter of 2019. On January 1, 2019, we adopted ASC 606 using the modified retrospective approach. Upon adoption, the fixed non-refundable and non-creditable upfront payment of $15.0 million received in 2017 was determined to be the transaction price. Revenue was recognized based on a measurement of progress toward the completion of the performance obligation of providing research services for two years, subject to an extension for up to six months. The measurement was calculated using an input-method based on research costs incurred by us during each reporting period compared to the total projected research costs to provide research services by us pursuant to the AbbVie Agreement. Such costs included external direct costs and internal direct labor consisting of the efforts of certain of our employees that dedicated their time providing research services pursuant to the AbbVie Agreement. Based on this methodology, we concluded that under ASC 606, approximately $9.8 million in revenue should be recognized through December 31, 2018, as compared to $9.4 million under ASC 605. We recorded a cumulative adjustment to decrease accumulated deficit and deferred revenue by $0.4 million as of the adoption date. In March 2019, we and AbbVie agreed to end our collaboration. Therefore, we recognized the remaining balance of the transaction price of $5.2 million in the first quarter of 2019, upon termination of the AbbVie Agreement. Revenue related to AbbVie for the years ended December 31, 2019, 2018 and 2017 was $5.2 million, $6.0 million and $3.4 million, respectively. There was no deferred revenue related to the AbbVie Agreement at December 31, 2019. Deferred revenue related to the AbbVie Agreement was $5.6 million at December 31, 2018. Operating Expenses We classify our operating expenses into two categories: research and development and general and administrative. Research and Development Our research and development expenses account for a significant portion of our operating expenses and relate to expenses incurred in connection with research and development activities, including the preclinical and clinical development of our drug candidates. These expenses primarily consist of preclinical and clinical expenses; payroll and personnel expenses, including stock-based compensation, for our research and development employees; consulting costs, laboratory supplies and facilities costs. We expense both internal and external research and development costs as they are incurred. Non-refundable advance payments for services that will be used or rendered for future research and development activities are recorded as prepaid expenses and recognized as an expense as the related services are performed. Our external research and development expenses consist primarily of: • expenses incurred with contract research organizations, investigative clinical trial sites and other vendors involved in conducting our clinical trials; • expenses incurred with contract manufacturing organizations for process development, scale up, as well as manufacturing of drug substance and drug candidates; • expenses incurred with third party vendors for performing preclinical testing on our behalf; and • consulting fees and certain laboratory supply costs related to the execution of preclinical studies and clinical trials. With respect to internal costs, several of our departments support multiple clinical programs, and we do not allocate those costs by clinical program. Internal research and development expenses consist primarily of personnel-related costs, facilities and infrastructure costs, certain laboratory supplies and non-capitalized equipment used for internal research and development activities. We expect our research and development expenses to increase over the next several years as we continue to execute on our business strategy, advance our current programs and expand our research and development efforts, and pursue regulatory approvals of any of our drug candidates that successfully complete clinical trials. General and Administrative General and administrative expenses consist primarily of payroll and personnel related expenses, including stock-based compensation, for our personnel in finance, legal, human resources, business and corporate development and other administrative functions, professional consulting fees for legal and accounting services, costs related to our intellectual property and other allocated costs, such as facility expenses not otherwise allocated to research and development, and infrastructure costs. We expect our general and administrative expenses to increase as a result of operating as a public company. Additional expenses include those related to compliance with the rules and regulations of the SEC and the Nasdaq Global Market, additional insurance expenses, investor relations activities and other administrative and professional services. Other Income (Expense), Net Other income (expense), net, consists primarily of changes in fair value related to the outstanding convertible preferred stock warrant liability and the convertible notes redemption features liability. Interest Income Interest income is primarily related to interest earned on our marketable securities. Interest Expense Interest expense consists primarily of interest expense related to our debt obligation, and the accretion of non-cash debt discounts related to the beneficial conversion features of our convertible notes, the convertible notes redemption features and the convertible preferred stock warrants. Results of Operations Comparison of the Years Ended December 31, 2019 and 2018 The following table summarizes our results of operations for the years ended December 31, 2019 and 2018 (dollars in thousands): * Percentage not meaningful Revenue Revenue for the year ended December 31, 2019 was $35.2 million, consisting of a $30.0 million clinical development milestone payment received in connection with the Sanofi Agreement and a portion of the upfront payments received in connection with the AbbVie Agreement. Revenue for the year ended December 31, 2018 was $69.1 million, consisting of a portion of the upfront and additional payments we received in connection with the Sanofi Agreement and a portion of the upfront payment received in connection with the AbbVie Agreement. The clinical development milestone payment of $30.0 million received in 2019 under the Sanofi Agreement was recognized as revenue when earned in the second quarter of 2019. The aggregate payments of $65.0 million received in 2017 and 2018 under the Sanofi Agreement were recognized ratably over the estimated performance period ended December 31, 2018, and we recorded approximately $63.1 million in revenue related to the Sanofi Agreement for the year ended December 31, 2018. The nonrefundable upfront payment under the AbbVie Agreement was recognized ratably over the estimated performance period, and we recorded approximately $5.2 million and $6.0 million in revenue related to the AbbVie Agreement for the years ended December 31, 2019 and 2018, respectively. Research and Development Expenses Research and development expenses were $74.1 million for the year ended December 31, 2019, an increase of $33.6 million, compared to $40.5 million for the year ended December 31, 2018. The increase was primarily driven by a $13.7 million increase in personnel related expenses, a $11.4 million increase in external rilzabrutinib program costs due to the initiation of a global Phase 3 trial in pemphigus in November 2018 and certain manufacturing campaigns to supply drug products for our rilzabrutinib clinical trials, and a $5.4 million increase in other unallocated research and development expenses, mainly facility costs related to our move to our new office space in February 2019. The increase in personnel related expenses is due to increased research and development headcount and increased stock-based compensation expenses. The following table summarizes research and development expenses (in thousands): (1) Preclinical external expenses include external research and development expenses for all of our preclinical programs. This includes the oral immunoproteasome program we reacquired from AbbVie in March 2019. (2) Personnel related expenses include stock-based compensation expense of $6.6 million and $1.4 million for the years ended December 31, 2019 and 2018, respectively. As our research and development personnel generally support several of our programs and a significant amount of our internal development activities broadly support all of our programs, we do not separately track or allocate our personnel related expenses by program. General and Administrative Expenses General and administrative expenses were $19.8 million for the year ended December 31, 2019, an increase of $8.4 million, compared to $11.5 million for the year ended December 31, 2018. The increase was primarily driven by a $7.6 million increase in personnel related expenses due to increased headcount expenses and increased stock-based compensation expenses. Other Income (Expense), Net There was no other income (expense), net, for the year ended December 31, 2019. Other expense, net, was $0.7 million for the year ended December 31, 2018 and primarily included expense related to the remeasurement and conversion of our preferred stock warrants upon our IPO. Interest Income Interest income for the years ended December 31, 2019 and 2018 was $5.0 million and $1.7 million, respectively, and consists primarily of interest income earned on our cash, cash equivalents and marketable securities. The increase of $3.3 million is mainly due to higher balances of marketable securities in 2019 as compared to 2018. Comparison of the Years Ended December 31, 2018 and 2017 The following table summarizes our results of operations for the years ended December 31, 2018 and 2017 (dollars in thousands): * Percentage not meaningful. Revenue Revenue for the year ended December 31, 2018 was $69.1 million, consisting of a portion of the upfront payment received in connection with the AbbVie Agreement and a portion of the upfront and additional payments we received in connection with the Sanofi Agreement. Revenue for the year ended December 31, 2017 was $5.2 million, consisting of portions of the upfront payments received in connection with the AbbVie Agreement and Sanofi Agreement, which were signed in June and November 2017, respectively. The aggregate payments of $65.0 million under the Sanofi Agreement were recognized ratably over the performance period, and we recorded $63.1 million and $1.9 million in revenue related to the Sanofi Agreement for the years ended December 31, 2018 and 2017, respectively. The nonrefundable upfront payment under the AbbVie Agreement was recognized ratably over the estimated performance period, and we recorded $6.0 million and $3.4 million in revenue related to the AbbVie Agreement for the years ended December 31, 2018 and 2017, respectively. Research and Development Expenses Research and development expenses were $40.5 million for the year ended December 31, 2018, an increase of $15.1 million, compared to $25.4 million for the year ended December 31, 2017. The increase was primarily driven by a $9.9 million increase in external rilzabrutinib program costs, a $4.9 million increase in personnel related expenses, and a $1.2 million increase in other unallocated research and development costs, partially offset by a decrease of $0.8 million in costs related to PRN2246/SAR442168. The increase in rilzabrutinib program costs was mainly due to various manufacturing campaigns to supply drug products for our rilzabrutinib clinical trials and the initiation of a global Phase 3 trial in pemphigus in November 2018. The increase in personnel related expenses was mainly due to our R&D headcount increase as we build out our R&D team. The following table summarizes research and development expenses (in thousands): (1) Preclinical external expenses include external research and development expenses for all of our preclinical programs. This includes the oral immunoproteasome program we reacquired from AbbVie in March 2019. (2) Personnel related expenses include stock-based compensation expense of $1.4 million and $0.5 million for the years ended December 31, 2018 and 2017, respectively. As our research and development personnel generally support several of our programs and a significant amount of our internal development activities broadly support all of our programs, we do not separately track or allocate our personnel related expenses by program. General and Administrative Expenses General and administrative expenses were $11.5 million for the year ended December 31, 2018, an increase of $5.0 million, compared to $6.4 million for the year ended December 31, 2017. The increase was primarily driven by an increase in personnel and facility expenses. The increase in personnel costs was related to increased headcount during 2018 as we built out our organization. The increase in facility costs was due to certain rent expense recognition starting from August 1, 2018, the date when we gained access to our new leased premises, which we commenced occupancy in February 2019. Other Income (Expense), Net Other expense, net, for the year ended December 31, 2018 was $0.7 million compared to other income, net, of $5.1 million for the year ended December 31, 2017. Other expense, net, for the year ended December 31, 2018 included $0.7 million of expense related to the conversion of our preferred stock warrants upon our IPO. Other income, net, for the year ended December 31, 2017 was primarily due to a net change of $5.1 million in 2017 for the fair values of the convertible note redemption features and the fair values of the outstanding convertible preferred stock warrants. Interest Income Interest income for the year ended December 31, 2018 was $1.7 million, related to our investments in marketable securities. Interest income for the year ended December 31, 2017 was insignificant. Interest Expense There was no interest expense for the year ended December 31, 2018. Interest expense for the year ended December 31, 2017 was $7.2 million, comprised of $5.5 million of debt discounts and $1.7 million of accrued interest expense on the convertible notes, which were converted into preferred stock in December 2017. Liquidity and Capital Resources Since inception and through December 31, 2019, we have financed our operations primarily with proceeds totaling $541.0 million from our IPO and a subsequent equity offering in October 2019, private placements of our convertible preferred stock and convertible notes and with payments totaling $110.0 million from license and research collaborations. As of December 31, 2019 and 2018, we held cash, cash equivalents and marketable securities totaling $367.8 million and $180.6 million, respectively. We do not have any products for sale and have not generated any product revenue since our inception. As of December 31, 2019, all our revenue has been generated from the non-refundable upfront and milestone payments received from our collaboration agreements with Sanofi and AbbVie. For the years ended December 31, 2019, 2018 and 2017, we recorded a net loss of $53.8 million, net income of $18.2 million and a net loss of $28.7 million, respectively. As of December 31, 2019, we have an accumulated deficit of $185.7 million, and we do not expect positive cash flows from operations for the foreseeable future. We expect to continue to incur significant expenses and net operating losses as we advance our clinical drug candidates and expand our pipeline, seek regulatory approval and, if successful, proceed to commercial launch activities. Furthermore, we expect to incur additional costs associated with operating as a public company. In addition, we do not yet have a sales organization or commercial infrastructure. Accordingly, we will incur significant expenses to develop a sales organization and/or commercial infrastructure in advance of generating any commercial product sales. As a result, we will need substantial additional capital to support our operating activities. We currently anticipate that we will seek to fund our operations through equity or debt financings or other sources, such as potential collaboration agreements with third parties. Based on our planned operations, we believe our cash, cash equivalents and marketable securities at December 31, 2019 are sufficient to fund our operations for at least the next 12 months from the issuance date of these financial statements. We have based our projections of operating capital requirements on assumptions that may prove to be incorrect and we may use all of our available capital resources sooner than we expect. Because of the numerous risks and uncertainties associated with research, development and commercialization of pharmaceutical products, we are unable to estimate the exact amount of our operating capital requirements. Our future funding requirements will depend on many factors, including, but not limited to: • the scope, rate of progress, results and costs of research and development activities, conducting preclinical studies, laboratory testing and clinical trials for our drug candidates; • the number and scope of clinical programs we decide to pursue; • the cost, timing and outcome of regulatory review of our drug candidates; • the scope and cost of manufacturing development and commercial manufacturing activities; • the timing and amount of milestone payments, if any, we receive under the Sanofi Agreement; • our ability to maintain existing and establish new, strategic collaborations, licensing or other arrangements on favorable terms, if at all; • the costs of preparing, filing, prosecuting, maintaining, defending and enforcing our intellectual property portfolio; • our efforts to enhance operational systems and our ability to attract, hire and retain qualified personnel, including personnel to support the development of our drug candidates; • the costs associated with being a public company; and • the costs associated with commercialization activities if any of our drug candidates are approved for sale. See our “Risk Factors” elsewhere in this report for a description of additional risks associated with our substantial capital requirements. Cash Flows The following table summarizes cash flows for each of the periods presented below (in thousands): Net cash provided by (used in) operating activities During the year ended December 31, 2019, net cash used in operating activities was $42.5 million, which resulted from a net loss of $53.8 million adjusted for changes in operating assets and liabilities and non-cash charges. Non-cash charges included $12.2 million in stock-based compensation and $1.8 million in depreciation and amortization, partially offset by $1.6 million from the amortization of discounts on marketable securities. Changes in operating assets and liabilities included a decrease of $5.2 million in deferred revenue and a decrease of $2.1 million in accounts payable, partially offset by a $6.8 million increase in accrued liabilities. During the year ended December 31, 2018, net cash used in operating activities was $21.2 million, which resulted from net income of $18.2 million adjusted for changes in operating assets and liabilities and non-cash charges. Non-cash charges included $2.8 million in stock-based compensation, $0.6 million related to the change in fair value of the convertible preferred stock warrant liability, $0.7 million for deferred rent and $0.3 million for depreciation and amortization. Changes in operating assets and liabilities included a decrease of $44.1 million in deferred revenue, an increase of $2.2 million in prepaid expenses and other assets, an increase of $1.0 million in accounts payable and an increase of $2.0 million in accrued liabilities. During the year ended December 31, 2017, net cash provided by operating activities was $26.8 million, which resulted from a net loss of $28.7 million adjusted for changes in operating assets and liabilities and non-cash charges. We received nonrefundable upfront payments of $40.0 million and $15.0 million from the Sanofi Agreement and the AbbVie Agreement, respectively. We recorded revenues of approximately $1.9 million and $3.4 million related to Sanofi and AbbVie, respectively, for the year ended December 31, 2017. The remaining $49.8 million was recorded as deferred revenue at December 31, 2017. Other changes in operating assets and liabilities included increases of $1.3 million and $2.0 million in accounts payable and accrued liabilities, respectively, partially offset by a decrease of $0.8 million in prepaid expenses and other current assets. Non-cash charges included debt discount amortization of $5.5 million, the conversion of accrued interest expense of $1.7 million into preferred stock, stock-based compensation and depreciation expenses of $1.0 million and $0.2 million, respectively, partially offset by a $5.1 million net gain related to changes in the fair values of the redemption features liability and convertible preferred stock warrant liability. Net cash used in investing activities During the year ended December 31, 2019, net cash used in investing activities was $182.6 million and is primarily the result of purchases in excess of maturities of marketable securities of $180.5 million and purchases of property and equipment of $2.2 million. During the year ended December 31, 2018, net cash used in investing activities was $146.9 million and is primarily the result of purchases in excess of maturities of marketable securities of $145.8 million and purchases of laboratory and computer equipment of $1.1 million. During the year ended December 31, 2017, net cash used in investing activities was $90,000 for the purchase of laboratory and computer equipment. Net cash provided by financing activities During the year ended December 31, 2019, net cash provided by financing activities was $230.1 million, resulting from net proceeds of $226.5 million from the equity offering of our common stock in October 2019 and $3.7 million from issuances of common stock upon exercise of options and participation in the employee stock purchase plan. During the year ended December 31, 2018, net cash provided by financing activities was $161.9 million and includes $110.6 million of net proceeds, after deducting underwriting discounts, commissions and offering costs, from our IPO of our common stock, $49.8 million of proceeds from our Series C preferred stock issuance and $1.5 million from the issuance of common stock pursuant to our equity incentive plans. During the year ended December 31, 2017, net cash provided by financing activities was $8.4 million, consisting of $8.1 million of proceeds from the issuance of convertible notes and $0.3 million of proceeds from the issuance of common stock. Off-Balance Sheet Arrangements We currently do not have, and did not have during the periods presented, any off-balance sheet arrangements, as defined under SEC rules. Contractual Obligations and Commitments The following table summarizes our contractual obligations as of December 31, 2019 (in thousands): Our corporate headquarters are located in South San Francisco, California, where we lease approximately 47,500 square feet of office, research and development, and laboratory space starting February 2019, for a seven-year period with an option to extend for another seven-year period, subject to certain conditions. Our previous lease, which expired on January 31, 2019, was for 30,000 square feet of office, research and development, and laboratory space in South San Francisco. JOBS Act The JOBS Act permits an “emerging growth company” such as ours to take advantage of an extended transition time to comply with new or revised accounting standards applicable to public companies. We have elected the extended transition period for complying with new or revised accounting standards pursuant to Section 107(b) of the JOBS Act, which extension runs until the earlier of the date we (i) are no longer an emerging growth company or (ii) affirmatively and irrevocably opt out of the extended transition period provided in the JOBS Act. As a result, our financial statements may not be comparable to companies that comply with new or revised accounting pronouncements as of public company effective dates. We will remain an emerging growth company until the earliest of (i) the last day of our first fiscal year (a) following the fifth anniversary of the completion of our IPO, (b) in which we have total annual gross revenues of at least $1.07 billion, or (c) in which we are deemed to be a large accelerated filer, which means the market value of our common stock that is held by non-affiliates as of the end of our second fiscal quarter, or June 30th, exceeds $700.0 million, and (ii) the date on which we have issued more than $1.0 billion in non-convertible debt securities during the prior three-year period. Critical Accounting Policies, Significant Judgments and Use of Estimates Our management’s discussion and analysis of our financial condition and results of operations is based on our financial statements, which have been prepared in accordance with generally accepted accounting principles in the United States (“U.S. GAAP”). The preparation of our financial statements requires us to make estimates and assumptions that affect the reported amounts of assets and liabilities and the disclosure of contingent assets and liabilities at the date of the financial statements, as well as the reported expenses incurred during the reporting periods. Our estimates are based on our historical experience and on various other factors that we believe are reasonable under the circumstances, the results of which form the basis for making judgments about the carrying value of assets and liabilities that are not readily apparent from other sources. Actual results may differ from these estimates under different assumptions or conditions. Revenue Recognition Effective January 1, 2019, we adopted ASC 606 using the modified retrospective approach. Under this approach, we recorded a cumulative adjustment to decrease accumulated deficit and deferred revenue by $0.4 million as of the adoption date. Under ASC 606, an entity recognizes revenue when its customer obtains control of promised goods or services, in an amount that reflects the consideration that the entity expects to receive in exchange for those goods or services. To determine revenue recognition for arrangements that an entity determines are within the scope of ASC 606, the entity performs the following steps: (i) identify the contract(s) with a customer; (ii) identify the performance obligations in the contract; (iii) determine the transaction price; (iv) allocate the transaction price to the performance obligations in the contract; and (v) recognize revenue when (or as) the entity satisfies a performance obligation. We only apply the five-step model to contracts when it is probable that we will collect the consideration we are entitled to in exchange for the goods and services we transfer to the customer. At contract inception, once the contract is determined to be within the scope of ASC 606, we assess the goods or services promised within each contract, determine those that are performance obligations and assess whether each promised good or service is distinct. We then recognize as revenue the amount of the transaction price that is allocated to the respective performance obligation when (or as) the performance obligation is satisfied. We have entered into licensing and collaboration agreements that are within the scope of ASC 606. In determining the appropriate amount of revenue to be recognized as we fulfill our obligations under such licensing and collaboration agreements, we perform the five-step model under ASC 606. As part of the accounting for these arrangements, we must develop assumptions that require judgment to determine the stand-alone selling price for each performance obligation identified in the contract. Licenses of Intellectual Property: If the license to our intellectual property is determined to be distinct from the other performance obligations identified in the arrangement, we recognize revenues from non-refundable, upfront fees allocated to the license when the license is transferred to the licensee and the licensee is able to use and benefit from the license. For licenses that are bundled with other promised goods or services, we utilize judgment to assess the nature of the combined performance obligation to determine whether the combined performance obligation is satisfied over time or at a point in time and, if over time, the appropriate method of measuring progress for purposes of recognizing revenue from non-refundable, upfront fees. We evaluate the measure of progress each reporting period and, if necessary, adjust the measure of performance and related revenue recognition. Milestone Payments: At the inception of each arrangement that includes development, regulatory and/or commercial milestone payments, we evaluate whether the milestones are considered probable of being reached and estimate the amount to be included in the transaction price using the most likely amount method. If it is probable that a significant reversal of cumulative revenue would not occur, the associated milestone value is included in the transaction price. Milestone payments that are not within our control or that of our licensee, such as regulatory approvals, are not considered probable of being achieved until those approvals are received or the underlying activity has been completed. The transaction price is then allocated to each performance obligation on a relative stand-alone selling price basis, for which we recognize revenue as or when the performance obligations under the contract are satisfied. At the end of each subsequent reporting period, we re-evaluate the probability of achievement of such development milestones and any related constraint, and if necessary, adjust our estimate of the overall transaction price. Any such adjustments are recorded on a cumulative catch-up basis, which would affect collaboration revenue in the period of adjustment. Royalties: For arrangements that include sales-based royalties, including milestone payments based on the level of sales, and the license is deemed to be the predominant item to which the royalties relate, we recognize revenue at the later of (i) when the related sales occur, or (ii) when the performance obligation to which some or all of the royalty has been allocated has been satisfied (or partially satisfied). To date, we have not recognized any royalty revenue resulting from any of our licensing arrangements. Research and Development Expense Accruals We accrue and expense research and development expense related to services performed by third parties based upon actual work completed in accordance with agreements established with such third parties. This process involves identifying services that have been performed and estimating the level of service performed and the associated contractual cost incurred for the service when we have not yet been invoiced or otherwise notified of actual cost. If timelines or contracts are modified based upon changes in the clinical trial protocol or scope of work to be performed, we modify our estimates of clinical trial accruals accordingly on a prospective basis. The financial terms of these agreements are subject to negotiation, vary from contract to contract and may result in uneven timing of payments. To date, we have not experienced any material differences between estimated clinical trial expenses and actual clinical trial expenses. Stock-based Compensation We use the Black-Scholes valuation model to estimate the grant date fair value of stock option awards with time-based vesting terms. Stock-based compensation expense is recognized based on the grant date fair value on a straight-line basis over the requisite service period and is reduced for forfeitures as they occur. The determination of fair value for stock-based awards on the date of grant using an option-pricing model requires us to make certain assumptions that represent our best estimates of volatility, risk-free interest rate, expected life and dividend yield. Changes in the assumptions can materially affect the fair value and ultimately how much stock-based compensation expense is recognized. These assumptions include: • Risk-Free Interest Rate: We base the risk-free interest rate on the interest rate payable on U.S. Treasury securities in effect at the time of grant, for a period that is commensurate with the assumed expected option term. • Expected Term of Options: The expected term of options represents the period of time options are expected to be outstanding. The expected term of the options granted is derived from the “simplified” method (that is, estimating the expected term as the mid-point between the vesting date and the end of the contractual term for each option). • Expected Stock Price Volatility: The expected volatility used is based on historical volatilities of similar entities within our industry for a period that is commensurate with our expected term assumption. • Expected Dividend Yield: The estimate for annual dividends is zero because we have not historically paid and do not expect for the foreseeable future to pay a dividend. Options granted to non-employee consultants are re-measured at the current fair value at the end of each reporting period until the underlying equity instruments vest. Stock-based compensation expense for non-employee consultants was insignificant for all periods presented. Determination of the estimated fair value of our common stock on grant dates prior to our IPO Prior to the IPO, the estimated fair value of our common stock was determined by our board of directors, with input from management, considering our most recently available third-party valuations of common stock and our board of directors’ assessment of additional objective and subjective factors that it believed were relevant, including factors that may have changed from the date of the most recent valuation through the date of the grant. The factors considered by our board of directors include, but are not limited to: the prices at which we sold shares of our convertible preferred stock to outside investors in arms-length transactions; the rights, preferences and privileges of our convertible preferred stock relative to those of our common stock; our results of operations, financial position and capital resources; current business conditions and projections; the lack of marketability of our common stock; the hiring of key personnel and the experience of management, progress of our research and development activities; our stage of development and material risks related to its business; the fact that the option grants involve illiquid securities in a private company; and the likelihood of achieving a liquidity event, such as an IPO or sale, in light of prevailing market conditions. Subsequent to the IPO, we estimate at the date of grant the fair value of the option to buy our underlying common stock, which is traded publicly on the Nasdaq Global Select Market. We have periodically determined the estimated fair value of our common stock at various dates using contemporaneous valuations performed in accordance with the guidance outlined in the American Institute of Certified Public Accountant’s Accounting and Valuation Guide, Valuation of Privately-Held Company Equity Securities Issued as Compensation, or the Practice Aid. The Practice Aid identifies various available methods for allocating enterprise value across classes and series of capital stock to determine the estimated fair value of common stock at each valuation date. In accordance with the Practice Aid, our board of directors considered the following methods: • Option Pricing Method. Under the option pricing method, or OPM, shares are valued by creating a series of call options with exercise prices based on the liquidation preferences and conversion terms of each equity class. The estimated fair values of the preferred and common stock are inferred by analyzing these options. • Probability-Weighted Expected Return Method. The probability-weighted expected return method, or PWERM, is a scenario-based analysis that estimates value per share based on the probability-weighted present value of expected future investment returns, considering each of the possible outcomes available to us, as well as the economic and control rights of each share class. For the valuations of our common stock performed in August 2017, December 2017, March 2018, June 2018 and July 2018, we used a hybrid of the OPM and PWERM methods to determine the estimated fair value of our common stock. Our board of directors and management develop best estimates based on application of these approaches and the assumptions underlying these valuations, giving careful consideration to the advice from our third-party valuation specialist. Such estimates involve inherent uncertainties and the application of significant judgment. As a result, if factors or expected outcomes change and we use significantly different assumptions or estimates, our stock-based compensation expense could be materially different. In determining the estimated fair value of our common stock, our board of directors also considered the fact that our stockholders could not freely trade our common stock in the public markets. Accordingly, we applied discounts to reflect the lack of marketability of our common stock based on the weighted-average expected time to liquidity. Determination of the fair value of our common stock on grant dates following our IPO The fair values of each granted option to buy underlying common stock is estimated, based on the price of our common stock as reported by the Nasdaq Global Select Market, at the date of grant. Stock-based compensation expense was $12.2 million, $2.8 million and $1.0 million for the years ended December 31, 2019, 2018 and 2017, respectively. As of December 31, 2019, we had $36.2 million of total unrecognized stock-based compensation expenses which we expect to recognize over a weighted-average period of 2.9 years. We have not recognized, and we do not expect to recognize in the near future, any tax benefit related to employee stock-based compensation expense as a result of the full valuation allowance on our deferred tax assets including deferred tax assets related to our net operating loss carryforwards. Income Taxes We account for income taxes under the asset and liability method. Deferred tax assets and liabilities are recognized for future tax consequences attributable to the differences between the financial statement carrying amounts of existing assets and liabilities and their respective tax bases and net operating loss and tax credit carryforwards. Valuation allowances are established when necessary to reduce deferred tax assets to the amount expected to be realized. Deferred tax assets and liabilities are measured at the balance sheet date using the enacted tax rates expected to apply to taxable income in the years in which those temporary differences are expected to be recovered or settled. The effect on deferred tax assets and liabilities of a change in tax rates is recognized in the period such tax rate changes are enacted. We record uncertain tax positions on the basis of a two-step process in which (1) we determine whether it is more likely than not that the tax positions will be sustained on the basis of the technical merits of the position and (2) for those tax positions that meet the more-likely-than-not recognition threshold, we recognize the largest amount of tax benefit that is more than 50 percent likely to be realized upon ultimate settlement with the related tax authority. Our policy is to recognize interest and penalties related to the underpayment of income taxes as a component of income tax expense or benefit. To date, there have been no interest or penalties charged in relation to the underpayment of income taxes. As of December 31, 2019, our total deferred tax assets were $45.9 million. The realization of deferred tax assets is dependent upon future earnings, if any, the timing and amount of which are uncertain. Accordingly, we have provided for a full valuation allowance against our deferred tax assets. Recent Accounting Pronouncements The information required by this item is included in Note 2, Significant Accounting Policies, to the Consolidated Financial Statements included elsewhere in Part II, Item 8, of this Annual Report on Form 10-K.

<s>[INST] Overview We are a latestage biopharmaceutical company focused on developing potential treatments for immunemediated diseases. Our proprietary Tailored Covalency® platform enables us to design and develop reversible covalent and irreversible covalent, small molecule inhibitors with potencies and selectivities that we believe will rival those of injectable biologics, but with the convenience of an oral or topical treatment. We retain full, worldwide rights to rilzabrutinib, PRN473 Topical, PRN1371 and our oral immunoproteasome inhibitor program, and have established an ongoing collaboration with Sanofi for PRN2246/SAR442168. Since commencing operations in 2011, we have devoted substantially all our resources to identifying and developing our drug candidates, including conducting preclinical studies and clinical trials and providing general and administrative support for these operations. Our clinical pipeline programs include rilzabrutinib for the treatment of pemphigus (pemphigus vulgaris (PV) and pemphigus foliaceus (PF)); rilzabrutinib for the treatment of immune thrombocytopenia (ITP); rilzabrutinib for the treatment of IgG4Related Disease (RD); PRN473 Topical, a reversible covalent BTK inhibitor being developed for immunemediated diseases that could benefit from localized application to the skin; and PRN2246/SAR442168, an irreversible BTK inhibitor which crosses the bloodbrain barrier, for the treatment of multiple sclerosis (MS) and other central nervous system (CNS) diseases. In January 2020, we announced suspension of PRN1371, an inhibitor of Fibroblast Growth Factor Receptor (FGFR) designed for the treatment of solid tumors, to focus our portfolio on immunemediated diseases. Based on results from our Phase 2 clinical trial in pemphigus, we initiated a global Phase 3 pivotal clinical trial of rilzabrutinib in pemphigus in November 2018. This Phase 3 clinical trial is evaluating rilzabrutinib in PV patients, and a smaller number of PF patients. We anticipate Phase 3 data in the second half of 2021, which has been accelerated from the original first half of 2022 timeline. In March 2019, we presented the Phase 2 Part A data at the 2019 AAD Annual Meeting as a latebreaking presentation. In December 2019, we announced CDA and CR rates from our Phase 2 Part B trial. Final data from the Phase 2 Part B trial will be submitted for presentation at an upcoming medical conference in the first half of 2020. In parallel, we are evaluating rilzabrutinib in a Phase 1/2 clinical trial in ITP, and recently amended the clinical trial protocol to add a longterm extension cohort for responders and to allow for the flexibility to enroll additional patients if we determine additional data would help inform the Phase 3 design. We presented positive data from our Phase 1/2 trial at the 61st ASH Annual Meeting in December 2019. We anticipate reporting Phase 2 data for rilzabrutinib in ITP in the second half of 2020. In January 2020, we announced an expansion in the development of rilzabrutinib into IgG4RD, an immunemediated disease of chronic inflammation and fibrosis that, if left untreated, can lead to severe morbidity including organ dysfunction and organ failure. We anticipate initiating a Phase 2 clinical trial for rilzabrutinib in IgG4RD in the first half of 2020. Beyond pemphigus, ITP, and IgG4RD, we believe there are numerous immunemediated diseases for which rilzabrutinib may have therapeutic benefit. We anticipate [/INST] Negative. </s>

I-AM CAPITAL ACQUISITION Co

2018-07-24

2018-05-31

Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations The following discussion and analysis of our financial condition and results of operations should be read in conjunction with the financial statements and the notes thereto contained elsewhere in this Report. Certain information contained in the discussion and analysis set forth below includes forward-looking statements that involve risks and uncertainties. Overview We are a blank check company incorporated on April 17, 2017 in Delaware and formed for the purpose of effecting a merger, share exchange, asset acquisition, share purchase, reorganization or similar business combination with one or more businesses. We intend to effectuate our business combination using cash from the proceeds of our IPO and the private placement, our securities, debt or a combination of cash, securities and debt. The issuance of additional shares of common stock or preferred stock: ● may significantly dilute the equity interest of our investors; ● may subordinate the rights of holders of common stock if we issue preferred shares with rights senior to those afforded to our common stock; ● could cause a change in control if a substantial number of our shares of common stock are issued, which may affect, among other things, our ability to use our net operating loss carry forwards, if any, and could result in the resignation or removal of our present officers and directors; ● may have the effect of delaying or preventing a change of control of us by diluting the stock ownership or voting rights of a person seeking to obtain control of us; and ● may adversely affect prevailing market prices for our securities. Similarly, if we issue debt securities, it could result in: ● default and foreclosure on our assets if our operating revenues after our business combination are insufficient to pay our debt obligations; ● acceleration of our obligations to repay the indebtedness even if we have made all principal and interest payments when due if we breach certain covenants that require the maintenance of certain financial ratios or reserves without a waiver or renegotiation of that covenant; ● our immediate payment of all principal and accrued interest, if any, if the debt security is payable on demand; ● our inability to obtain additional financing if the debt security contains covenants restricting our ability to obtain additional financing while such security is outstanding; ● our inability to pay dividends on our common stock; ● using a substantial portion of our cash flow to pay principal and interest on our debt, which will reduce the funds available for dividends on our common stock if declared, expenses, capital expenditures, acquisitions and other general corporate purposes; ● limitations on our flexibility in planning for and reacting to changes in our business and in the industry in which we operate; ● increased vulnerability to adverse changes in general economic, industry and competitive conditions and adverse changes in government regulation; and ● limitations on our ability to borrow additional amounts for expenses, capital expenditures, acquisitions, debt service requirements, execution of our strategy and other purposes and other disadvantages compared to our competitors who have less debt. We expect to continue to incur significant costs in the pursuit of our acquisition plans. Our plans to raise capital or to complete a business combination may not be successful. Recent Events On May 3, 2018, we entered into a definitive agreement to invest up to $49 million in Smaaash. Following the closing, our primary business will be to act as the sole master distributor of Smaaash’s active entertainment games in North and South America and as the master franchisee for Smaaash’s active entertainment centers in North and South America. The transaction is subject to customary closing conditions. See our Current Reports on Form 8-K filed with the SEC on May 9, 2018 and June 28, 2018 for further information. Results of Operations We have neither engaged in any operations nor generated any revenues to date. Our only activities from April 17, 2017 (date of inception) through May 31, 2018 were organizational activities, those necessary to prepare for our IPO, which was consummated on August 22, 2017, and identifying a target company for a business combination including the Transaction. Following our IPO, we have not generated any operating revenues and will not until after the completion of our initial business combination. We have generated $521,702 through May 31, 2018 of non-operating income in the form of interest income. We expect to incur increased expenses as a result of being a public company (for legal, financial reporting, accounting and auditing compliance), as well as for due diligence expenses. For the year ended May 31, 2018, we had net loss of $8,862, which consists of operating costs of $530,564 offset by interest income of $521,702 on cash and marketable securities held in the trust account. Liquidity and Capital Resources The completion of our IPO and simultaneous private placement, inclusive of the underwriters’ partial exercise of their over-allotment option, generated gross proceeds to us of $54,615,000. Related transaction costs amounted to approximately $3,838,000, consisting of $3,360,000 of underwriting fees, including $1,820,000 of deferred underwriting commissions payable (which are held in the trust account) and $478,000 of IPO costs. Following our IPO and the partial exercise of the over-allotment option, a total of $55,740,000 was placed in the trust account and we had $552,190 of cash held outside of the trust account, after payment of all costs related to the IPO. As of May 31, 2018, we had cash and marketable securities held in the trust account of $53,353,715, substantially all of which is invested in U.S. treasury bills with a maturity of 180 days or less. Interest income earned on the balance in the trust account may be available to us to pay taxes. Since inception, we have withdrawn $406,050 of interest income from the trust account. As of May 31, 2018, we had cash of $458,063 held outside the trust account, which is available for use by us to cover the costs associated with identifying a target business including Smaaash, negotiating a business combination, due diligence procedures and other general corporate uses. In addition, as of May 31, 2018, we had accrued expenses of $63,579. For the year ended May 31, 2018, cash used in operating activities amounted to $470,153, mainly resulting from net loss of $8,862, offset by interest earned on marketable securities held in the trust account of $521,702. Changes in our operating assets and liabilities generated cash of $60,411. We intend to use substantially all of the funds held in the trust account, including any amounts representing interest earned on the trust account (which interest shall be net of taxes payable and up to a maximum of $600,000 of working capital released to us and excluding deferred underwriting commissions) to complete our initial business combination. We may withdraw interest to pay taxes and up to $600,000 for working capital expenses, if any. To the extent that our capital stock or debt is used, in whole or in part, as consideration to complete our initial business combination, the remaining proceeds held in the trust account will be used as working capital to finance the operations of the target business or businesses, make other acquisitions and pursue our growth strategies. We intend to use the funds held outside the trust account primarily to identify and evaluate target businesses, perform business due diligence on prospective target businesses, travel to and from the offices, plants or similar locations of prospective target businesses or their representatives or owners, review corporate documents and material agreements of prospective target businesses (as well as pay personnel and advisors to do the forgoing), structure, negotiate and complete a business combination, and to pay taxes to the extent the interest earned on the trust account is not sufficient to pay our taxes. In order to fund working capital deficiencies or finance transaction costs in connection with an intended initial business combination, our sponsor or an affiliate of our sponsor or certain of our officers and directors may, but are not obligated to, loan us funds as may be required. If we complete our initial business combination, we would repay such loaned amounts. In the event that our initial business combination does not close, we may use a portion of the working capital held outside the trust account to repay such loaned amounts but no proceeds from our trust account would be used for such repayment. We do not believe we will need to raise additional funds in order to meet the expenditures required for operating our business. However, if our estimates of the costs of identifying a target business, undertaking in-depth due diligence and negotiating an initial business combination are less than the actual amount necessary to do so, we may have insufficient funds available to operate our business prior to our business combination. Moreover, we may need to obtain additional financing either to complete our business combination or because we become obligated to redeem a significant number of our public shares upon completion of our business combination, in which case we may issue additional securities or incur debt in connection with such business combination. Subject to compliance with applicable securities laws, we would only complete such financing simultaneously with the completion of our business combination. In the current economic environment, it has become especially difficult to obtain acquisition financing. If we are unable to complete our initial business combination because we do not have sufficient funds available to us, we will be forced to cease operations and liquidate the trust account. In addition, following our initial business combination, if cash on hand is insufficient, we may need to obtain additional financing in order to meet our obligations. Off-balance sheet financing arrangements We have no obligations, assets or liabilities which would be considered off-balance sheet arrangements. We do not participate in transactions that create relationships with unconsolidated entities or financial partnerships, often referred to as variable interest entities, which would have been established for the purpose of facilitating off-balance sheet arrangements. We have not entered into any off-balance sheet financing arrangements, established any special purpose entities, guaranteed any debt or commitments of other entities, or purchased any non-financial assets. Contractual obligations We do not have any long-term debt, capital lease obligations, operating lease obligations or long-term liabilities, other than an agreement to pay the sponsor a monthly fee of $10,000 for office space, utilities and administrative support provided to us. We began incurring these fees on August 16, 2017 and will continue to incur these fees monthly until the earlier of the completion of our initial business combination or our liquidation. Critical Accounting Policies The preparation of financial statements and related disclosures in conformity with GAAP requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities, disclosure of contingent assets and liabilities at the date of the financial statements, and income and expenses during the periods reported. Actual results could materially differ from those estimates. The Company has not identified any critical accounting policies.

<s>[INST] Overview We are a blank check company incorporated on April 17, 2017 in Delaware and formed for the purpose of effecting a merger, share exchange, asset acquisition, share purchase, reorganization or similar business combination with one or more businesses. We intend to effectuate our business combination using cash from the proceeds of our IPO and the private placement, our securities, debt or a combination of cash, securities and debt. The issuance of additional shares of common stock or preferred stock: may significantly dilute the equity interest of our investors; may subordinate the rights of holders of common stock if we issue preferred shares with rights senior to those afforded to our common stock; could cause a change in control if a substantial number of our shares of common stock are issued, which may affect, among other things, our ability to use our net operating loss carry forwards, if any, and could result in the resignation or removal of our present officers and directors; may have the effect of delaying or preventing a change of control of us by diluting the stock ownership or voting rights of a person seeking to obtain control of us; and may adversely affect prevailing market prices for our securities. Similarly, if we issue debt securities, it could result in: default and foreclosure on our assets if our operating revenues after our business combination are insufficient to pay our debt obligations; acceleration of our obligations to repay the indebtedness even if we have made all principal and interest payments when due if we breach certain covenants that require the maintenance of certain financial ratios or reserves without a waiver or renegotiation of that covenant; our immediate payment of all principal and accrued interest, if any, if the debt security is payable on demand; our inability to obtain additional financing if the debt security contains covenants restricting our ability to obtain additional financing while such security is outstanding; our inability to pay dividends on our common stock; using a substantial portion of our cash flow to pay principal and interest on our debt, which will reduce the funds available for dividends on our common stock if declared, expenses, capital expenditures, acquisitions and other general corporate purposes; limitations on our flexibility in planning for and reacting to changes in our business and in the industry in which we operate; increased vulnerability to adverse changes in general economic, industry and competitive conditions and adverse changes in government regulation; and limitations on our ability to borrow additional amounts for expenses, capital expenditures, acquisitions, debt service requirements, execution of our strategy and other purposes and other disadvantages compared to our competitors who have less debt. We expect to continue to incur significant costs in the pursuit of our acquisition plans. Our plans to raise capital or to complete a business combination may not be successful. Recent Events On May 3, 2018, we entered into a definitive agreement to invest up to $49 million in Smaaash. Following the closing, our primary business will be to act as the sole master distributor of Smaaash’s active entertainment games in North and South America and as the master franchisee for Smaaash’s active entertainment centers in North and South America. The transaction is subject to customary closing conditions. See our Current Reports on Form 8K filed with the SEC on May 9, 2018 and June 28, 2018 for further information. Results of Operations We have neither engaged in any operations nor generated any revenues to date. Our only activities from April 17, 2017 (date of inception) through May 31, 2018 were organizational activities, those necessary to prepare for our IPO, which was consummated on August 22, 2017, and identifying a target company for a business combination including the Transaction. Following our IPO, we have not generated any operating revenues and will not until after the completion of our initial business combination. We have generated $521,702 through May 31, 2018 of nonoperating income in the form of interest income. We expect to incur increased expenses as a result of being a public company (for legal, financial reporting, accounting and auditing compliance), as well as for due diligence expenses. For the year [/INST] Negative. </s>

Yext, Inc.

2018-03-16

2018-01-31

Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations The following discussion and analysis of our financial condition and results of operations should be read in conjunction with our consolidated financial statements and related notes appearing elsewhere in this Annual Report on Form 10-K. As discussed in the section titled "Special Note Regarding Forward Looking Statements," the following discussion and analysis contains forward looking statements that involve risks and uncertainties, as well as assumptions that, if they never materialize or prove incorrect, could cause our results to differ materially from those expressed or implied by such forward looking statements. Factors that could cause or contribute to these differences include, but are not limited to, those discussed in the section titled "Risk Factors" under Part I, Item 1A in this Annual Report on Form 10-K. Overview Yext is a knowledge engine. Our platform lets businesses control their digital knowledge in the cloud and sync it to approximately 150 services and applications, which we refer to as our PowerListings Network and includes Apple Maps, Bing, Cortana, Facebook, Google, Google Assistant, Google Maps, Siri and Yelp. We have established direct data integrations with applications in our PowerListings Network that end consumers around the globe use to discover new businesses, read reviews and find accurate answers to their queries. Our cloud-based platform, the Yext Knowledge Engine, powers all of our key features, including Listings, Pages and Reviews, along with our other features and capabilities. We offer annual and multi-year subscriptions to our platform. We had historically priced our subscriptions based on custom combinations of the features that the customer wished to access and the number of locations that the customer managed with our platform. Beginning in October 2015, we began pricing new subscriptions in a more discrete range of packages, with pricing based on specified feature sets and the number of locations managed by the customer with our platform. More recently, we are pricing subscriptions based not only on the number of physical locations, but also on the number of persons and other entities managed with our platform, such as physicians, wealth advisors and insurance agents, among others. We now refer to these locations, persons and other entities collectively as "licenses," which we believe reflects the broadening of our business into new services and our current pricing methodology. We sell our solution globally to customers of all sizes, through direct sales efforts to our customers, including third-party resellers, and through a self-service purchase process. In transactions with resellers, we are only party to the transaction with the reseller and are not a party to the reseller's transaction with its customer. While our revenue is predominantly based in the U.S., we have continued to grow internationally in recent years. We offer the same services internationally as we do in the United States, and we intend to continue to pursue a strategy of expanding our international operations. Our revenue from non-U.S. operations has grown from approximately 2% of our total revenue in the fiscal year ended January 31, 2016 to more than 10% of total revenue in the fiscal year ended January 31, 2018. Our non-U.S. revenue is defined as revenue derived from contracts that are originally entered into with our non-U.S. offices, regardless of the location of the customer. We generally direct non-U.S. customer sales to our non-U.S. offices. Our business has evolved in recent years. For example: • in 2015, we continued to expand our PowerListings Network to include over 100 global applications; • in 2016, we launched specialized integrations to our platform with applications like Uber and Snapchat, added our Reviews feature to our platform and held our inaugural industry and customer event in New York City; and • in 2017, we introduced the Yext App Directory, which enables businesses to connect information from systems across the business, such as workforce management systems and customer relationship management databases and held our second annual industry and customer event, ONWARD 2017 (formerly called "LocationWorld"), in November 2017, in New York City. We have experienced rapid growth in recent periods, nearly all of which has been organic growth as we have not historically conducted many acquisitions. Evidencing our strengthening market position in recent years, we have grown the number of licenses listed in our Knowledge Engine platform from approximately 345,000 as of January 31, 2015 to approximately 1,468,000 as of January 31, 2018. Our revenue was $170.2 million, $124.3 million and $89.7 million for the fiscal years ended January 31, 2018, 2017 and 2016, respectively. In April 2017, we closed our initial public offering ("IPO"), in which we issued and sold 12,075,000 shares of common stock inclusive of the underwriters’ option shares that were exercised in full. The price per share to the public was $11.00. We received aggregate proceeds of $123.5 million from the IPO, net of underwriters’ discounts and commissions, before deducting offering costs of $4.4 million. Upon the closing of the IPO, all shares of our outstanding preferred stock automatically converted into 43,594,753 shares of common stock. Fiscal Year Our fiscal year ends on January 31. References to fiscal 2018, for example, are to the fiscal year ended January 31, 2018. Components of Results of Operations Revenue We derive our revenue primarily from subscription services. We sell subscriptions to our cloud-based platform through contracts that are typically one year in length, but may be up to three years or longer in length. Revenue is a function of the number of customers, the number of licenses at each customer, the package, or for older contracts, number of features, to which each customer subscribes, the price of the package or the feature set and renewal rates. Revenue is recognized ratably over the contract term beginning on the commencement date of each contract, at which time the customers are granted access to the platform, the appropriate package or feature set and associated support. We typically invoice our customers in monthly, semi-annual or annual installments at the beginning of each subscription period. Amounts that have been invoiced are initially recorded as deferred revenue and are recognized ratably over the subscription period. Cost of Revenue Cost of revenue includes fees we pay for our PowerListings Network application integrations. Our arrangements with PowerListings Network providers follow one of three mechanisms: unpaid, fixed, or variable fee based on licenses served or revenue. The arrangements with many of our larger providers are unpaid. As the value of our customers' digital knowledge increases over time to our PowerListings Network providers, we expect that we will be able to negotiate lower or no fee contracts and, therefore, our provider fees as a percentage of total revenue will generally decline. Cost of revenue also includes expenses related to hosting our platform and providing support services. These expenses are primarily comprised of personnel and related costs directly associated with our cloud infrastructure and customer support, including salaries, data center capacity costs, stock-based compensation expense, benefits, and other allocated overhead costs. Operating Expenses Sales and marketing expenses. Sales and marketing expenses are our largest cost and consist primarily of salaries and related costs, including commissions and stock-based compensation expense, as well as costs related to advertising, marketing, brand awareness activities and lead generation. Research and development expenses. Research and development expenses consist primarily of salaries and related costs, including stock-based compensation expense and costs to develop new products and features. Research and development expenses are partially offset by capitalized software development costs, which we expect to grow as we continue to invest in research and development activities. General and administrative expenses. General and administrative expenses consist primarily of salaries and related costs, including stock-based compensation expense, for our finance and accounting, human resources, information technology and legal support departments, as well as professional and consulting fees in connection with these departments. Results of Operations The following table sets forth selected consolidated statement of operations data for each of the periods indicated: (1) Amounts include stock-based compensation expense as follows: The following table sets forth selected consolidated statements of operations data for each of the periods indicated as a percentage of total revenue: Fiscal Year Ended January 31, 2018 Compared to Fiscal Year Ended January 31, 2017 Revenue and Cost of Revenue Total revenue was $170.2 million for the fiscal year ended January 31, 2018, compared to $124.3 million for the fiscal year ended January 31, 2017, an increase of $45.9 million or 37%. This increase was primarily due to new customer acquisitions and expanded subscriptions sold to existing customers. Revenue from our enterprise and mid-size customers, which include third-party reseller customers, increased 43%, growing from approximately $106.6 million to $152.7 million, and excludes revenue from small business customers, which by their nature have limited licenses and inherently high turnover. Cost of revenue was $44.1 million for the fiscal year ended January 31, 2018, compared to $37.0 million for the fiscal year ended January 31, 2017, an increase of $7.1 million or 19%. This increase was primarily due to an increase of $4.0 million in personnel-related costs, which mainly consisted of salaries and wages, reflecting higher headcount, and an increase of $0.9 million in depreciation expense. Stock-based compensation expense increased $0.9 million due to a combination of the increased fair value of our underlying common stock and additional stock-based awards granted. Gross margin improved to 74.1% from 70.3%, as revenue growth outpaced the increase in cost of revenue. Operating Expenses Sales and marketing expenses were $127.0 million for the fiscal year ended January 31, 2018, compared to $81.5 million for the fiscal year ended January 31, 2017, an increase of $45.5 million, or 56%. The increase was primarily due to an increase of $27.4 million in personnel-related costs, which mainly consisted of salaries and wages, as well as commissions, as we continued to expand our sales force to invest in our overall growth. Stock-based compensation expense increased $6.8 million due to a combination of the increased fair value of our underlying common stock and additional stock-based awards granted. Research and development expenses were $25.7 million for the fiscal year ended January 31, 2018, compared to $19.3 million for the fiscal year ended January 31, 2017, an increase of $6.4 million, or 33%. The increase was primarily due to an increase of $3.1 million in personnel-related costs, which mainly consisted of salaries and wages, reflecting higher headcount. Stock-based compensation expense increased $1.8 million due to a combination of the increased fair value of our underlying common stock and additional stock-based awards granted. General and administrative expenses were $40.1 million for the fiscal year ended January 31, 2018, compared to $29.2 million for the fiscal year ended January 31, 2017, an increase of $10.9 million, or 37%. The increase was primarily due to an increase of $4.6 million in personnel-related costs, which mainly consisted of salaries and wages, reflecting higher headcount. Stock-based compensation expense increased $3.1 million due to a combination of the increased fair value of our underlying common stock and additional stock-based awards granted. Fiscal Year Ended January 31, 2017 Compared to Fiscal Year Ended January 31, 2016 Revenue and Cost of Revenue Revenue increased primarily due to the continued growth of our customer base and expanded subscriptions sold to existing customers. Approximately $13.2 million of this increase was attributable to new customers during the period. Growth was even greater for revenue from our enterprise and mid-size business and reseller customers, which represent the substantial majority of our revenue, and not including direct sales to small business customers, which by their nature have limited licenses and experience inherently high turnover. Our revenue from those enterprise and mid-size customers grew by 46% from $73.1 million to $106.6 million. Cost of revenue increased primarily due to an increase in PowerListings Network application provider fees of $2.8 million, which grew from $16.3 million to $19.1 million, as some of our PowerListings Network application provider costs are variable and increase with increased sales volume. Of the increase in provider costs during the fiscal year ended January 31, 2017, $1.9 million was attributable to increases in variable costs from certain PowerListings Network provider arrangements that required us to pay increased fees based on the number of active licenses on our platform or as a percentage of our revenue. In addition, personnel-related costs, which mainly consisted of salaries and wages, increased $1.6 million from $8.9 million to $10.5 million, driven by increased headcount. Gross margin improved to 70.3% from 65.4%, as revenue growth outpaced the increase in cost of revenue. Operating Expenses The increase in sales and marketing expenses was primarily driven by personnel-related costs, which increased $21.4 million, from $27.3 million to $48.7 million, and mainly consisted of salaries and wages, commissions and bonuses. The increase in personnel-related costs was primarily due to an increased headcount, which grew from 249 to 372 employees in the sales and marketing function year over year, as we continued to expand our sales force to invest in our overall growth. Stock-based compensation expense increased $2.8 million from $1.6 million to $4.4 million, due to a combination of additional stock-based awards to new hires and the increasing valuation of our underlying common stock. In addition, in November 2016, we held our inaugural LocationWorld industry and customer event, which accounted for $1.6 million in sales and marketing expense. Research and development expenses increased primarily due to increases in personnel-related costs, which increased $2.8 million due to increased headcount and mainly consisted of salaries and wages. Stock-based compensation increased $0.7 million, from $1.3 million to $2.0 million, due to a combination of additional stock-based awards to new hires and the increasing valuation of our underlying common stock. The overall increase reflects our continued investment in our overall growth. General and administrative expenses increased primarily due to increases in personnel-related costs, which increased $4.8 million and mainly consisted of salaries and wages, in line with our increase in headcount, which grew from 55 to 82 employees in general and administrative functions year over year. Recruiting and professional fees increased $1.4 million from $6.5 million to $7.9 million to support our overall growth and scale our operations. Stock-based compensation increased $1.8 million, from $1.1 million to $2.9 million, due to a combination of additional stock-based awards to new hires and the increasing valuation of our underlying common stock. Quarterly Results of Operations The following tables set forth our unaudited quarterly consolidated statements of operations data for each of the eight quarters in the period ended January 31, 2018. The information for each of these quarters has been prepared on the same basis as the audited annual consolidated financial statements included elsewhere in this Annual Report on Form 10-K and, in the opinion of management, includes all adjustments, which consist only of normal recurring adjustments, necessary for the fair presentation of the results of operations for these periods in accordance with GAAP. This data should be read in conjunction with our audited consolidated financial statements and related notes included elsewhere in this Annual Report on Form 10-K. These quarterly operating results are not necessarily indicative of our operating results for a full year or any future period. Quarterly Trends Our quarterly revenue has increased sequentially for all periods presented, primarily due to new customer acquisitions and expanded subscriptions sold to existing customers. We expect both upselling to our existing customer base and new customer acquisitions to continue to be significant drivers of our revenue growth. We have not historically experienced meaningful seasonality in our revenue, although our recent growth and the nature of our subscription agreements, generally resulting in revenue recognition ratably over the contract term, may have the effect of mitigating potential seasonality. Total cost of revenue has generally increased over the periods, primarily due to increased personnel-related costs, coinciding with an increase in the number of employees required to run our growing business. Gross margin has generally improved over the periods, as revenue growth outpaced the increase in cost of revenue, and in more recent quarters has begun to stabilize. We have seen our PowerListings Network application provider costs decline as a percentage of revenue as our data set becomes more important to those providers such that we are able to negotiate more favorable terms with them. Gross margin may decrease at times as we enter new international markets in which we have yet to achieve efficiencies of scale, or introduce new features and products. Sales and marketing expenses generally increased over the periods, primarily due to an expanding sales and marketing team and related expenses. Research and development expenses have generally increased over the periods, primarily due to an increase in personnel-related costs associated with developing new products and features for our platform. General and administrative expenses have grown sequentially for all periods presented, primarily due to an increase in costs required to support our growing business. Our quarterly results may fluctuate due to various factors affecting our performance. Because we recognize revenue from subscription and support fees ratably over the term of the contract, changes in our contracting activity in the near term may not be apparent as a change to our reported revenue until future periods. Most of our expenses are recorded as period costs and thus factors affecting our cost structure may be reflected in our financial results sooner than changes to our revenue. Liquidity and Capital Resources As of January 31, 2018, our principal sources of liquidity were cash, cash equivalents and marketable securities totaling $118.3 million. Our cash, cash equivalents and marketable securities are comprised primarily of bank deposits, money market funds, commercial paper, corporate bonds and U.S. treasury securities. We believe our existing cash, cash equivalents and marketable securities will be sufficient to meet our projected operating requirements for at least the next 12 months. Our future capital requirements will depend on many factors, including those set forth under "Risk Factors." We may in the future enter into arrangements to acquire or invest in complementary businesses, services and technologies, and intellectual property rights. We may be required to seek additional equity or debt financing. In the event that additional financing is required from outside sources, we may not be able to raise it on terms acceptable to us or at all. If we are unable to raise additional capital when desired, our business, operating results and financial condition would be adversely affected. Credit Facility On March 16, 2016, we entered into a Loan and Security agreement with Silicon Valley Bank that provides for a $15.0 million revolving credit line ("Revolving Line") and a $7.0 million Letter of Credit facility (together with the Revolving Line, the "Credit Agreement"). The original Credit Agreement had a maturity date of March 16, 2018. Subsequent to the fiscal year ended January 31, 2018, in March 2018, the Credit Agreement was amended to extend the maturity date to March 16, 2020. We are obligated to pay ongoing commitment fees at a rate equal to 0.25% for the Revolving Line and 1.75% for any issued letters of credit. Subject to certain terms of the Credit Agreement, we may borrow, prepay and reborrow amounts under the Revolving Line at any time during the agreement and amounts repaid or prepaid may be reborrowed. Interest rates on borrowings under the Revolving Line will be based on one-half of one percent (0.50%) above the prime rate. The prime rate is defined as the rate of interest per annum from time to time published in the money rate section of the Wall Street Journal. The Credit Agreement contains certain customary affirmative and negative covenants, including an adjusted quick ratio of at least 1.25 to 1.00, minimum revenue, a limit on our ability to incur additional indebtedness, dispose of assets, make certain acquisition transactions, pay dividends or make distributions, and certain other restrictions on our activities. On November 18, 2016, we drew $5.0 million on our Revolving Line for operating purposes. On April 28, 2017, we repaid the $5.0 million on our Revolving Line. As of January 31, 2018, we had no debt outstanding and availability under our Revolving Line was $15.0 million. Cash Flows The following table summarizes our cash flows: Operating Activities Cash used in operating activities of $31.9 million for the fiscal year ended January 31, 2018 was primarily due to the net loss of $66.6 million, a change in accounts receivable of $17.0 million, mainly due to timing of billing and cash collections during the period, a change in deferred commissions of $4.4 million and a change in prepaid expenses and other current assets of $4.0 million. These decreases were partially offset by a change in deferred revenue of $31.8 million, stock-based compensation expense of $22.4 million, depreciation and amortization of $5.1 million and a change in deferred rent of $0.8 million. Cash used in operating activities of $7.7 million for the fiscal year ended January 31, 2017 was primarily due to a net loss of $43.2 million, partially offset by stock-based compensation expense of $9.9 million, the release of $5.8 million of restricted cash primarily associated with amounts previously held as collateral against our office leases, and depreciation and amortization of $4.1 million. The net change in operating assets and liabilities was primarily due to a change in the deferred revenue balance of $20.9 million and accounts receivable balance of $4.1 million, mainly due to timing of billing and cash collections during the period. The increase in accounts payable, accrued expenses and other current liabilities of $6.0 million was offset by increases in prepaid expenses and other current assets of $1.6 million and deferred commissions of $5.6 million. The increase in deferred commissions reflected the growth in headcount and sales resulting in increased compensation and sales commissions. Cash used in operating activities of $10.5 million for the fiscal year ended January 31, 2016 was primarily due to a net loss of $26.5 million, partially offset by stock-based compensation expense of $4.5 million and depreciation and amortization of $3.1 million. The net change in operating assets and liabilities was primarily due to a change in the deferred revenue balance of $12.9 million, partially offset by an increase in accounts receivable of $12.1 million, mainly due to timing of billing and cash collections during the period. The change in accounts payable, accrued expenses and other current liabilities of $8.3 million was attributable to an increase in compensation cost due to headcount growth, as well as future payments for sales tax due to customer billing. The change in deferred rent of $2.1 million was related to a tenant improvement allowance received for the leasehold improvements in our New York headquarters. These changes were offset by changes in prepaid expenses and other current assets of $0.2 million. The changes were attributable to increased spending related to operational growth of our business. Investing Activities Cash used in investing activities of $88.1 million for the fiscal year ended January 31, 2018 was related to purchases of marketable securities of $110.6 million and capital expenditures of $3.7 million, offset by maturities and sales associated with marketable securities of $26.2 million. Cash used in investing activities for the fiscal year ended January 31, 2017 was $3.8 million and primarily related to capital expenditures of $3.5 million. Cash used in investing activities for the fiscal year ended January 31, 2016 was $10.0 million and primarily related to capital expenditures, largely associated with leasehold improvements in our New York headquarters. Financing Activities Cash provided by financing activities of $129.6 million for the fiscal year ended January 31, 2018 was primarily related to proceeds from our IPO of $123.5 million, net of underwriting discounts and commissions, as well as proceeds from exercises of stock options of $11.6 million, and proceeds from employee stock purchase plan withholdings of $3.8 million. These amounts were partially offset by the $5.0 million repayment on our Revolving Line and $4.3 million of payments related to deferred offering costs. Cash provided by financing activities for the fiscal year ended January 31, 2017 was $6.0 million and primarily related to $5.0 million drawn on our revolving credit line, as well as $1.3 million of proceeds from the exercise of stock options, partially offset by payments of deferred offering costs and deferred financing costs. Cash provided by financing activities for the fiscal year ended January 31, 2016 was $1.6 million, which consisted primarily of $28.3 million used for share repurchases pursuant to a tender offer and stock option settlements in connection with the tender offer, offset by $29.5 million in proceeds from the contemporaneous sale of common stock to existing investors and $0.4 million in proceeds from the exercise of stock options. Contractual Obligations We are obligated under certain non-cancelable operating leases for office space, the agreements for which expire at various dates between fiscal years 2019 and 2028, including a long term operating lease for our primary facility in New York, which expires in December 2020. We are a party to various agreements with PowerListings Network application providers, the agreements for which expire at various dates between fiscal years 2019 and 2035. The following table summarizes our non-cancelable contractual obligations as of January 31, 2018 (in thousands): (1) Includes the minimum contractual commitment levels of any variable payments to PowerListings Network application providers. We have minimum contractual commitments with certain of our PowerListings Network application providers. Also includes other contractual obligations in the normal course of business. Off-Balance Sheet Arrangements We do not engage in transactions that generate relationships with unconsolidated entities or financial partnerships, such as entities often referred to as structured finance or special purpose entities, as part of our ongoing business. Accordingly, our operating results, financial condition and cash flows are not subject to off-balance sheet risks. Critical Accounting Policies and Estimates Our management's discussion and analysis of our financial condition and results of operations is based on our financial statements, which have been prepared in accordance with GAAP. The preparation of these financial statements requires us to make estimates and assumptions that affect the reported amounts of assets and liabilities and the disclosure of contingent assets and liabilities at the date of the financial statements, as well as the reported revenue generated and expenses incurred during the reporting periods. Our estimates are based on our historical experience and various other factors that we believe are reasonable under the circumstances, the results of which form the basis for making judgments about items that are not readily apparent from other sources. Actual results may differ from these estimates under different assumptions or conditions. Refer to Note 2 "Summary of Significant Accounting Policies" to our consolidated financial statements for further discussion on our accounting policies. Our most critical accounting policies and estimates, based on the degree of judgment and complexity, are discussed below. Revenue Recognition We derive our revenue primarily from subscription services. We sell subscriptions to our platform through contracts that are typically one year in length, but may be up to three years or longer in length. Our subscription contracts do not provide customers with the right to take possession of the software supporting the applications and, as a result, are accounted for as service contracts. We sell our products through our direct sales force to our customers, including third-party resellers. We recognize revenue when four basic criteria are met: (1) persuasive evidence exists of an arrangement with the customer reflecting the terms and conditions under which the services will be provided; (2) services have been provided or delivery has occurred; (3) the fee is fixed or determinable; and (4) collection is reasonably assured. Collectability is assessed based on a number of factors, including the creditworthiness of a customer and transaction history. We recognize revenue based on the amount billed to our customers. Our revenue consists of contractual fees for subscription and support services charged to our customers on a per-license basis. In transactions with resellers, we contract only with the reseller, in which pricing and length of subscription and support services are agreed upon. The reseller negotiates the price charged and length of subscription and support service directly with its customer. We do not pay separate fees to third-party resellers and do not have direct interactions with the reseller’s customer. Subscription Revenue. Subscription revenue recognition commences on the date that our platform is made available to the customer, which is the subscription start date, provided all of the other criteria described above are met. Revenue is recognized based on the terms of the customer contracts, which include a fixed fee based upon the actual or contractual number of licenses, and is recognized on a straight-line basis over the contractual term of the arrangement. Multiple Deliverable Arrangements. Certain of our arrangements include both a subscription to our platform and support services. We evaluate each element in an arrangement to determine whether it represents a separate unit of accounting. An element constitutes a separate unit of accounting when the delivered item has standalone value and delivery of the undelivered element is probable and within our control. Our support services are not sold separately from the subscription and there is no alternative use for them. Further, no other vendor provides similar support services. Based on these factors, the support services do not have standalone value. Accordingly, subscription and support revenue is combined and recognized as a single unit of accounting. Stock-Based Compensation Stock-based compensation for all stock-based awards, including options to purchase common stock, restricted stock and restricted stock units, is measured at fair value on the date of grant and recognized over the service period. The fair value of stock options is estimated on the date of grant using a Black-Scholes model. The fair value of restricted stock and restricted stock units are estimated on the date of grant based on the fair value of our common stock. Stock-based compensation expense is recognized over the requisite service periods of awards, which is typically four years for options and one to four years for restricted stock and restricted stock units, and includes an estimated forfeiture rate. The estimated forfeiture rate applied is based on historical forfeiture rates. We plan to elect to continue to estimate a forfeiture rate upon adoption of ASU No. 2016-09, "Improvements to Employee Share-Based Payments Accounting," effective February 1, 2018. The estimated number of stock-based awards that will ultimately vest requires judgment, and to the extent actual results, or updated estimates, differ from our current estimates, such amounts will be recorded as a cumulative adjustment in the period estimates are revised. A higher forfeiture rate will result in an adjustment that will decrease stock-based compensation expense, whereas a lower forfeiture rate will result in an adjustment that will increase stock-based compensation expense. Our assumptions about stock price volatility are based on the average of the historical volatility for a sample of comparable companies. The expected life assumptions for employee grants are based upon the simplified method, as we do not yet have sufficient historical exercise data to provide a reasonable basis upon which to estimate our expected term, due to the limited period of time our equity shares have been publicly traded. The expected life assumptions for non-employees are based upon the remaining contractual term of the option. The dividend yield assumption is zero, because we have not historically paid any dividends and do not expect to declare or pay any dividends in the foreseeable future. The risk-free interest rate is based on the U.S. treasury yield curve in effect at the time of grant. We will continue to use judgment in evaluating the assumptions related to our stock-based compensation. As we continue to accumulate additional data related to our common stock, we may refine our estimates. If factors change and different assumptions are used, the impact to our stock-based compensation expense could be material. Income Taxes We account for income taxes in accordance with ASC Topic 740, “Income Taxes”. Under this method, deferred income taxes are provided for temporary differences between the financial reporting and tax basis of our assets and liabilities. We classify all deferred tax assets and liabilities as non-current on the consolidated balance sheet. The effect of a change in tax rates on deferred tax assets and liabilities is recognized within the (provision for) benefit from income taxes on the consolidated statement of operations and comprehensive loss in the period that includes the enactment date. We reduce deferred tax assets, if necessary, by a valuation allowance if it is more likely than not that we will not realize some or all of our deferred tax assets. In making such a determination, we consider all available positive and negative evidence, including future reversals of existing taxable temporary differences, projected future taxable income, tax-planning strategies, and results of recent operations. Refer to Note 11 "Income Taxes" to our consolidated financial statements for additional information on the composition of these valuation allowances and for information on the impact of U.S. tax reform legislation. We recognize the tax benefit from an uncertain tax position only if it is more likely than not that the tax position will be sustained on examination by taxing authorities, based on the technical merits of the position. We recognize interest and penalties related to uncertain tax positions within the (provision for) benefit from income taxes on our consolidated statement of operations and comprehensive loss. Recent Accounting Pronouncements See Note 2 "Summary of Significant Accounting Policies" to the consolidated financial statements for our discussion about adopted and pending recent accounting pronouncements.

<s>[INST] Overview Yext is a knowledge engine. Our platform lets businesses control their digital knowledge in the cloud and sync it to approximately 150 services and applications, which we refer to as our PowerListings Network and includes Apple Maps, Bing, Cortana, Facebook, Google, Google Assistant, Google Maps, Siri and Yelp. We have established direct data integrations with applications in our PowerListings Network that end consumers around the globe use to discover new businesses, read reviews and find accurate answers to their queries. Our cloudbased platform, the Yext Knowledge Engine, powers all of our key features, including Listings, Pages and Reviews, along with our other features and capabilities. We offer annual and multiyear subscriptions to our platform. We had historically priced our subscriptions based on custom combinations of the features that the customer wished to access and the number of locations that the customer managed with our platform. Beginning in October 2015, we began pricing new subscriptions in a more discrete range of packages, with pricing based on specified feature sets and the number of locations managed by the customer with our platform. More recently, we are pricing subscriptions based not only on the number of physical locations, but also on the number of persons and other entities managed with our platform, such as physicians, wealth advisors and insurance agents, among others. We now refer to these locations, persons and other entities collectively as "licenses," which we believe reflects the broadening of our business into new services and our current pricing methodology. We sell our solution globally to customers of all sizes, through direct sales efforts to our customers, including thirdparty resellers, and through a selfservice purchase process. In transactions with resellers, we are only party to the transaction with the reseller and are not a party to the reseller's transaction with its customer. While our revenue is predominantly based in the U.S., we have continued to grow internationally in recent years. We offer the same services internationally as we do in the United States, and we intend to continue to pursue a strategy of expanding our international operations. Our revenue from nonU.S. operations has grown from approximately 2% of our total revenue in the fiscal year ended January 31, 2016 to more than 10% of total revenue in the fiscal year ended January 31, 2018. Our nonU.S. revenue is defined as revenue derived from contracts that are originally entered into with our nonU.S. offices, regardless of the location of the customer. We generally direct nonU.S. customer sales to our nonU.S. offices. Our business has evolved in recent years. For example: in 2015, we continued to expand our PowerListings Network to include over 100 global applications; in 2016, we launched specialized integrations to our platform with applications like Uber and Snapchat, added our Reviews feature to our platform and held our inaugural industry and customer event in New York City; and in 2017, we introduced the Yext App Directory, which enables businesses to connect information from systems across the business, such as workforce management systems and customer relationship management databases and held our second annual industry and customer event, ONWARD 2017 (formerly called "LocationWorld"), in November 2017, in New York City. We have experienced rapid growth in recent periods, nearly all of which has been organic growth as we have not historically conducted many acquisitions. Evidencing our strengthening market position in recent years, we have grown the number of licenses listed in our Knowledge Engine platform from approximately 345,000 as of January 31, 2015 to approximately 1,468,000 as of January 31, 2018. Our revenue was $170.2 million, $124.3 million and $89.7 million for the fiscal years ended January 31, 2018, 2017 and 2016, respectively. In April 2017, we closed our initial public offering ("IPO"), in which we issued and sold 12,075,000 shares of common stock inclusive of the underwriters’ option shares that were exercised in full. The price per share to the public was $11.00. We received aggregate proceeds of $123.5 [/INST] Negative. </s>

Yext, Inc.

2019-03-15

2019-01-31

Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations The following discussion and analysis of our financial condition and results of operations should be read in conjunction with our consolidated financial statements and related notes appearing elsewhere in this Annual Report on Form 10-K. As discussed in the section titled "Special Note Regarding Forward Looking Statements," the following discussion and analysis contains forward looking statements that involve risks and uncertainties, as well as assumptions that, if they never materialize or prove incorrect, could cause our results to differ materially from those expressed or implied by such forward looking statements. Factors that could cause or contribute to these differences include, but are not limited to, those discussed in the section titled "Risk Factors" under Part I, Item 1A in this Annual Report on Form 10-K. Overview Yext is a knowledge engine. Our platform lets businesses control their digital knowledge in the cloud and sync it to more than 150 services and applications, which we refer to as our Knowledge Network and includes Amazon Alexa, Apple Maps, Bing, Cortana, Facebook, Google, Google Assistant, Google Maps, Siri and Yelp. We have established direct data integrations with applications in our Knowledge Network that end consumers around the globe use to discover new businesses, read reviews and find accurate answers to their queries. Our cloud-based platform, the Yext Knowledge Engine, powers all of our key features, including Listings, Pages and Reviews, along with our other features and capabilities. We offer annual and multi-year subscriptions to our platform. Subscriptions are offered in a discrete range of packages with pricing based on specified feature sets and the number of licenses managed with our platform. We sell our solution globally to customers of all sizes, through direct sales efforts to our customers, including third-party resellers, and through a self-service purchase process. In transactions with resellers, we are only party to the transaction with the reseller and are not a party to the reseller's transaction with its customer. While the majority of our revenue is based in the U.S., we continue to grow internationally. We offer the same services internationally as we do in the United States, and we intend to continue to pursue a strategy of expanding our international operations. Our revenue from non-U.S. operations was more than 14% of total revenue for the fiscal year ended January 31, 2019. Our non-U.S. revenue is defined as revenue derived from contracts that are originally entered into with our non-U.S. offices, regardless of the location of the customer. We generally direct non-U.S. customer sales to our non-U.S. offices. Our business has evolved in recent years. For example: • in 2016, we launched specialized integrations to our platform with applications like Uber and Snapchat, added our Reviews feature to our platform and held our inaugural industry and customer event in New York City. • in 2017, we introduced the Yext App Directory, which enables businesses to connect information from systems across the business, such as workforce management systems and customer relationship management databases and held our second annual industry and customer event, ONWARD 2017 (formerly called "LocationWorld"), in November 2017, in New York City. • in 2018, we launched a global integration with Amazon to give businesses control over the answers Amazon Alexa provides about them and held our third annual industry and customer event, ONWARD18, in October 2018, in New York City. We have experienced rapid growth in recent periods, nearly all of which has been organic growth as we have not historically conducted many acquisitions. Our revenue was $228.3 million, $170.2 million and $124.3 million for the fiscal years ended January 31, 2019, 2018 and 2017, respectively. Fiscal Year Our fiscal year ends on January 31st. References to fiscal 2019, for example, are to the fiscal year ended January 31, 2019. Components of Results of Operations Revenue We derive our revenue primarily from subscriptions and associated support to our cloud-based Knowledge Engine platform. Our contracts are typically one year in length, but may be up to three years or longer in length. Revenue is a function of the number of customers, the number of licenses with each customer, the package to which each customer subscribes, the price of the package and renewal rates. Revenue is generally recognized ratably over the contract term beginning on the commencement date of each contract, which is the date our platform is made available to customers. At the beginning of each subscription term we invoice our customers, typically in annual installments, but also monthly, quarterly, and semi-annually. Amounts that have been invoiced for non-cancelable contracts are recorded in accounts receivable and in unearned revenue or revenue, depending on when the transfer of control to customers has occurred. Cost of Revenue Cost of revenue primarily relates to costs incurred in association with our cloud-based Knowledge Engine platform, which includes fees we pay to our Knowledge Network application providers. The nature of these arrangements may be unpaid, fixed, or variable. The arrangements with many of our larger providers are unpaid. As the value of our customers' digital knowledge increases over time to our Knowledge Network application providers, we expect that we will be able to negotiate lower or no fee contracts and, therefore, our provider fees as a percentage of total revenue will generally decline. Cost of revenue also includes expenses related to hosting our platform and associated support, which is comprised of salaries, data center capacity costs, stock-based compensation expense, benefits, and other allocated overhead costs. Operating Expenses Sales and marketing expenses. Sales and marketing expenses consist primarily of personnel and related costs, including salaries, costs of obtaining revenue contracts and stock-based compensation expense. Sales and marketing expenses also consist of costs related to advertising, marketing, brand awareness activities and lead generation. Research and development expenses. Research and development costs are expensed as incurred. Research and development expenses consist primarily of salaries and related costs, including stock-based compensation expense and exclude capitalized software development costs. General and administrative expenses. General and administrative expenses consist primarily of salaries and related costs, including stock-based compensation expense, for our finance and accounting, human resources, information technology and legal support departments, as well as professional and consulting fees in connection with these departments. Results of Operations The following table sets forth selected consolidated statement of operations data for each of the periods indicated: (1) Results for the fiscal year ended January 31, 2019 reflect our modified retrospective adoption of ASU 2014-09. Results for the fiscal years ended January 31, 2018 and 2017, respectively, continue to be reported in accordance with historical accounting standards under ASC 605. See Note 2 "Summary of Significant Accounting Policies," for further discussion. (2) Amounts include stock-based compensation expense as follows: The following table sets forth selected consolidated statements of operations data for each of the periods indicated as a percentage of total revenue: Fiscal Year Ended January 31, 2019 Compared to Fiscal Year Ended January 31, 2018 Revenue and Cost of Revenue Total revenue was $228.3 million for the fiscal year ended January 31, 2019, compared to $170.2 million for the fiscal year ended January 31, 2018, an increase of $58.1 million or 34%. This increase was primarily due to new customers and expanded subscriptions sold to existing customers. Revenue from our enterprise and mid-size customers, which include third-party reseller customers, grew from approximately $152.7 million to $213.0 million, and excludes revenue from small business customers, which by their nature have inherently high turnover. Cost of revenue was $57.4 million for the fiscal year ended January 31, 2019, compared to $44.1 million for the fiscal year ended January 31, 2018, an increase of $13.3 million or 30%. This increase was primarily due to a $5.2 million increase in personnel-related costs, which mainly consisted of salaries and wages. Knowledge Network application provider fees, as well as costs associated with our data centers, each increased $1.7 million. In addition, depreciation expense and stock-based compensation expense each increased $1.5 million. Gross margin improved to 74.9% from 74.1%, as revenue growth outpaced the increase in cost of revenue. Operating Expenses Sales and marketing expense was $158.8 million for the fiscal year ended January 31, 2019, compared to $127.0 million for the fiscal year ended January 31, 2018, an increase of $31.9 million, or 25%. The increase was primarily due to a $13.1 million increase in personnel-related costs, which mainly consisted of salaries and wages, as well as an increase in stock-based compensation expense of $11.4 million. These increases were partially offset as sales and marketing expense for the fiscal year ended January 31, 2019 benefited from the modified retrospective adoption of ASU 2014-09, effective February 1, 2019, which resulted in capitalizing more costs associated with obtaining revenue contracts, and such costs being amortized over a longer period of time than under the previous guidance. Research and development expense was $36.1 million for the fiscal year ended January 31, 2019, compared to $25.7 million for the fiscal year ended January 31, 2018, an increase of $10.4 million, or 41%. The increase was primarily due to a $5.4 million increase in personnel-related costs, which mainly consisted of salaries and wages, as well as a $4.7 million increase in stock-based compensation expense. General and administrative expense was $51.6 million for the fiscal year ended January 31, 2019, compared to $40.1 million for the fiscal year ended January 31, 2018, an increase of $11.5 million, or 29%. The increase was primarily due to a $4.3 million increase in stock-based compensation expense, as well as a $3.5 million increase in personnel-related costs, which mainly consisted of salaries and wages, reflecting higher headcount. Fiscal Year Ended January 31, 2018 Compared to Fiscal Year Ended January 31, 2017 Revenue and Cost of Revenue Total revenue was $170.2 million for the fiscal year ended January 31, 2018, compared to $124.3 million for the fiscal year ended January 31, 2017, an increase of $45.9 million or 37%. This increase was primarily due to new customers and expanded subscriptions sold to existing customers. Revenue from our enterprise and mid-size customers, which include third-party reseller customers, increased 43%, growing from approximately $106.6 million to $152.7 million, and excludes revenue from small business customers, which by their nature have inherently high turnover. Cost of revenue was $44.1 million for the fiscal year ended January 31, 2018, compared to $37.0 million for the fiscal year ended January 31, 2017, an increase of $7.1 million or 19%. This increase was primarily due to an increase of $4.0 million in personnel-related costs, which mainly consisted of salaries and wages, reflecting higher headcount, and an increase of $0.9 million in depreciation expense. Stock-based compensation expense increased $0.9 million due to a combination of the increased fair value of our underlying common stock and additional stock-based awards granted. Gross margin improved to 74.1% from 70.3%, as revenue growth outpaced the increase in cost of revenue. Operating Expenses Sales and marketing expense was $127.0 million for the fiscal year ended January 31, 2018, compared to $81.5 million for the fiscal year ended January 31, 2017, an increase of $45.5 million, or 56%. The increase was primarily due to an increase of $27.4 million in personnel-related costs, which mainly consisted of salaries and wages, as well as commissions, as we continued to expand our sales force to invest in our overall growth. Stock-based compensation expense increased $6.8 million due to a combination of the increased fair value of our underlying common stock and additional stock-based awards granted. Research and development expense was $25.7 million for the fiscal year ended January 31, 2018, compared to $19.3 million for the fiscal year ended January 31, 2017, an increase of $6.4 million, or 33%. The increase was primarily due to an increase of $3.1 million in personnel-related costs, which mainly consisted of salaries and wages, reflecting higher headcount. Stock-based compensation expense increased $1.8 million due to a combination of the increased fair value of our underlying common stock and additional stock-based awards granted. General and administrative expense was $40.1 million for the fiscal year ended January 31, 2018, compared to $29.2 million for the fiscal year ended January 31, 2017, an increase of $10.9 million, or 37%. The increase was primarily due to an increase of $4.6 million in personnel-related costs, which mainly consisted of salaries and wages, reflecting higher headcount. Stock-based compensation expense increased $3.1 million due to a combination of the increased fair value of our underlying common stock and additional stock-based awards granted. Quarterly Results of Operations The following tables set forth our unaudited quarterly consolidated statements of operations data for each of the eight quarters in the period ended January 31, 2019 and 2018, respectively. The information for each of these quarters has been prepared on the same basis as the audited annual consolidated financial statements included elsewhere in this Annual Report on Form 10-K and, in the opinion of management, includes all adjustments, which consist only of normal recurring adjustments, necessary for the fair presentation of the results of operations for these periods in accordance with GAAP. This data should be read in conjunction with our audited consolidated financial statements and related notes included elsewhere in this Annual Report on Form 10-K. These quarterly operating results are not necessarily indicative of our operating results for a full year or any future period. 1 As adjusted from previously reported quarterly amounts due to the adoption of ASU 2014-09. See Note 2 "Summary of Significant Accounting Policies" to our consolidated financial statements for a discussion on our adoption. See Note 15 “Selected Quarterly Financial Data (Unaudited)” for adjustments to previously reported quarterly amounts for the fiscal year ended January 31, 2019. 2 Results for each of the quarterly periods within the fiscal year ended January 31, 2018 continue to be reported in accordance with historical accounting standards under ASC 605. Quarterly Trends Our quarterly revenue has increased sequentially for all periods presented, primarily due to new customers and expanded subscriptions and associated support sold to existing customers. We expect both upselling to our existing customer base and new customers to continue to be significant drivers of our revenue growth. While unearned revenue on the consolidated balance sheet may be influenced by seasonality driven by annual invoicing in the fourth quarter, we have not historically experienced meaningful seasonality in our revenue. The nature of our subscription agreements generally results in revenue recognition ratably over the contract term, thereby mitigating the effect of potential seasonality in our revenue. Total cost of revenue has increased sequentially for all periods presented, primarily due to increased personnel-related costs, including salaries and wages. Gross margin has generally improved over the periods, as revenue growth outpaced the increase in cost of revenue, and in more recent quarters has begun to stabilize. We have seen our Knowledge Network application provider costs decline as a percentage of revenue as our data set becomes more important to those providers such that we are able to negotiate more favorable terms with them. Gross margin may decrease at times as we enter new international markets in which we have yet to achieve efficiencies of scale, or introduce new features and products. Sales and marketing expenses generally increased over the periods, primarily due to increased personnel-related costs, including salaries and wages. Research and development expenses have generally increased over the periods, primarily due to an increase in personnel-related costs associated with developing new products and features for our platform. General and administrative expenses have grown sequentially for all periods presented, primarily due to an increase in costs required to support our growing business. Our quarterly results may fluctuate due to various factors affecting our performance. Because we generally recognize revenue from our contracts with customers ratably over the term of the contract, changes in our contracting activity in the near term may not be apparent as a change to our reported revenue until future periods. Most of our expenses are recorded as period costs and thus factors affecting our cost structure may be reflected in our financial results sooner than changes to our revenue. Liquidity and Capital Resources As of January 31, 2019, our principal sources of liquidity were cash, cash equivalents and marketable securities totaling $142.8 million. Our cash, cash equivalents and marketable securities are comprised primarily of bank deposits, money market funds, commercial paper, corporate bonds and U.S. treasury securities. We believe our existing cash, cash equivalents and marketable securities will be sufficient to meet our projected operating requirements for at least the next 12 months. Our future capital requirements will depend on many factors, including those set forth under "Risk Factors." We may in the future enter into arrangements to acquire or invest in complementary businesses, services, technologies, intellectual property rights, and new or expanded facilities. We may be required to seek additional equity or debt financing. In the event that additional financing is required from outside sources, we may not be able to raise it on terms acceptable to us or at all. If we are unable to raise additional capital when desired, our business, operating results and financial condition would be adversely affected. Credit Facility On March 16, 2016, we entered into a Loan and Security agreement with Silicon Valley Bank that provides for a $15.0 million revolving credit line ("Revolving Line") and a $7.0 million Letter of Credit facility (together with the Revolving Line, the "Credit Agreement"). The original Credit Agreement had a maturity date of March 16, 2018. Subsequent to the fiscal year ended January 31, 2018, in March 2018, the Credit Agreement was amended to extend the maturity date to March 16, 2020. We are obligated to pay ongoing commitment fees at a rate equal to 0.25% for the Revolving Line and 1.75% for any issued letters of credit. Subject to certain terms of the Credit Agreement, we may borrow, prepay and reborrow amounts under the Revolving Line at any time during the agreement and amounts repaid or prepaid may be reborrowed. Interest rates on borrowings under the Revolving Line will be based on one-half of one percent (0.50%) above the prime rate. The prime rate is defined as the rate of interest per annum from time to time published in the money rate section of the Wall Street Journal. The Credit Agreement contains certain customary affirmative and negative covenants, including an adjusted quick ratio of at least 1.25 to 1.00, minimum revenue, a limit on our ability to incur additional indebtedness, dispose of assets, make certain acquisition transactions, pay dividends or make distributions, and certain other restrictions on our activities. As of January 31, 2019, we were in compliance with all debt covenants. As of such date, the $15.0 million Revolving Line was fully available. The $7.0 million Letter of Credit facility had $5.3 million allocated as security in connection with office space as of the fiscal year ended January 31, 2019. Subsequent to the fiscal year-end, in February 2019, an additional $1.4 million was allocated in connection with new office space, resulting in $0.3 million remaining available under the Letter of Credit facility. Cash Flows The following table summarizes our cash flows: Operating Activities Net cash provided by operating activities of $5.2 million for the fiscal year ended January 31, 2019 was primarily due to a change in unearned revenue of $47.0 million and non-cash charges related to stock-based compensation expense of $44.2 million, as well as a change in accounts payable, accrued expenses and other current liabilities of $17.3 million and non-cash charges related to depreciation and amortization expense of $6.8 million. These increases were partially offset by the net loss of $74.8 million, as well as changes in costs to obtain revenue contracts of $16.8 million, accounts receivable of $11.6 million, mainly due to timing of billing and cash collections during the period, and prepaid expenses and other current assets of $6.7 million. Net cash used in operating activities of $32.4 million for the fiscal year ended January 31, 2018 was primarily due to the net loss of $66.6 million, a change in accounts receivable of $17.0 million, mainly due to timing of billing and cash collections during the period, a change in deferred commissions of $4.4 million and a change in prepaid expenses and other current assets of $4.0 million. These decreases were partially offset by a change in deferred revenue of $31.8 million, stock-based compensation expense of $22.4 million, depreciation and amortization of $5.1 million and a change in deferred rent of $0.8 million. Net cash used in operating activities of $13.5 million for the fiscal year ended January 31, 2017 was primarily due to a net loss of $43.2 million, partially offset by stock-based compensation expense of $9.9 million, and depreciation and amortization of $4.1 million. The net change in operating assets and liabilities was primarily due to a change in the deferred revenue balance of $20.9 million and accounts receivable balance of $4.1 million, mainly due to timing of billing and cash collections during the period. The increase in accounts payable, accrued expenses and other current liabilities of $6.0 million was offset by increases in prepaid expenses and other current assets of $1.6 million and deferred commissions of $5.6 million. The increase in deferred commissions reflected the growth in headcount and sales resulting in increased compensation and sales commissions. Investing Activities Net cash provided by investing activities of $28.1 million for the fiscal year ended January 31, 2019 was due to maturities of marketable securities of $86.3 million, partially offset by purchases of marketable securities of $52.9 million, and capital expenditures of $5.3 million. Net cash used in investing activities of $88.1 million for the fiscal year ended January 31, 2018 was related to purchases of marketable securities of $110.6 million and capital expenditures of $3.7 million, offset by maturities and sales associated with marketable securities of $26.2 million. Net cash used in investing activities for the fiscal year ended January 31, 2017 was $3.8 million and primarily related to capital expenditures of $3.5 million. Financing Activities Net cash provided by financing activities of $24.4 million for the fiscal year ended January 31, 2019 was primarily related to proceeds from exercises of stock options of $18.9 million, and $5.7 million of net proceeds from employee stock purchase plan withholdings. Net cash provided by financing activities of $129.6 million for the fiscal year ended January 31, 2018 was primarily related to proceeds from our IPO of $123.5 million, net of underwriting discounts and commissions, as well as proceeds from exercises of stock options of $11.6 million, and $3.8 million of net proceeds from employee stock purchase plan withholdings. These amounts were partially offset by the $5.0 million repayment on our Revolving Line and $4.3 million of payments related to deferred offering costs. Net cash provided by financing activities for the fiscal year ended January 31, 2017 was $6.0 million and primarily related to $5.0 million drawn on our revolving credit line, as well as $1.3 million of proceeds from the exercise of stock options, partially offset by payments of deferred offering costs and deferred financing costs. Contractual Obligations We are obligated under certain non-cancelable operating leases for office space, the agreements for which expire at various dates between fiscal years 2020 and 2028, including a long term operating lease for our primary facility in New York, which expires in December 2020. We are a party to various agreements with Knowledge Network application providers, the agreements for which expire at various dates between fiscal years 2020 and 2035. The following table summarizes our non-cancelable contractual obligations as of January 31, 2019 (in thousands): (1) Includes the minimum contractual commitment levels of any variable payments to certain Knowledge Network application providers, as well as other contractual obligations in the normal course of business. Subsequent to the fiscal year ended January 31, 2019, we entered into lease agreements for offices in Rosslyn, VA and London, UK, with expiration dates subsequent to the fiscal year ending January 31, 2024, and related aggregate contractual obligations of approximately $41 million. Off-Balance Sheet Arrangements We do not engage in transactions that generate relationships with unconsolidated entities or financial partnerships, such as entities often referred to as structured finance or special purpose entities, as part of our ongoing business. Accordingly, our operating results, financial condition and cash flows are not subject to off-balance sheet risks. Critical Accounting Policies and Estimates Our management's discussion and analysis of our financial condition and results of operations is based on our financial statements, which have been prepared in accordance with GAAP. The preparation of these financial statements requires us to make estimates and assumptions that affect the reported amounts of assets and liabilities and the disclosure of contingent assets and liabilities at the date of the financial statements, as well as the reported revenue generated and expenses incurred during the reporting periods. Our estimates are based on our historical experience and various other factors that we believe are reasonable under the circumstances, the results of which form the basis for making judgments about items that are not readily apparent from other sources. Actual results may differ from these estimates under different assumptions or conditions. See Note 2 "Summary of Significant Accounting Policies" to our consolidated financial statements for further discussion on our accounting policies. Our most critical accounting policies and estimates, based on the degree of judgment and complexity, are discussed below. Revenue Recognition We derive our revenue primarily from our subscription and associated support to our cloud-based Knowledge Engine platform, through contracts that are typically one year in length, but may be up to three years or longer in length. Our subscriptions do not provide customers with the right to take possession of the software supporting the applications and, as a result, are accounted for as service contracts. The recognition of revenue is determined through application of the five-step model in accordance with ASC 606. Revenue is recognized upon transfer of control of services to our customers, including third-party resellers, in an amount that reflects the consideration we expect to receive in exchange for those services. In transactions with resellers, we contract only with the reseller, in which pricing and length of subscription and support services are agreed upon. The reseller negotiates the price charged and length of subscription and support service directly with its customer. We do not pay separate fees to third-party resellers and do not have direct interactions with the reseller’s customer. Revenue is generally recognized ratably over the contract term beginning on the commencement date of each contract, which is the date our platform is made available to our customers. Amounts that have been invoiced for non-cancelable contracts are recorded in accounts receivable and in unearned revenue or revenue, depending on when the transfer of control to customers has occurred. See Note 2 "Summary of Significant Accounting Policies" and Note 3 "Revenue" to our consolidated financial statements for further discussion on our revenue recognition. Costs Capitalized to Obtain Revenue Contracts We capitalize costs to obtain revenue contracts which are incremental and recoverable, including sales commissions, certain related incentives, and associated payroll tax and fringe benefit costs. We amortize such costs on a straight-line basis over the average benefit period, which is typically three years for new contracts and one year for renewals. We determined the average benefit period having considered both qualitative and quantitative factors, most notably the estimated life of capitalized software development costs resulting from additional functionality to our cloud-based Knowledge Engine platform. Amortization of costs capitalized to obtain revenue contracts is included in sales and marketing expense in the consolidated statements of operations and comprehensive loss. Stock-Based Compensation Stock-based compensation for all employee stock-based awards, including restricted stock units, restricted stock and options to purchase common stock, is measured at fair value on the date of grant and recognized over the service period. The fair value of restricted stock units and restricted stock are calculated based on the fair value of our common stock on the date of grant, while the fair value of stock options are calculated using a Black-Scholes model. Stock-based compensation expense is recognized over the requisite service periods of awards, which is typically four years for options and one to four years for restricted stock and restricted stock units. The estimated forfeiture rate applied is based on historical forfeiture rates. The estimated number of stock-based awards that will ultimately vest requires judgment, and to the extent actual results, or updated estimates, differ from our current estimates, such amounts will be recorded as a cumulative adjustment in the period actual results are realized or estimates are revised. A higher forfeiture rate will result in an adjustment that will decrease stock-based compensation expense, whereas a lower forfeiture rate will result in an adjustment that will increase stock-based compensation expense. Our assumptions about stock price volatility are based on the average of the historical volatility for a sample of comparable companies. The expected life assumptions for employee grants are based upon the simplified method, as we do not yet have sufficient historical exercise data to provide a reasonable basis upon which to estimate our expected term due to the limited period of time our equity shares have been publicly traded. The risk-free interest rate is based on the U.S. treasury yield curve in effect at the time of grant. The dividend yield assumption is zero, because we have not historically paid any dividends and do not expect to declare or pay any dividends in the foreseeable future. We calculate the expected life assumptions for non-employees based on the remaining contractual term of the award, and plan to continue to use the contractual term upon adoption of ASU 2018-07, "Compensation - Stock Compensation (Topic 718): Improvements to Non-employee Share-Based Payment Accounting," effective February 1, 2019. We will continue to use judgment in evaluating the assumptions related to our stock-based compensation. As we continue to accumulate additional data related to our common stock, we may refine our estimates. If factors change and different assumptions are used, the impact to our stock-based compensation expense could be material. Income Taxes We account for income taxes in accordance with ASC Topic 740, “Income Taxes,” under which deferred income taxes are provided for temporary differences between the financial reporting and tax basis of our assets and liabilities. We classify all deferred tax assets and liabilities as non-current on the consolidated balance sheet. The effect of a change in tax rates on deferred tax assets and liabilities is recognized within the (provision for) benefit from income taxes on the consolidated statement of operations and comprehensive loss in the period that includes the enactment date. We reduce deferred tax assets, if necessary, by a valuation allowance if it is more likely than not that we will not realize some or all of our deferred tax assets. In making such a determination, we consider all available positive and negative evidence, including future reversals of existing taxable temporary differences, projected future taxable income, tax-planning strategies, and results of recent operations. We recognize the tax benefit from an uncertain tax position only if it is more likely than not that the tax position will be sustained on examination by taxing authorities, based on the technical merits of the position. We recognize interest and penalties related to uncertain tax positions within the (provision for) benefit from income taxes on our consolidated statement of operations and comprehensive loss. Recent Accounting Pronouncements See Note 2 "Summary of Significant Accounting Policies" to the consolidated financial statements for our discussion about adopted and pending recent accounting pronouncements.

<s>[INST] Overview Yext is a knowledge engine. Our platform lets businesses control their digital knowledge in the cloud and sync it to more than 150 services and applications, which we refer to as our Knowledge Network and includes Amazon Alexa, Apple Maps, Bing, Cortana, Facebook, Google, Google Assistant, Google Maps, Siri and Yelp. We have established direct data integrations with applications in our Knowledge Network that end consumers around the globe use to discover new businesses, read reviews and find accurate answers to their queries. Our cloudbased platform, the Yext Knowledge Engine, powers all of our key features, including Listings, Pages and Reviews, along with our other features and capabilities. We offer annual and multiyear subscriptions to our platform. Subscriptions are offered in a discrete range of packages with pricing based on specified feature sets and the number of licenses managed with our platform. We sell our solution globally to customers of all sizes, through direct sales efforts to our customers, including thirdparty resellers, and through a selfservice purchase process. In transactions with resellers, we are only party to the transaction with the reseller and are not a party to the reseller's transaction with its customer. While the majority of our revenue is based in the U.S., we continue to grow internationally. We offer the same services internationally as we do in the United States, and we intend to continue to pursue a strategy of expanding our international operations. Our revenue from nonU.S. operations was more than 14% of total revenue for the fiscal year ended January 31, 2019. Our nonU.S. revenue is defined as revenue derived from contracts that are originally entered into with our nonU.S. offices, regardless of the location of the customer. We generally direct nonU.S. customer sales to our nonU.S. offices. Our business has evolved in recent years. For example: in 2016, we launched specialized integrations to our platform with applications like Uber and Snapchat, added our Reviews feature to our platform and held our inaugural industry and customer event in New York City. in 2017, we introduced the Yext App Directory, which enables businesses to connect information from systems across the business, such as workforce management systems and customer relationship management databases and held our second annual industry and customer event, ONWARD 2017 (formerly called "LocationWorld"), in November 2017, in New York City. in 2018, we launched a global integration with Amazon to give businesses control over the answers Amazon Alexa provides about them and held our third annual industry and customer event, ONWARD18, in October 2018, in New York City. We have experienced rapid growth in recent periods, nearly all of which has been organic growth as we have not historically conducted many acquisitions. Our revenue was $228.3 million, $170.2 million and $124.3 million for the fiscal years ended January 31, 2019, 2018 and 2017, respectively. Fiscal Year Our fiscal year ends on January 31st. References to fiscal 2019, for example, are to the fiscal year ended January 31, 2019. Components of Results of Operations Revenue We derive our revenue primarily from subscriptions and associated support to our cloudbased Knowledge Engine platform. Our contracts are typically one year in length, but may be up to three years or longer in length. Revenue is a function of the number of customers, the number of licenses with each customer, the package to which each customer subscribes, the price of the package and renewal rates. Revenue is generally recognized ratably over the contract term beginning on the commencement date of each contract, which is the date our platform is made available to customers. At the beginning of each subscription term we invoice our customers, typically in annual installments, but also monthly, quarterly, and semiannually. Amounts that have been invoiced for noncancelable contracts are recorded in accounts receivable and in unearned revenue or revenue, depending on when the transfer of control to customers has occurred. Cost of Revenue Cost of revenue primarily relates to costs incurred in association with our cloudbased Knowledge Engine platform, which includes fees we pay to our Knowledge [/INST] Positive. </s>